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Rising Yields Take Toll On Stocks

S&PDouble click on any image for a full size view

As always happens, rising yields have finally started to matter to the stock market.

What I wanted to discuss in this blog post is to what extent damage has been done, is there more to come, and what are we doing based upon the analysis.

If you look at the S&P 500 graph above, you will see that I have annotated it.  It is those annotations that I want to focus our analysis on so that we can develop a thesis for action.

Let’s start with the blue arrows on the price graph.  The lines around the price graph are trend lines based upon the 50 (solid green), 200 (solid purple), and 250 (solid red) day moving averages.  The dashed lines represent a band of +/- 10% around each of those trend lines.  The S&P 500 tends to move between the bands around the 250 day moving average.  These act as significant support and resistance levels to prices on the index.    You can see that I have a blue arrow pointing to the price line where it bounced off the dashed red line at the top when the market peaked in Jan/Feb this year and fell back to support at the purple 200 day moving average line.

The other moving average lines also act as support and resistance to prices on the on the index – I’ve marked several other blue arrows to show you how it happens.

What I want to focus you on is the last arrow on the right.  That is where we are today and you can see that the price has bounced off the 200 day moving average – and so far the 200 is holding.  I don’t have an arrow pointing to the peak price on the graph on September 20th, but you can see that prices never moved up to the top of the red dashed line – meaning they were never as extended as they were in Jan/Feb.  Part of that is the slope of the move up to both peaks – in the Jan/Feb peak, you can see prices moved up faster and the line is much steeper than the move to the recent peak.  From a technical perspective, that is a healthier move higher and more sustainable than the steeper/faster move in prices.

However, on the downside, I want you to look at the green 50 day moving average line and you can see that for three days, it held the price decline, but when it broke, you see the big move down yesterday (the long red thick straight line next to today’s much smaller/thinner red line).  The long red line represents a big move in prices yesterday (down 3.4%) and the thickness represents huge volume (the highest of the year).

What we want to focus on is whether the purple 200 day moving average line can hold and the market can stabilize, or will it break and we are left with the 250 day moving average as our last resistance before a significant correction ensues.

In writing this blog over the years, I’ve written about my Trendline Rule of Three.  When a support or resistance trend line is broken for less than three days, then you can consider that it held.  But if that line is broken for more than three days or three percent, then you must begin to look at the next trendline for your support or resistance.  In our discussion of the green 50 day moving average above, after three days, it was broken for greater than 3% meaning it is no longer in play and our hopes rest on the purple 200 day moving average holding and stabilizing the market.

But, since hope is not an investment strategy, we must look at supporting evidence to draw a conclusion.  Things like:

> price oscillators to gauge whether we are over-bought or over-sold,

> monthly price levels to confirm changes in trend,

> investor cash flow coming into or out of the market,

> volatility readings, and

> the health of the financial markets overall.

Price Oscillators

Lets focus on the two green boxes.  The uppermost one shows the relative strength index and the significant move below the 30 indicator line tells us that we are severely over-sold at the current time.  The lower one shows a similar reading below the 20 and 15 indicator lines.

Both of these price oscillators are short term indicators, but they are saying that we will be having a near-term bounce higher in prices soon.

Neither of these indicates how high the market will go back up on that bounce.  Just remember, 3.5% above current levels is the green 50 day moving average line that will act as resistance to any move higher.  So you have to assume that any move higher will be limited to 3.5% or less on the first attempt to move back above the 50 day moving average.  Does it have to be limited?  No, but the odds are greater that it will be since the resistance is there.  In most cases, to break above a resistance trend line, it takes a few attempts and even a retrace back to the lower support level (currently our purple 200 day moving average line).

Our conclusion is that we are due for a short-term bounce higher in stock prices in the near future.  It may be limited to 3% or so and it may retest resistance of the 200 day moving average line.

Monthly Price Levels

We look at monthly price levels to confirm either a continuation of a trend or a change in trend.

Last month we had a high on the index of 2940.91, and we closed positive for the month.  This month, we have broken beneath last month’s low 2864.12. We now need to close beneath 2864.12 on the last trading day of this month to imp give us a reversal of the bull market uptrend.

Our conclusion is that since we are trading below 2864.12 now, this indicates we need to be cautious with our investment activity, but not take any action to prematurely sell significant amounts of our stock holdings.

Investor Cash Flow

Let’s look at the Red box on the money flow indicator.  You can see that in Jan/Feb, cash flow into the market reach unsustainable readings, indicating that investor enthusiasm and euphoria got too high which always precedes a drop in stock prices.  The pink arrow to its right shows you that there was never the excess cash flow indicative of investor euphoria.  That supports our analysis above when examining the price line that we had never gotten as extended on prices as we did in Jan/Feb.

I also want you to see that we do not have a reading below the 20 indicator line telling us that lack of cash flow has reached unsustainable levels, meaning this intermediate term indicator says it is not yet time to be a buyer.   A reading below the 20 line (and particular the 10 line which isn’t labeled) is one of those situations where, if you are an investor that wants to use margin, you would have a fairly low risk entry point to buy stock on margin.  Clearly we are not there yet, so going all in on the market and using margin to buy stocks in the current sell-off is a dangerous prospect.

Our conclusion here is that from an intermediate term perspective it is not time to be either a buyer or a seller.

Volatility Readings

The black line superimposed over the green area graph is the VIX Volatility Index.  It represents investors buying options to protect against a significant correction in the market.  You can see the purple and pink arrow pointing to the black line graph.  Back in Jan/Feb, this line went from under 10 to above 35.  Under 10 is an indication that the market has too much enthusiasm and that raising some cash is warranted – over 35 is an indication that there is too much pessimism and that a buying opportunity should come soon.

The pink arrow shows you where we are today.  The steep increase of the past two days coincides naturally with the sell-off.  However, you can see that we have not risen above the level of the sell-off last April where the 200 day moving average resistance line held at a higher low than the Jan/Feb correction.  We can also see that the line never got below 10 after the Jan/Feb correction, never indicating a significant correction was coming.

Our conclusion here is that volatility has returned, but the VIX is not currently telling us that the sell-off is likely to turn into a full blown correction.  That can change in an instant, but right now the odds are against it.

Financial Market Health

The green area graph in the bottom panel represents the TED Spread.  The ted spread is the difference between interest paid on dollar denominated bank deposits in Europe versus the USA.  The concept is that the difference widens during times of financial market stress and narrows during times of relative calm in the markets.

I’ve drawn a purple downward sloping arrow from the peak of the green area graph  in April to today’s level.  Back in April, we were all concerned about the health of some of the European banks who were under-capitalized but had loan losses that would cause the banks to go under.  Due to the interconnected nature of the financial system, a major European bank failing would have world-wide repercussions on the financial system, and potentially could take down other banks, including those in the USA.

That peak on the graph coincided with the April sell-off in the market, but as Germany stepped in an recapitalized the failing banks, the crisis was averted and the financial system stress abated.  You can see that I have circled in purple the today’s level, which has been holding steady at a low level during this sell-off.

Our conclusion here is that the Ted Spread is indicating that at the current time there is not some macro economic issue that would impact the global financial system causing the stock market to drop significantly.

Conclusion and Strategy

Based upon our reading of the trend lines, price levels, and indicators, the current sell-off should be contained to either the 200 day moving average or the 250 day moving average.  We will likely see a move higher to the 50 day moving average and a retest of the 200 day moving average while the market consolidates this move lower and looks for a reason to either break above the 50 or below the 200 – and since we are entering earnings season, the results being better or worse than expected will probably be the determining factor in this movement.

From the conclusion above, our strategy is to be cautious but not panic and sell prematurely in this sharp sell-off.  We want to wait to see if the 200 day moving average holds as resistance, and if not, whether the 250 day moving average holds as resistance. We also want to end the month above 2864.12 on the S&P 500 Index, which is between the 50 and 200 day moving averages.

We are, however, selling some shares of companies whose price is currently greater than their fair value.  This will give us some cash to reinvest in companies that are both undervalued and that have sold off greater than the broader market.  We have been making those sales, and when we determine if the 200 holds, that will be our indicator to begin buying.

In an uptrending market, we would hold onto those shares and not sell them as the earnings growth anticipates higher fair market values ahead.  However, given uncertainty, we must stick to our discipline and act prudently for clients.  The companies will move into the bull pen of companies we have owned in the past that we want to own in the future based upon valuation and earnings growth.

Reading the market is never easy and it is always a best guess proposition based upon your reading of the price action and the indicators you trust.  I have been at this for 35+ years, and by writing this blog, I am hoping to share some of the knowledge I have accumulated and inform you of what we are doing with client money and why based upon our analysis and strategy.

As things change, I will be back here on the blog with updates for you – let’s just keep a positive outlook that it will be because of higher prices.

–Mark