Even though the S&P 500 has declined about 6.5% since the April closing high, the current pattern or sector rotation implies this is not yet the beginning of a new bear trend.

The first two charts below show the period of distribution preceding the 2011 correction, characterized by a rotation into the classically defensive sectors of Consumer Staples, Healthcare and Utilities.

The following two charts show the April and May highs of this year were not characterized by a similar pattern of rotation into these defensive sectors.  This supports our thesis that the broad market indices should test or moderately exceed the April and May highs  before embarking on a new bear trend.  If this outlook is correct, then we should observe a more obvious rotation into the defensive sectors of consumer staples, healthcare and utilities over the next several months. 

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This week’s news that Spain double-dips back into recession follows last week’s news the UK also re-entered a recession. In fact, the partial list of Western European countries (re) entering a recession keeps growing, and includes Greece, Portugal, Italy, Ireland and Belgium (there are actually 11 countries on this list).

The problem is that if the dominoes keep falling in Europe, and China continues to slow, the negative impact on the U.S. economy is most likely unavoidable.

Despite the mainstream contention that U.S. markets will not be largely impacted by European (or Asian) recessions, the long-term correlations in the global markets suggests otherwise.

The chart below of the S&P 500, Britain’s FTSE 100 and Germany’s DAX 100 shows the long-term correlation between these markets. In fact, global markets have been highly correlated since the latter part of the 1990’s, showing there is very little risk reduction in global equity diversification.

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As a reminder the equity markets continue to be highly driven by the musings – intentions – interventions of the Federal Reserve Bank, consider these two incidents:

On March 26 Fed Chief Bernanke said that further improvements in the labor market could be supported by “continued accommodative policies.”  The chart below shows the rather immediate results of that comment.

In contrast, when the minutes of the Federal Reserve’s policy meeting in March were released, the following chart shows the reaction in the S&P 500 upon the knowledge that only a couple of members suggested that more “quantitative easing” could become necessary if the economy lost momentum.

Both charts are intra-day showing the trading in 30 minute increments. The impact on both days was nearly 1% volatility within that 30 minute period.

Today stocks have rallied sharply mainly on the proclamation from Fed Chief Ben Bernanke that the central bank needs to extend its accommodative monetary policies intended to encourage job growth – and which, oh by the way, have helped levitate stocks for three years.

Never mind that increasing the central bank’s balance sheet by 2 trillion dollars since 2008 has hardly helped the Fed fulfill one of its twin mandates – maximizing employment – as the chart below indicates. This graphic from Calculated Risk compares the current jobs recovery to the other post-WWII employment recessions.

The obvious take-away is that the Fed’s money printing efforts seem to have bypassed Main Street and landed on Wall Street. As the old saying goes, “Don’t fight the Fed,” or any central bank, for that matter, especially when they join forces to monetarily inundate the globe.

For practical purposes, we can divide the economies of the world into two categories: the commodity consuming economies (U.S. and the developed European countries) and the commodity producing economies (Australia, Canada, Brazil – to name a few).  Of greater concern is the bubble this monetary policy is creating in the U.S. equity market.

Since 1998 there has been a persisting correlation between the U.S. equity market and the currencies of these commodity producing economies, as the global demand for commodities has helped fuel stock prices.  As the chart below shows, since the beginning of this year the commodity-based equities have weakened against the S&P 500, possibly reflecting a lower global demand for commodities.

It appears the increased liquidity fueled by the Fed interventions, along with the anticipation of more liquidity is finding its way into the U.S. equity markets,  resulting in this divergence – and which should eventually pressure equity prices.

Charts are for illustrative purposes only, do not represent any actual portfolio, and are not a solicitation or an offer to buy any security or instrument, or to participate in any trading strategy.  Please keep in mind that you cannot invest directly in an index or an average, such as the S&P 500 Index.

Since Apple (AAPL) is the most heavily weighted stock in the U.S. equity indices and therefore most all index funds, (along with being the largest holding in most hedge funds), it is a good idea to put into perspective the meteoric stock price increase since 2009.

The following chart is courtesy of Matthew Claassen at Claassen Research, and shows the comparison between the rapid advance in Apple’s stock price and the NASDAQ Composite price bubble in year 2000.

Even though this comparison shows correlation, history does not always repeat exactly. However, history does suggest that these parabolic-type advances can outlast expectations, but also can end very badly.

Apple compared to NASDAQ Composite 1993-2000

One way to determine if the market is “overbought” or “oversold”‘ is to look at an indicator of the market in relation to its past. One such indicator is the 200-day moving average (200 DMA).

A moving average is the average closing price of an index or a security over a specific period. While it smooths the price data to show the trend, it does not predict the direction of the price. It is, however, useful in looking at a trend, which in this case the 200 DMA would be considered an indicator of a long term trend.

An oversold/overbought condition can be determined by looking at the price of an index in relation to its 200 DMA. In the chart below, the smoothed blue line is the 200 DMA, and the dotted red lines represent a 10% distance both above and below the 200 DMA.

Coming out of the 2002-2003 bear market, it was not uncommon for the S&P 500 price to trade more than 7-8% above the 200 DMA. However, when the index reached this extreme, the market became overbought and eventually regressed back to the moving average.

During the precipitous drop in 2008, the market traded below the lower 10% band becoming so oversold that it snapped back to trade above the upper 10% band in 2009. Just like a stretched rubber band when released, the market also tends to snap back to the opposite extreme when stretched to extreme oversold or overbought conditions.

Overbought and oversold conditions can persist an irrationally long time, but history suggests that once these extreme conditions are reached, the days of that trend persisting without a reaction are numbered. Currently, the market is about 8% above the 200 DMA.

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For the last 11 weeks the market has enjoyed a momentum drive that has trumped Greek sovereign default risk, some corporate earnings concerns, and even over-bullish and over-bought technical indicators. This driving force behind the market seems to be the anticipation of another round of quantitative easing. As we witnessed in both QE1 and QE2, the Fed’s willingness to intervene with aggressive stimulation can become the dominant force in the market.

Previous momentum trends similar to the current market have lasted between ten and twelve weeks before corrections lasting two to four weeks, as can be observed in April of 2010…

And again in November of 2010…

And most recently in February of 2011.

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Historically, the intermediate trends in commodity prices and treasury yields have been a reliable indicator of investor perceptions of the economy. In fact, since 1998 there has been an observable positive correlation between equities, commodity prices and treasury yields.  Strength in commodities and yields tend to indicate confidence in the economy, and thus are usually accompanied by increasing equity prices.

Recently there has been a divergence between equities, and treasury yields and commodities (not included on the chart below), as indicated by the second set of green arrows.  This weakness in yields and commodity prices would be interpreted as a negative outlook on economic growth for the coming year.  We do not know whether this divergence will be resolved by equities turning down, or yields and commodities turning up, but we can reasonably assume that this recent unconfirmed strength in equity prices raises the risk level.

However, the chart also shows the last time there was a divergence between yields and equity prices – in 2010 when the Fed Chief Ben Bernanke indicated a second round of quantitative easing (QE2).  The equity market lifted off, and subsequently yields rose.  Perhaps we are seeing a repeat of this scenario where recent gains in equity prices are anticipating another round of artificial stimulation to be announced by the Fed in their March meeting.

Another observable pattern has been the negative correlation between equity prices and the U.S. dollar index. Typically, rising equity prices are the “risk-on” trade, and the dollar index declines.  When declining equity prices and fear enter the market, investors tend to flee to the “risk-off” trade consisting of the dollar index and treasury bonds. Recently, rising equity prices have been accompanied by a rising dollar index as indicated  by (C) on the chart below.

This uncharacteristic correlation happened in early 2010 (A) and was followed by a decline in equity prices (B).  It is interesting that the current risk-on trade (E) is following the same pattern.  It is reasonable to conclude that either the dollar index will continue to turn down (D) to make way for higher equity prices, or we will soon see a correction.

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Even though the correction in gold is reminiscent of the steep draw-down in 2008, the fundamental factors driving gold have not changed – the underlying driver being the penchant of central banks to devalue their currency in hopes of eventually having even a remote chance of paying off massive debt with cheaper dollars, euros, yen, etc.

These massive sovereign debts and dangerous deficits may succeed in delaying the consequences of violating natural laws, but thinking people around the world are taking steps to hedge against these consequences, including accumulating forms of currency with intrinsic value.

Unchanged fundamentals, however, do not preclude periodic corrections, some of which will bring the consensus to conclude that “the bull market in gold is over.” Using the iShares Comex Gold Trust as a proxy for gold, the first chart below shows the extent so far of the current correction compared to the one in 2008, if you are looking at the price of gold on a daily basis.

Even if you are only looking at the price of gold on a monthly basis, the correction so far is still significant, but not as steep as in 2008.

A quarterly check on the price of gold hardly raises an eyebrow…

…and if you only check the price of gold at the end of each year, you might wonder what all the fuss is about.

Based on sentiment alone, it’s possible the current correction may have run most of its course. The chart below is from SentimenTrader, and shows public opinion on gold is nearing the lows of 2008.  Typically, sentiment is a contrary indicator, and the current negative opinion should eventually be bullish for gold.

Should the sell-off continue for a while longer, the trend-line of gold since the 2008 correction will be broken, and the next area of support should be around 1462.50 for the spot price.

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Charts are for illustrative purposes only, do not represent any actual portfolio, and are not a solicitation or an offer to buy any security or instrument, or to participate in any trading strategy.

On Wednesday of this week the market surged over 4% on the news of a coordinated central bank intervention. This extraordinary action between the Federal Reserve, the European Central Bank, the Bank of England, the Bank of Canada, the bank of Japan and the Swiss National Bank would not have happened of there were not an urgent need – most likely a major foreign bank on the verge of collapse.

This was not the first time for central banks to coordinate urgent intervention. Two recent examples are December 2007 and October 2008. In both of these instances the market surged in the short term, but was followed by a resumption of the market’s intermediate downtrend.

On Thursday USA Today ran a front page article enumerating the 10 biggest point gains for the Dow Jones Industrial Average, of which Wednesday’s 490 point gain was the 10th. I thought it would be interesting to chart the other nine biggest point gains to see the price action that preceded and followed these explosive rallies.  With the exception of the March 2009 rally, every other instance was shortly followed by a resumption of the intermediate downtrend.

The bottom line is that these single-day surges are more indicative of bear market rallies, rather than new or renewed bull markets.

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A sideways trading pattern has developed over the last two weeks in the S&P 500 that has taken the shape of a triangle identified by the blue lines on the chart below.  This is commonly known as a continuation pattern, and can either be bullish or bearish.  As you can see the short term trend since October has been bullish, increasing the probability of a breakout above the top end of the trading range at 1292.  If this breakout does occur, a near-term target for the S&P 500 would be around 1340. 

Since the expectations are for a breakout to the up-side, a breakdown below the bottom of this trading range would a negative, possibly resuming the longer-term bear trend.  Until this pattern is resolved one way or the other, the market truly does have its “feet firmly planted in mid-air.”

In addition to the shorter-term perspective above, another pattern has been developing regarding the longer-term outlook.  The market appears to be tracking a pattern similar to the one in the March to June 2008 time period.  At that time, the 200-day price average proved to the point where the counter-trend rally ended, and that leg of the secular bear market resumed.  If this pattern is repeating, the rally from the October low could be terminating over the next several weeks.

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Thanks to Matt Claassen and Ron Griess for recently pointing out these chart patterns.  Certain types of patterns that represent the struggle between buyers and sellers tend to repeat, and it is the recognition of these patterns that allows us to guess at what the possibilities might be. The weakness of this methodology, however, is that these possibilities can change from minute to minute as the market changes.

The strength of last Thursday’s rally was a news driven event that pushed up some of the European stock indexes over 5%, and over 3% on this side of the pond. One of the offshoots was the financial press obsessing about the historically big month for stocks in October, and the bullish implications going forward. So, Ron Griess from The Chart Store decided to do a study looking at other months since 1928 where there were strong gains for the S&P Composite, and the subsequent market performance. The results of that study are in the table below.

A quick look at the table shows that one month later about 50% of the time the market followed-through to the upside, with nearly the same results going out one year later. Even though there was a bullish bias about 65% of the time for the intervening months, the moral of the story is that these occasions do not extend any predictive value to the long term investor, especially if this volatility is rooted in highly emotional news events.

In fact, the fragility of the agreement among the Eurozone policy makers to once again bail our Greece and shore up bank capital to insulate against further sovereign-debt default was demonstrated by the surprise announcement that Greece will hold a voter referendum on the bail-out plan. This news event startled investors resulting in global markets tumbling on the news on Monday and Tuesday.

Below you can see the French and the German markets falling nearly 5% at the news on Monday, along with the Euro gapping lower, as seen in the third chart below.

The damage was also done in the U.S. markets, as evidenced by chart of the S&P 500 (SPX) below. The starting price for the SPX on the big up-day last Thursday was 1243.97. The fact that those strong gains were quickly surrender this week, and the market closed back below 1243.97 shows that the investor emotion that created this strong up-day has been reversed.

It would not be unexpected to see a reaction rally in the market, possibly to test the 200-day moving average (dotted line on the chart). Keep in mind that today we have a Federal Reserve announcement, a G-20 meeting this week, a November 23 deadline for a $1.2 Trillion deficit reduction agreement by the Super Committee, and the on-going Greek problems to boot.

Given the market’s proclivity to wide emotional swings on news-driven events, it would not be surprising to see at least one of these events startle the markets (to put it lightly).

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The chart below shows a trading range that can be very typical of a bear market – volatility on both the downside and upside. A bear market rally can be powerful when it is initially fueled by traders rushing to buy back the shares they have sold short.

Two things are noticeable from this chart: the trading range since the initial leg down in August, and the frequent number of 90% days, also called panic buying or selling days. A 90% down day is when 90% of the volume for the day is in declining stocks, and 90% of the total point moves are to the downside. The opposite would be true for a 90% up day.

In the chart I have highlighted the 90% up and down days in green and red respectively, beginning with the decline in July. Intuitively, one would expect that the 90% up days would be fueling a sustainable up-trend. During this trading range, however, the market’s upside momentum has fallen off after a second 90% up day. The observation is simply that after several 90% up days, buyers are exhausted and sellers once again take control, at least until Germany and France come out and say that they are planning to do a plan to save Greece from itself and recapitalize the failing banks in the Eurozone. Then the traders and computer algorithms get all excited again.

Since August there have been approximately eight 90% up days, but the market has gone nowhere.

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Our long term view is that the secular bear trend has resumed for the U.S. and global equity markets. One bit of supporting evidence is the percent of stocks trading above the 200-day moving average (MA).  Simply stated, it is a breadth indicator intended to gauge the underlying strength or weakness of an index.

The blue line in the chart is a one-month moving average of this indicator, and a change in the long term trend of the market is indicated when it moves above or below the 50% mark.  In order to reduce some of the whipsaws, I have changed the signal levels to 55% and 45%.  A bear signal was given in November ‘07 when the percent of stocks trading above their 200-day MA dropped below 45%.  The lower panel of this chart shows the price trend of the S&P 500.  This signal remained in effect until the bull signal in June of ‘09.  Recently, this indicator moved below 45% for the first time since June of ‘09, adding to the evidence that the market is back in bear market territory.

No one knows what tomorrow holds, let along the future. A chart is not a prediction, but rather a picture of where the stock, index or investment has been. It is, however, a good visual representation of the struggle between the buyers (demand) and the sellers (supply), and a basis for guessing which trend is in play, and how long it may continue.

Certain types of patterns that represent this struggle between buyers and sellers tend to repeat, and identifying these patterns can allow us to guess at what the outcome may be over the long or short term.  My thinking on the short-to-intermediate trend of the market is a possible low around 1064 on the S&P 500, followed by a 60-90 day rally that could take the price back up to the neckline of the head-and-shoulders pattern (around 1260) before we see the next leg down in this secular bear market.

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The chart below shows the volatility in the market since the beginning of the topping process in February of this year. However, volatility is not endemic to our era. The subsequent charts from Ron Griess at The Chart Store show the market volatility in another era: 1929 to 1942.

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