Opinion: The evidence is in: Stocks are in a ‘bull trap’

via marketwatch:

The stock market today mirrors the years 2000 and 2007, when prices peaked

The bulls are back.

The S&P 500 Index SPX, +0.09%  rose nearly 8% in January and was 14% off the December lows. Which begs the questions: What slowing global growth? What reduced earnings expectations? What trade wars?

Who cares. It’ll all sort itself out. All that matters was the Federal Reserve caving in spectacularly and laying the foundation for the big bull case. The “Central Bank Two-Step” is back: Dovish + dovish = nothing but higher prices. The lows are in; what else can I buy? This pretty much sums up current sentiment.

And so goes the familiar script during emerging bear markets: A general sense of relief that the lows are in, and a return of optimism and greed after an aggressive counter rally following an initial scary drop. Long forgotten are the December lows after six weeks of higher prices.

While indeed a renewed fully dovish Fed may be all that’s needed to keep 2019 bullish (after all, this playbook has worked for the past 10 years), there is evidence that this rally may turn out to be a big, fat bull trap.

And it’s not a single data point, but rather a confluent set of factors that give credence to this possibility.

Let me walk you through the factors step by step.

First, here’s the big monthly chart, which includes SPX, some basic technical elements, but also a price chart of the 10-year yield TNX, +2.13% and the unemployment rate:

(Click here for a larger version of the chart.)

Note the common and concurrent elements of the previous two big market tops (2000, 2007) versus now:

  • New market highs tagging the upper monthly Bollinger band on a monthly negative RSI (relative strength index) divergence — check.
  • A steep correction off the highs that breaks a multi-year trend line — check.
  • A turning of the monthly MACD (Moving Average Convergence Divergence) toward south and the histogram to negative — check.
  • A correction that transverses all the way from the upper monthly Bollinger band to the lower monthly Bollinger band before bouncing — check.
  • A counter rally that moves all the way from the lower Bollinger band to the middle Bollinger band, the 20MA — check.
  • A counter rally that produces a bump in the RSI around the middle zone, alleviating oversold conditions — check.
  • All these events occurring following an extended trend of lower unemployment, signaling the coming end of a business cycle — check.
  • All these events coinciding with a reversal in yields — check.
  • All these events coinciding with a Federal Reserve suddenly halting its rate hike cycle — check.

I submit that the counter rally is consistent with all of those factors. Indeed, as with counter rallies in the past, this rally remains below its broken trend line.

What can we learn from the counter rallies during the two previous emerging bear markets?

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In 2008, following the 2007 top, SPX fell deep below its 200 MA (moving average), but then saw an aggressive counter rally in a rising wedge pattern that stopped at the 200 MA before everything reversed:

(Click here for a larger version of the chart.)

What did optimistic, coast-is-clear buyers know then? Nothing, as SPX didn’t bottom until it got to 666 points in March 2009.

In 2001, SPX rallied hard from a yearly low in December (similar to now), and the high was made Jan. 31, the last trading day of the month. Unbeknownst to buyers then, that day turned out to be the high for years to come as markets turned south in advance of the coming recession:

(Click here for a larger version of the chart.)

Lows didn’t come until 2002-2003.

Look, my eyes are wide open here, I recognize that between the dovish Fed and a potential China deal, markets may just drift higher and any pullbacks could turn into buying opportunities.

However, as long as SPX remains below its 200 MA without a confirmed breakout above the confluent set of elements discussed above, there is well-founded risk that this market can still turn into a full-fledged bear market. After all, economic growth is slowing, earnings growth is slowing and the last three times the Fed halted its rate-hike cycle a recession soon followed.

And what do we have so far? An aggressive counter rally below the 200 MA in a very steep ascension pattern approaching key 0.618 Fibonacci resistance. (A Fibonacci retracement is created by taking two extreme points on a stock chart and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. Then horizontal lines are drawn and used to identify possible support and resistance levels.):

(Click here for a larger version of the chart.)

In early 2018, the 200 MA was support. In the fall it became resistance. SPX remains below it, and I think it’s fair to say we’re no longer oversold. Indeed, a dovish Fed has now been priced in. Chairman Jay Powell made sure of that on Jan. 4 and confirmed it this week. That carrot is gone.

While the bull case remains technically unconfirmed at this stage, the bull-trap scenario will also remain unconfirmed for some time. The first few down days following the peak in January 2001 and the peak in May 2008 did not have anyone waving a big, white flag screaming the top is in.

It’s easy to see these things in hindsight, but much harder, if not impossible, if you’re in the thick of things. And this is where we are now — in the thick of things — and will be for weeks to come, but I suspect we’ll know more in the next month or two. Stay sharp.

Sven Henrich is founder and the lead market strategist of NorthmanTrader.com. He has been a frequent contributor to CNBC and MarketWatch, and is well-known for his technical, directional and macro analysis of global equity markets. His Twitter handle is @NorthmanTrader.

 

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