Are various warning signs going off as the stock market reaches resistance?

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by Troy

The S&P has now pushed towards 3000 as various “warning signs” go off. Today’s headlines:

  1. NASDAQ’s quick recovery
  2. A new yield curve
  3. Smart Money Index
  4. Monthly RSI divergence
  5. New highs vs. new lows
  6. Round # resistance

Go here to understand our fundamentals-driven long term outlook. For reference, here’s the random probability of the U.S. stock market going up on any given day.

NASDAQ’s quick recovery

The stock market has made a quick recovery from its correction in May. The S&P and Dow made new all-time highs days ago, and the NASDAQ has now joined the party.

Here’s what happened next to the NASDAQ when it went from correction territory (-10%) to a new 1 year high in less than 5 weeks.

Quick recoveries are driven by many investors who want to buy the dip.

A new yield curve

Tavi Costa posted a popular tweet about another section of the yield curve that has just inverted.

I’m generally skeptical of things that are popular, because what’s popular in the finance industry is usually hype (extreme bear hype or extreme bull hype). So I did a bit of research to see what happens next to the S&P 500 when the 30 year yield vs. Fed Funds rate inverts.

While this is a short term bearish factor and late-cycle sign for the bull market, the stock market tends to rally another 1+ year before the bull market ends.

Here’s February 2006:

Here’s March 2000:

Here’s August 1998:

Here’s February 1989:

Smart Money Index

The Smart Money Flow Index is calculated by adding the Dow’s change in the last hour of each day and subtracting the Dow’s change in the first 30 minutes of each day.

This index is based on the idea that “smart money” trades in the final hour of each trading day while the “dumb money” trades at the start of each day (reacts to the news).

The Smart Money Flow Index has been above its 50 day moving average (intermediate term trend) for 114 consecutive days. This is a long streak, and could end within the next few days.

Similar streaks were mostly bullish for the S&P 2-3 months later, and 1 year later.

Monthly RSI divergence

I see financial commentators talk about momentum divergences a lot, such as

The S&P is making a HUGE monthly RSI divergence! Prepare for a crash!

Here’s the thing. Almost every major top (2000, 2007, etc) has a monthly RSI divergence. But not every monthly RSI divergence leads to a major top. More often than not, RSI divergences don’t mean much.

The following chart illustrates every single case in which the S&P is at a 3 year high, but monthly RSI is not at a 3 year high (i.e. divergence).

“Divergences” happen quite often.

A monthly RSI divergence occurs when:

  1. The S&P rallies extremely hard, setting a high for RSI.
  2. Then the S&P rallies in a more choppy manner, “washing out” RSI and making new highs while RSI does not make new highs.

All major tops have an RSI divergence because the pace of the stock market’s rally tends to slow down before it tops. But not every rally that slows down leads to a major top. Sometimes the rally slows down (RSI washes out), and then pushes higher again.

Here’s the problem with permabears who rely on RSI divergences.

  1. If the market does not soar enough, BY DEFINITION RSI will make a “bearish divergence”. Permabears will complain.
  2. In order for a RSI divergence to not exist, the stock market needs to soar. Then the bears won’t complain about a “bearish divergence”. Instead, they’ll complain about “RSI is too high! Get ready for a crash!”

In other words:

  1. If the market doesn’t soar enough, complain about “RSI divergence”
  2. If the market does soar, complain about “RSI is too high!”

That doesn’t make sense to me. It’s like saying “if I flip heads, bearish. If I flip tails, also bearish”.

New highs vs. new lows

Steve Burns posted an interesting tweet. (I recommend following Steve if you’re new to trading. He doesn’t really have anything to sell.)

Is this true? Are new highs more bullish than new lows?

I compared 2 statements:

  1. Buy the S&P when yesterday made a 1 year high
  2. Buy the S&P when yesterday made a 1 year low

When it comes to short term trading, it’s generally better to buy when the S&P is making new highs than new lows. There is a bit of a “momentum effect” in the short term.

Round # resistance

And lastly, the S&P is close to hitting its 3000 round # resistance.

You know what standard technical analysis books say: “round #’s are resistance/support”. This implies that the S&P will face resistance at 3000.

When the S&P reached 2000, it was followed by a correction.

When the S&P reached 1000, it sliced right through that resistance

Personally, I don’t worry about the S&P at 3000. 3000 is not a magical number. It isn’t much different from 2999, 2998, 3001, 3002. Here’s a quote from Warren Buffett’s 2007 letter to shareholders.

It’s commentators’ job to help you hyperventilate. It’s your job as an investor/trader to stay calm.

We don’t use our discretionary outlook for trading. We use our quantitative trading models because they are end-to-end systems that tell you how to trade ALL THE TIME, even when our discretionary outlook is mixed. Members can see our model’s latest trades here updated in real-time.

Conclusion

Here is our discretionary market outlook:

  1. Long term: risk:reward is not bullish. In a most optimistic scenario, the bull market probably has 1 year left.
  2. Medium term (next 6-9 months): most market studies are bullish.
  3. Short term (next 1-3 months) market studies are mixed.
  4. We focus on the medium-long term.

Goldman Sachs’ Bull/Bear Indicator demonstrates that risk:reward favors long term bears.

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