Another Warning Sign for Stocks

Both Tom McClellan and Jim Stack recently pointed out that the Coppock curve – a very long term momentum oscillator – has turned down (here are the links to Jim Stack's and Tom McClellan's articles on the topic). It should be pointed out that the Coppock curve is generally better at catching market bottoms than tops, as the stock market tends to make spike lows and rounded tops. As an indicator catching major lows, the Coppock curve has an excellent track record. However, it has been recognized that it does in fact also warn of major peaks, only this requires two downturns in the curve in succession, over a period of about one to two years. As can be seen on McClellan's chart below, a second peak has just been put in. As he points out, the curve could still reverse course if the DJIA rises sufficiently (namely to currently 16,238 points), which would invalidate the signal. Whipsaws do occasionally happen. 

 


 

CoppockFeb2014Tom McClellan's chart of the Coppock Curve and the DJIA. At a DJIA value of 16,238, the curve would revert to 'unchanged' again – click to enlarge.

 


 

 

According to Jim Stack's review of the signal, there have only been seven such double-tops in the Coppock curve in 93 years (the current one would be number 8) – and five of them were followed by the worst bear markets on record.

Incidentally, the trend-following modified Davis method employed by our correspondent Frank Roellinger (which focuses on the Russell 2000 index) has narrowly averted a sell signal last week. According to this method, the correction is at this point still regarded as noise. Just keep this in mind, as the model has worked very well so far.

 

Sign of a Bottom, or Kick-Off?

We have seen two articles late last week discussing money flows. Their authors are arguing that large outflows that occurred last week are a sign that the 'correction is over'. One such signal has been given by EM flows according to a proprietary index used by BofA, the other by outflows from the SPY ETF according to Jim Puplava. The problem with this is in our view that it seems very difficult to call what has occurred a 'capitulation' when numerous sentiment indicators have merely declined from absolute record highs to levels that prior to the Bernanke echo bubble used to be associated with major peaks. 'Capitulation' in our opinion requires more confirmation than just a one-shot extreme in money flows from the biggest ETF. We also don't agree that a high TRIN recorded so close to an all time high is necessarily meaningful (the TRIN or Arms Index measures the action in declining vs. advancing stocks by dividing the a/d ratio by the a/d volume ratio).

This is so because all such 'overbought/oversold' measures tend to not only show 'oversold' or 'overbought' conditions, they also indicate 'kick-off moves' when a major trend change is underway. There have e.g. been numerous instances of extremely high TRIN readings in 2007 and 2008 before the market crashed. Even prior to the 2011 correction we have seen TRIN readings exceeding the most recent one on several occasions preceding the biggest portion of the downturn. The recent spike in the TRIN is actually not even a dimple on a long term chart  – it is only a high reading in the context of the past two years, a time during which market corrections have become ever more shallow.

 


 

TRINA long term chart of the TRIN. Elevated readings do of course occur near lows, but they also appear when 'kick-off moves' are underway. The most recent spike in the TRIN was only 'high' in the context of the action since the 2011 low, and there have in fact been a number of higher readings even during that period. Only 2013 was a year with barely any noteworthy moves in the TRIN. Note how volatility in the TRIN began increasing in 2007-2008 prior to the market falling out of bed – click to enlarge.

 


 

We only want to make one point here: there is unfortunately nothing that differentiates the high 'oversold' reading seen at short term lows from those seen during 'kick-off moves'. There is simply no telling what the signal per se really means, which is why one must keep an eye on other signals as well. Given that the market on average rises about 67% of the time, the number of 'oversold' readings that are indicating lows is of course commensurately higher.

Next, we want to show a chart of the DJIA with Fibonacci retracement levels of the recent correction. This is in connection with our recent discussion of Lindsay's 'Three Peaks and Domed House' formation as well as our most recent update. We pointed out in the update that in terms of the formation, the market had likely just reached point 26 of the schematic, a temporary low. This has in hindsight indeed turned out to be the case. Of course, there is no way of telling whether or not this low was part of the formation unless the market continues to follow the template, which is why we want to take a look at retracement targets. In the market event that originally inspired Lindsay to create the schematic and search for recurrences of the pattern, the DJIA managed precisely a 50% retracement move, which was accomplished in five trading days. On Friday, the DJIA ended almost exactly at the 38% retracement level, on the fourth trading day since the beginning of the bounce:

 


 

Indu-retracement targetsDJIA with Fibonacci retracement level of the recent correction. In the real life example that inspired Lindsay's 3P + DH schematic, the market managed a 50% retracement within five trading days before turning down again – click to enlarge.

 


 

We would argue that anything more than a 61.8% retracement would likely invalidate the pattern, so the next few days are critical. In 1937, the market managed a 78% retracement rally, but that followed on the heels of a four month long 14% correction, so it is not comparable. In the past 15 years, major peaks have actually occurred in a manner more akin to what happened in 1937, with the market retesting its highs after a few months and failing to push through. Keep also in mind that according to the presidential cycle model, the market should actually manage to make a high in April (it has been following this model as well so far this year).

 

Other Charts of Interest

Next, here is a recent chart of the SKEW index (a variation of the Ansbacher Index, which measures the premiums paid on equidistant calls and puts). SKEW shows how pricey far out of the money options are relative to nearer to the money strikes. In other words, it indicates how big the demand for 'tail risk' protection is (we have discussed SKEW in more detail previously, you can see a longer term chart here: “SPX Options SKEW vs. VIX”).  In previous articles on SKEW we mentioned that spikes in this measure often lead the market by a few weeks or even months (i.e., the lead time varies widely). So it is not a timing indicator, but basically just a 'heads-up' indicator. Several months have now passed since the most recent peak, which was among the highest in history. A secondary peak was put in just before the recent correction began.

 


 

SKEW

SPX options skew since 2011. The recent peak was one of the highest on record – click to enlarge.

 


 

Next is a chart of the SPX plotted with the inverse of weekly unemployment claims. It is well known that the two data series trend together (or putting it differently: unemployment claims are inversely correlated with the SPX), but we find it interesting that there is a growing divergence visible over time:

 


 

SPX vs. UE claimsThe SPX and weekly unemployment claims (plotted inversely) –  note the growing divergence (from peak to peak) since the year 2000 market top – click to enlarge.

 


 

And lastly, here is a chart of the DJIA divided by an index of real GDP since 1928:

 


 

DJIA-GDP ratioThe DJIA divided by an index of real GDP (1929=100) – click to enlarge.

 


 

 

 

Charts by: Tom McClellan, StockCharts, BarCharts, St. Louis Federal Reserve Research


 

 

 

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