A Bittersweet Setup For Cocoa?

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Unlike many commodities that have been getting crushed lately, Cocoa has been able to avoid the meltdown (so to speak). Through September, the iPath Cocoa ETN (NIB) was up a 22% for the year. And while its uptrend remains intact — and we are not about to fight it too forcefully — there are 3 reasons why a bittersweet counter-trend pullback may be in store for the commodity.

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First, from 2011 to 2013, NIB dropped by almost 50%. Its recent rally has now reached the 61.8% Fibonacci Retracement level of that decline in the past few days. This can present a major hurdle for even the strongest of trends.

Secondly, looking at the Commitment of Traders report in Cocoa futures, we note that dealers’ net position is now close to a record short level (set earlier this year). And while dealers have been on the wrong side of the trade so far for much of the year, they are typically positioned correctly at major turning points.

Lastly, looking at seasonality we note that October is historically the weakest month for Cocoa. And it isn’t close as the following chart from sentimentrader.com shows. Cocoa is down roughly 30% of the time in October, to the tune of about 2.5%, on average.

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While we would not stick a fork in the Cocoa rally without some price evidence first, considering the three points made above, we wouldn’t exactly call this a sweet spot of a long entry either.

And a bonus — this was one cocoa post without the word “ebola” in it…almost.

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"Raw Cocoa Nibs" photo by Joana Petrova.

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Small vs. Large Cap Quarterly Divergence Last Seen in 3Q 2007

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The 3rd quarter produced yet another divergence among large and small cap stocks. While the large cap S&P 500 index gained 0.6%, the small cap Russell 2000 actually lost ground, finishing 7.7% lower for the quarter. In our database of the Russell 2000 (back to 1991), this is the 8th such quarterly divergence between the two indexes.

While this is a pretty small sample size, returns going forward were actually fairly positive. This should come as no surprise, however, as most of the examples occurred during the blowoff phase of the secular bull market in the mid to late-1990’s.

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Despite these positive average returns, there were a few inauspicious dates within the sample that present a concern regarding the present situation. The two troublesome occurrences were the 2nd quarter of 1998 and the 3rd quarter of 2007.

Following the 1998 example, the S&P 500 dropped over 10% in the 3rd quarter and the Russell 2000 lost more than 20%. The 2007 occurrence, which is the only divergence in the past 15 years, of course immediately preceded the cyclical top in stocks.

Why would we place any more weight on those two examples than any of the others — or to the overall average? The circumstances are arguably more similar to the market’s present situation than some of the others. The market is now 5 years into a cyclical bull market and beginning to show signs of a breakdown in the breadth of its rally, i.e., the negative divergence among small caps. This is similar to conditions in 1998 and 2007. Yes, occurrences in 1997 and 1999 also displayed similar characteristics. However, all gains made by the Russell 2000 following the late 1997 divergence were wiped out by the 1998 correction and the post-1999 gains were wiped out after the 2000 blowoff top.

We are not dismissing the positive average performance following such divergences. Indeed, that is why these things should always be vetted. The divergence, historically, has not been the immediate death knell that some may think. That said, the results should not be treated within a vacuum either, particularly considering the limited sample size. We are big proponents of market breadth as it relates to the health of a market — i.e., the more stocks participating, the better. Therefore, the current iteration of this divergence, based on our other analysis, strikes us as more of a concern than the average stats would suggest.

Sure the market can continue higher for some time, extending such divergences. However, eventually these conditions tend to get corrected. And the more egregious the divergence, the more corrective the action tends to be.

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Stocks Entering Best Stretch of Presidential Cycle…By Far

Most investors are likely familiar with the Presidential Cycle as it pertains to the stock market. It refers to the tendency of the stock market to generally conform to a certain trading pattern throughout the course of a 4-year Presidential term. While the market obviously doesn’t follow the pattern in lockstep every year, it  actually has been pretty consistent historically.

In terms of the market’s current position, bulls will be heartened to hear that stocks are now entering the strongest stretch of the entire cycle. From the 4th quarter of the 2nd year of a president’s term (begins October 1st) through the 2nd quarter of the 3rd year (June 30 next year), the Dow Jones Industrial Average has averaged a 14.6% return since 1900. This is far and away the best of any 3 quarter stretch.

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This very positive stretch contains 3 of the best 4 performing quarters of the entire Presidential Cycle, on average. Thus, it is not surprising that no other 3-quarter stretch comes close to the one coming up.

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Now, despite the positive average return over this stretch, we will reiterate that these seasonal type indicators are general tendencies, averaged over a long period. It is not a guarantee that stocks will conform to this pattern during this cycle. Case in point — the last time we posted regarding the Presidential Cycle was 6 months ago. That post pointed out the mirror opposite of this one: that stocks were entering the weakest 2-quarter stretch of the entire Presidential Cycle. Well, far from dropping over the past 2 quarters as it had done on average since 1900, the Dow posted positive returns in both the 2nd quarter and 3rd quarter (as of yesterday), totaling roughly 4%.

The takeaway? Seasonal patterns and cycles are general tendencies formed over long periods. As such, they should be treated as secondary indicators. That said, the Presidential Cycle has been one of the more consistent seasonal cycles. Therefore, while it is not a lock, the next 3 quarters should provide a slight tailwind for stock investors.

(Check out Ryan Detrick’s blog, the Almanac Trader blog and this teriffic post from Urban Carmel for more information on the Presidential Cycle).

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Stocks’ Roller-Coaster Week Has Negative Short-Term Implications

Last week, the S&P 500 registered a rare display of volatility. The week contained both the largest 2 up days in the past month and the largest 2 down days. This was just the 54th time since 1950 that the 2 largest up and down days in the past month occurred in a 5-day span. A few of those instances were clustered together so the unique occurrences were actually fewer. In terms of a calendar week, it was just the 13th such occurrence in 64 years.

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So what does this unique burst of volatility portend for the stock market? Historically, returns have been weaker than normal going forward, particularly in the short-term. The average 3-week return following these 5-day spans since 1950 has been a dismal -2.93%. More than half of all occurrences led to a negative 1-month forward return.

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There were zero occurrences of this phenomenon between 1988 and 1995. Since 1996, there have been 17 (displayed in the chart). Results following these 17 have been especially poor in the near-term. After 2 weeks, only 2 of the 17 occurrences showed a positive return and the 3-week average return is a putrid -5.56%.

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The average returns are skewed a bit by the Fall 2008 sell off which was forewarned by one of these volatility bursts in mid-September. However, the returns are also arguably understated as many of these bursts immediately preceded serious but short-lived sell offs such as October 1997 and May 2010. Thus the statistics on drawdowns following these occurrences are perhaps even more striking than the return data. For example, the average 1-month and 3-month drawdowns following all occurrences since 1950 is -5.48% and -7.01%, respectively. This compares with average drawdowns of -2.48% and -4.43% for 1 and 3 months following all days. Since 1996, 1-month and 3-month drawdowns have averaged -7.65% and -10.37% following the 5-day volatility bursts.

Lastly, while it is probably a stretch to make such a link, we don’t want to fail to mention the fact that a few of these occurrences happened almost immediately prior to some major cyclical tops, including February 1966, December 1972, April 2000 and June 2007.

We don’t want to make too much of any potential longer-term implications of these 5-day spans containing the 2 biggest up and down days of the past month (though, we certainly have our share of other concerns and this would fit in). However, this volatility burst has been fairly consistent as a harbinger of not only increased volatility overall, but increased volatility to the downside. So, although nothing has been able to break this almost 2-year run up in the S&P 500, this not portend good things for the index in the short-term.

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Hong Kong Hang Seng Testing Key Breakout Level
On September 9, we posted a chart showing a key long-term breakout in the Hong Kong Hang Seng Index. It broke above the 61.8% Fibonacci Retracement level of its 2007-2009 decline on a monthly chart at about 23,800. This level also signified 3 monthly tops since 2010, so the breakout was indeed significant.
Since that post, the Hang Seng has dropped straight down about 5%. Since we are looking through a long-term monthly lens, that is not a huge percentage. However, it has now pulled back to the breakout level, closing yesterday at 23,766. While bulls would have preferred that the Hang Seng simply take off and not look back, a pullback to to current levels is not unwelcomed — especially for those looking for an entry point.
This area offers an excellent entry point for longs, from a risk:reward perspective. As long as it can hold this former breakout level, it has tremendous upside potential once it resumes its uptrend. For longs entered here, a stop could be placed on a close below further support identified at around 23,000.
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Hong Kong Hang Seng Testing Key Breakout Level

On September 9, we posted a chart showing a key long-term breakout in the Hong Kong Hang Seng Index. It broke above the 61.8% Fibonacci Retracement level of its 2007-2009 decline on a monthly chart at about 23,800. This level also signified 3 monthly tops since 2010, so the breakout was indeed significant.

Since that post, the Hang Seng has dropped straight down about 5%. Since we are looking through a long-term monthly lens, that is not a huge percentage. However, it has now pulled back to the breakout level, closing yesterday at 23,766. While bulls would have preferred that the Hang Seng simply take off and not look back, a pullback to to current levels is not unwelcomed — especially for those looking for an entry point.

This area offers an excellent entry point for longs, from a risk:reward perspective. As long as it can hold this former breakout level, it has tremendous upside potential once it resumes its uptrend. For longs entered here, a stop could be placed on a close below further support identified at around 23,000.

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90% Down Volume Days Have Been Good Buy Signals…With One Catch

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The concept of a 90% Down Day was introduced, or at least popularized, by Lowry’s Research a number of years ago. As I understand it, such days are characterized by at least 90% of issues closing lower on a given day as well as 90% of volume occurring in declining stocks on that day. Historically, 90% Down Days often mark an exhaustion or capitulation of selling pressure and occur at, or quickly lead to, short or intermediate-term bottoms.

Today’s Chart Of The Day looks at days with 90% of volume on the NYSE occurring in declining stocks, as we saw yesterday. In general, they have led to significant outperformance by stocks over the short to intermediate-term. This table illustrates the outperformance by the S&P 500 following such days since 1965.

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Since the November 2012 low which marked the start of the current low-volatility, straight up move in the S&P 500, results have been even better, naturally. This is true even relative to the overall positive environment.

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It stands to reason that the returns following 90% Down Volume Days over the past 2 years would be exceptionally positive, given the rally in the stock market. In order to isolate historical periods that may be similar to this one, we also tallied results for 90% Down Volume Days since 1965 that occurred when the S&P 500 was above its 50-Day Simple Moving Average. Returns since 1965 were even more positive than normal.

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So is there any catch? Well, the theory behind the 90% Down Day indicator is to identify potential points of exhaustion or capitulation of selling. That is, points at which selling has become so overdone that there are few sellers left in the market, at least in the short-term. The trouble with that theory as it applies to our current circumstance is that we are just coming off of an all-time high. Given that, how is it possible that selling can be exhausted already, except for the shortest of durations? With that point in mind, we tested all historical 90% Down Volume Days that were initiated from within 1% of a 52-week high. As it turns out, this is indeed the “catch”.

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Returns following 90% Down Volume Days beginning from within 1% of a 52-week high have not only been lower than other days following 90% Down Volume Days — they have been lower than average returns following all days! This is quite extraordinary given the outsized returns following 90% Down Days from above the 50-Day SMA, a category which includes this data set. Since 1965, of the 16 occurrences starting from within 1% of a 52-week high, 7 have led to a negative return 1 month later and the average 1-month return following all 16 has been negative.

So overall, particularly in the past 2 years, returns following 90% Down Volume days have been exceptionally positive. The only caveat is that those occurring from within 1% of a 52-week high, like yesterday’s did, have actually led to subpar returns. It will be interesting to see which tendency exerts the most pressure this time.

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Bull Flag Signaling 1 More Chance To Buy This Biotech ETF?
Biotech stocks have alternated between hero and villain in 2014 (FYI, we have been on either side of this sector at times this year). After rocketing higher to begin the year, the sector abruptly halted its parabolic rise in February and began an equally rapid descent. To be honest, we thought the bubbly sector had popped. However, it came roaring back to life over the past few months to make new highs (to our surprise) and resume its leadership role.
Many people have been left out of this latest run higher, ourselves included. However, the opportunity may not be over. While the Biotechnology Index ($BTK) and iShares Nasdaq Biotech ETF ($IBB) have made new highs, the broad, more equally-weighted SPDR S&P Biotech ETF, $XBI, has not. It is currently presenting a compelling entry point, however, to make a possible run at new highs itself.
The rally in XBI off its April low made it to just above the 78.6% Fibonacci Retracement of the February-April decline. It has consolidated those gains nicely, and tightly, in a possible pattern called a Bull Flag. This pattern is a continuation pattern, meaning it should break out eventually and “continue” its previous trend (up). The bottom of the Bull Flag (currently is around the 153 level. XBI made a low today (so far) of 154.88 so it is approaching that level.
In addition, the following layers of support lie in the same vicinity:
50-Day Simple Moving Average ~153.5
23.6% Fibonacci Retracement of the April-August rally ~152.7
38.2% Fibonacci Retracement of the July-August rally ~152.7
August 22 breakout gap ~153.63
This approximate level gives traders an attractive entry point on the long side. A close below about 152 would negate the Bull Flag as well as breaking the other support layers. While support below would come in at around 145 (200-Day SMA, 38.2% FR of April-August rally & 61.8% FR of July-August rally), it would not be as high-odds a setup as currently, given the Bull Flag.
A break out above the Bull Flag would measure a target around the lows 170’s, or right at the former high. Other patterns involved in XBI measure quite a bit higher but we’ll cross that bridge if we get to it.
The fact that $IBB and $BTK still look solid in their potential to eventually further their moves into new high territory bodes well for $XBI and this trade as well. If you missed the Biotech train all year, this may be your shot to get aboard. We should find out pretty quickly either way.
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Bull Flag Signaling 1 More Chance To Buy This Biotech ETF?

Biotech stocks have alternated between hero and villain in 2014 (FYI, we have been on either side of this sector at times this year). After rocketing higher to begin the year, the sector abruptly halted its parabolic rise in February and began an equally rapid descent. To be honest, we thought the bubbly sector had popped. However, it came roaring back to life over the past few months to make new highs (to our surprise) and resume its leadership role.

Many people have been left out of this latest run higher, ourselves included. However, the opportunity may not be over. While the Biotechnology Index ($BTK) and iShares Nasdaq Biotech ETF ($IBB) have made new highs, the broad, more equally-weighted SPDR S&P Biotech ETF, $XBI, has not. It is currently presenting a compelling entry point, however, to make a possible run at new highs itself.

The rally in XBI off its April low made it to just above the 78.6% Fibonacci Retracement of the February-April decline. It has consolidated those gains nicely, and tightly, in a possible pattern called a Bull Flag. This pattern is a continuation pattern, meaning it should break out eventually and “continue” its previous trend (up). The bottom of the Bull Flag (currently is around the 153 level. XBI made a low today (so far) of 154.88 so it is approaching that level.

In addition, the following layers of support lie in the same vicinity:

  • 50-Day Simple Moving Average ~153.5
  • 23.6% Fibonacci Retracement of the April-August rally ~152.7
  • 38.2% Fibonacci Retracement of the July-August rally ~152.7
  • August 22 breakout gap ~153.63

This approximate level gives traders an attractive entry point on the long side. A close below about 152 would negate the Bull Flag as well as breaking the other support layers. While support below would come in at around 145 (200-Day SMA, 38.2% FR of April-August rally & 61.8% FR of July-August rally), it would not be as high-odds a setup as currently, given the Bull Flag.

A break out above the Bull Flag would measure a target around the lows 170’s, or right at the former high. Other patterns involved in XBI measure quite a bit higher but we’ll cross that bridge if we get to it.

The fact that $IBB and $BTK still look solid in their potential to eventually further their moves into new high territory bodes well for $XBI and this trade as well. If you missed the Biotech train all year, this may be your shot to get aboard. We should find out pretty quickly either way.

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The Most Important Trendline In Equity Land: New Highs-New Lows
The problem with trendlines is that they are usually subjective. Rarely are they cut-and-dry. And even when they are obvious, it has become more commonplace recently that breaks of trendlines, up or down, have been false moves. That’s not too surprising given the tremendous increase in traders and investors adopting technical analysis as well as widespread access to such resources. The more attention that is focused on a particular type of analysis, the harder it is to exploit such analysis. Thus, the exploiters become the exploitees. Whether it’s the algo-bots or simply the collective market forces that forbid the consensus of participants from profiting from “obvious” signals, trendline breaks are now very often fakeouts. As often as not, it seems, prices revert back to the primary trend in short order causing traders to…draw a new trendline. Thus, the subjectivity.
Therefore, our pick for the most important trendline to watch in the world of equities is not an equity, or equity index, at all. It is an indicator. Whereas equity trendlines are prone to false breaks of late, indicators often conform to truer, more reliable trendlines. But why would an indicator trendline be the most important? Considering this market environment is one characterized by divergences and weakening internals — perhaps moreso than any time since the 1998-2000 period — a focus on that dynamic seems more than appropriate.
The indicator we have selected for this distinction is the number of New 52-Week Highs minus New 52-Week Lows on the NYSE. We’ve discussed the weakening trend of New Highs several times over the past few months, including on September 10, September 2, July 25 and May 1. The reason we chose this particular indicator is due to A) the cleanliness of the trendline and B) the degree to which it has been helpful in the past.
As we have cautioned ad nauseam, the difficulty with divergences is the unpredictability in timing their impact. They can persist for a long time without serious consequences. One way to combat that unpredictability is by using a trendline, or similiar method, to detect when the indicator breaks down (or out). This can signify a point of impact.
For example, New Highs have been declining for some time so we need a way of determining when that trend will matter. Since they do not have much room to break down, as they are bound by zero, we use the spread between New Highs and New Lows. Looking at this indicator, we can see clear, distinct uptrends from cyclical lows to cyclical tops (by the way, we could use simply New Lows but we like the added information of having both series in the indicator).
This analysis was very helpful in identifying major turns in the past two cycles. On the chart, you can see that New Highs-New Lows made a series of higher lows from 1998 to 2000. During the sell off in September 2001, the indicator broke the uptrend, spiking lower. This was a head’s up that the major trend was broken. FYI, yes the large cap indexes clearly topped in 2000 and had already suffered major damage by September 2001; however, many small and mid caps held up fairly well in 2000 and early 2001 (of course, many of them suffered bear markets from 1998 to 2000). It wasn’t until until 2001 than many of them broke trend and began their descent into the real carnage of 2002.
Likewise, from 2004 to 2007, New Highs-New Lows formed a similar uptrend. The trendline break was a more timely one this time, occurring in July 2007, just off the top. It was again a head’s up that more serious damage was to come than the mild corrections of the years prior.
Currently, we see the same condition. While the NYSE New Highs have been steadily declining, the uptrend in New Highs-New Lows is still in force, stretching back to 2011 (and 2009 as well, but we like to start the trend over after the  indicator breaks out to the upside like it did in 2010.)
It has paid and will likely continue to pay to avoid becoming too bearish from a longer, cyclical-term perspective until this uptrend line breaks. It will likely do so into a “warning shot” sell off as in 2001 and 2007. That is, it will occur into a sharp pullback that, while perhaps too late to warn of that concurrent weakness, will provide a warning that the longer-term picture has changed, for the worse.
** FYI, despite the recent rise in New Lows, it does not appear as if the New High-New Low uptrend line will be threatened today, as the statistics currently stand.
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The Most Important Trendline In Equity Land: New Highs-New Lows

The problem with trendlines is that they are usually subjective. Rarely are they cut-and-dry. And even when they are obvious, it has become more commonplace recently that breaks of trendlines, up or down, have been false moves. That’s not too surprising given the tremendous increase in traders and investors adopting technical analysis as well as widespread access to such resources. The more attention that is focused on a particular type of analysis, the harder it is to exploit such analysis. Thus, the exploiters become the exploitees. Whether it’s the algo-bots or simply the collective market forces that forbid the consensus of participants from profiting from “obvious” signals, trendline breaks are now very often fakeouts. As often as not, it seems, prices revert back to the primary trend in short order causing traders to…draw a new trendline. Thus, the subjectivity.

Therefore, our pick for the most important trendline to watch in the world of equities is not an equity, or equity index, at all. It is an indicator. Whereas equity trendlines are prone to false breaks of late, indicators often conform to truer, more reliable trendlines. But why would an indicator trendline be the most important? Considering this market environment is one characterized by divergences and weakening internals — perhaps moreso than any time since the 1998-2000 period — a focus on that dynamic seems more than appropriate.

The indicator we have selected for this distinction is the number of New 52-Week Highs minus New 52-Week Lows on the NYSE. We’ve discussed the weakening trend of New Highs several times over the past few months, including on September 10, September 2July 25 and May 1. The reason we chose this particular indicator is due to A) the cleanliness of the trendline and B) the degree to which it has been helpful in the past.

As we have cautioned ad nauseam, the difficulty with divergences is the unpredictability in timing their impact. They can persist for a long time without serious consequences. One way to combat that unpredictability is by using a trendline, or similiar method, to detect when the indicator breaks down (or out). This can signify a point of impact.

For example, New Highs have been declining for some time so we need a way of determining when that trend will matter. Since they do not have much room to break down, as they are bound by zero, we use the spread between New Highs and New Lows. Looking at this indicator, we can see clear, distinct uptrends from cyclical lows to cyclical tops (by the way, we could use simply New Lows but we like the added information of having both series in the indicator).

This analysis was very helpful in identifying major turns in the past two cycles. On the chart, you can see that New Highs-New Lows made a series of higher lows from 1998 to 2000. During the sell off in September 2001, the indicator broke the uptrend, spiking lower. This was a head’s up that the major trend was broken. FYI, yes the large cap indexes clearly topped in 2000 and had already suffered major damage by September 2001; however, many small and mid caps held up fairly well in 2000 and early 2001 (of course, many of them suffered bear markets from 1998 to 2000). It wasn’t until until 2001 than many of them broke trend and began their descent into the real carnage of 2002.

Likewise, from 2004 to 2007, New Highs-New Lows formed a similar uptrend. The trendline break was a more timely one this time, occurring in July 2007, just off the top. It was again a head’s up that more serious damage was to come than the mild corrections of the years prior.

Currently, we see the same condition. While the NYSE New Highs have been steadily declining, the uptrend in New Highs-New Lows is still in force, stretching back to 2011 (and 2009 as well, but we like to start the trend over after the  indicator breaks out to the upside like it did in 2010.)

It has paid and will likely continue to pay to avoid becoming too bearish from a longer, cyclical-term perspective until this uptrend line breaks. It will likely do so into a “warning shot” sell off as in 2001 and 2007. That is, it will occur into a sharp pullback that, while perhaps too late to warn of that concurrent weakness, will provide a warning that the longer-term picture has changed, for the worse.

** FYI, despite the recent rise in New Lows, it does not appear as if the New High-New Low uptrend line will be threatened today, as the statistics currently stand.

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Rare Display Of Caution From Options Traders
We have mentioned the International Securities Exchange Call/Put Ratio a few times in this space (unlike most exchanges, the ISE presents its ratio with Call volume as the numerator instead of the denominator). The last time we mentioned it was on August 4 when we noted that, despite just a 6-day, 3% decline off of the highs at the time, the ISE Call/Put Ratio registered its lowest reading in its history (since 2006) on August 1. While there were indications that the reading may have been somewhat skewed by a fat-finger trade, the reading — from a contrary basis — did prove somewhat prescient as the market bottomed 4 days later, within 1% of the August 1 close.
Today’s Chart Of The Day looks at the ISE Call/Put Ratio again, in a similar light. On each of the past 2 days, the ratio closed under 100 for just the 4th time in history. This, despite the S&P 500 being just 3 days removed from its all-time high. We hesitate to put a lot of stock in a study with just 3 prior data points. Additionally, with the S&P 500 down a mere 1.5% from its high, our skeptical antennae is raised questioning whether this is a true indicator of investor caution. With that said, the prior 3 occurrences of consecutive readings under 100 have produced some remarkably positive results over the intermediate-term.
March 17-19 2008 The S&P 500 formed an intermediate-term low on March 17. It rallied as much as 10% over the next 6 weeks and didn’t close lower for 3 months.
November 17-19 2008 The S&P 500 dropped over 6% the following day, forming an intermediate-term low. Over the next 6 weeks, it gained as much as 16% above the 19th close and never closed lower over the following 3 months.
June 20-21 2013 The S&P 500 dropped over 1% the following day, forming an intermediate-term low. Over the following 6 weeks, it gained as much as 8% above the 21st close and has not closed lower since.
Clearly the stock market performance following these consecutive days with ISE Call/Put Ratios under 100 have been exceptionally positive, especially as measured by the risk to reward ratio. That said, we will reiterate that we would not get too giddy on the bullish side considering A) there are only 3 precedents and B) we are only 3 days removed from the all-time high. However, taken at face value this development is a positive one.
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Rare Display Of Caution From Options Traders

We have mentioned the International Securities Exchange Call/Put Ratio a few times in this space (unlike most exchanges, the ISE presents its ratio with Call volume as the numerator instead of the denominator). The last time we mentioned it was on August 4 when we noted that, despite just a 6-day, 3% decline off of the highs at the time, the ISE Call/Put Ratio registered its lowest reading in its history (since 2006) on August 1. While there were indications that the reading may have been somewhat skewed by a fat-finger trade, the reading — from a contrary basis — did prove somewhat prescient as the market bottomed 4 days later, within 1% of the August 1 close.

Today’s Chart Of The Day looks at the ISE Call/Put Ratio again, in a similar light. On each of the past 2 days, the ratio closed under 100 for just the 4th time in history. This, despite the S&P 500 being just 3 days removed from its all-time high. We hesitate to put a lot of stock in a study with just 3 prior data points. Additionally, with the S&P 500 down a mere 1.5% from its high, our skeptical antennae is raised questioning whether this is a true indicator of investor caution. With that said, the prior 3 occurrences of consecutive readings under 100 have produced some remarkably positive results over the intermediate-term.

  • March 17-19 2008 The S&P 500 formed an intermediate-term low on March 17. It rallied as much as 10% over the next 6 weeks and didn’t close lower for 3 months.
  • November 17-19 2008 The S&P 500 dropped over 6% the following day, forming an intermediate-term low. Over the next 6 weeks, it gained as much as 16% above the 19th close and never closed lower over the following 3 months.
  • June 20-21 2013 The S&P 500 dropped over 1% the following day, forming an intermediate-term low. Over the following 6 weeks, it gained as much as 8% above the 21st close and has not closed lower since.

Clearly the stock market performance following these consecutive days with ISE Call/Put Ratios under 100 have been exceptionally positive, especially as measured by the risk to reward ratio. That said, we will reiterate that we would not get too giddy on the bullish side considering A) there are only 3 precedents and B) we are only 3 days removed from the all-time high. However, taken at face value this development is a positive one.

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UPDATE: Russia Short-Term Bounce Done, Long-Term Bottom Still Possible

Starting on May 13, we have been opining about a probable short-term, and possible long-term, bottom in Russian stocks. The main catalyst was the positive action off of the 61.8% Fibonacci Retracement supoort line from the 2009 to 2011 rally. The Russian RTS Index bounced then tested that level, as did the Market Vectors ETF, RSX.

The short-term bounce did transpire as the RTS rallied close to 30% off the key Fibonacci level. A long-term potential turn, however, was stifled by the downtrend line stemming from 2012 (and from 2011 on the RSX). Subsequently, and concurrently with the second round of U.S.-led sanctions, Russian stocks dropped hard in July and into August.

On August 6, we published a post saying it’s “Now Or Never” for Russian stocks. The RTS had traded all the way back to the 61.8% Fibonacci Retracement of the rally from March to June. We felt it was the last gasp for the Russian market if it wanted to maintain any momentum from its initial bottoming pattern. At a minimum, we felt pessimism had become extreme and at least a short-term bounce may be in order. The RTS (and RSX) responded immediately, rallying some 12%.

Alas, it has proven to be merely a bounce as Russian stocks formed a lower high and proceeded to drop again. The result was a potential head-and-shoulder pattern. In the past 2 days, the RTS and RSX have broken their uptrend lines from the March low, confirming the end of the recent bounce. Additionally, the trendline would also signify the neckline of the head-and-shoulder pattern, which has significantly negative connotations.

We’re not so sure that the h-&-s pattern is valid. Considering the major 61.8% Fibonacci Retracement line from the 2009-2011 rally remains in place, a long-term bottom is still possible (though it is not as attractive a scenario as it was this spring). If that level is able to hold, it could form a double-bottom with the March low, providing a springboard for a longer-term turn.

For now, we would step away, content that the 12% bounce off the August 6 post is likely all we’ll get out of Russian stocks following the trend break. We will continue to monitor the action should the RTS or RSX probe the major Fibonacci line again.

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The Ugliest Chart In Equity Land: Small Cap Growth

One great thing about markets is that at any given time you’ll find no shortage of constructive looking charts and suspect looking charts. This is especially true given the inverse relationship between currencies and their interplay with commodities. A list of the ugliest charts of the year would be dominated by weak currencies like the yen and some of the European currencies and especially by soft commodities like sugar, cotton and any of the grains. As far as equity charts go, our vote for the ugliest chart goes to the ratio between small cap growth stocks and the S&P 500.

While small cap growth stocks have not been subjected to the pounding that the yen or soybeans have, it is the potential damage suggested by the current setup that has our attention. For unlike, say wheat which is down 30% this year, the weakness in small cap growth stocks — and perhaps the rest of the stock market – may just be starting.

The index we are using is the S&P Small Cap Pure Growth Index. This is a composite of only the small caps in the S&P 600 that meet the strict criteria of a “growth” stock (similarly, the S&P Small Cap Pure Value Index includes only those meeting the criteria of “value”. This may sound obvious, but many indexes divide up all of the stocks from the main index, i.e., the S&P 600, into either the growth or the value segment, even if a stock does not fully fit the criteria. In fact, various constituents may be included in both the growth and value indexes.

So what makes the chart of the S&P Small Cap Pure Growth Index so ugly? (By the way, Small Cap Pure Value does not look much better.) When we measure it relative to the S&P 500, three factors contribute to make the recent action look particularly bad. First, after hitting a high late last year, the ratio has made a number of lower highs now. Most egregiously, when the Small Cap Pure Growth Index hit a new high in early July, the ratio distinctly failed to do so. Secondly, after the early July failure, the ratio dropped to the lows it hit in May when small caps were getting punished. In the last 2 months, the ratio has failed to mount even a meager bounce off of those lows, forming what we call a bear flag. This pattern typically leads to a breakdown and further lower prices. Sure enough, and thirdly, the ratio did indeed break down in the past 2 days to not only a new low but a 52-week low. We would add that the clean, textbook manner in which this chart has unfolded makes us like it even more as it gives us confidence that it is conforming to what it “should be” doing.

One might argue that much of the damage has been done, given the ratio is at a 52-week low. However, that is often the benefit of using such “relative” analysis – it can provide forewarning of impending absolute weakness in the underlying index. The S&P Small Cap Pure Growth Index has actually suffered little in the way of actual losses so far, having traded in a range for the past 10 months. If absolute damage is to follow, there is ample room to drop should the index break below the bottom of the range. This is why we say it is the ugliest chart due to the potential risks.

Furthermore, while the S&P 500 has held up well over this time (obviously contributing mightily to the ratio’s weakness being that it is the denominator), there is precedent for this ratio breakdown leading to weakness in the broad market. There is only one other occasion historically where we find a similar setup of the index making a lower high followed by a drop in the ratio to a 52-week low. That was December 2007. Like the present time, that period had seen little in the way of weakness among large cap indexes, like the S&P 500. However, the breakdown preceded a major cyclical bear market. If this development threatens to lead to a similar broad market decline, then the damage has certainly not been done. The S&P 500 is literally 2 days removed from an all-time high!

Now even if a similar scenario unfolds leading to a major broad market selloff, it most certainly won’t happen in a straight shot. Again, the major indexes are practically still at their highs. Additionally, the ratio may not continue to drop, if the S&P 500 starts to play “catch up” to the downside. (The ratio could even rise as a result of the small cap growth stocks resuming an uptrend, although that would not be our bet).

However, this ratio breakdown is more evidence of the bigger picture thinning of the rally. Fewer stocks and sectors are participating in the gains. We are obviously not the only ones to point out the relative weakness in small cap stocks and we have been alerting readers of this condition for several months now. However, the awareness of this condition does not bulletproof the market from the ramifications. Sometimes, particularly in hindsight, the warnings are as clear as they are in this chart. Therefore, while the timing is always tricky, the result of the current thinning condition should ultimately be a correction of some magnitude.

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Social Media Bubble Fails To Reinflate
We have discussed several times the tendency for sectors representing the bubble du jour — or at least the froth du jour — to top out (pop) ahead of the market, thus serving as a warning shot. Such froth is a result of over-crowding by investors as they chase the hot sector of the day. This behavior can be seen by following the level of margin debt, the behavior of which suggests much of the debt goes toward the bubbly sectors.
In a May 22 post, we pointed out how margin debt has historically topped simultaneously with the hot sector or bubble of the day. In the past few cycles, whether it was internet stocks in 2000 or financials in 2007, the bubbly sectors also peaked several months ahead of the major market averages. In the current cycle, margin debt peaked in February. We identified biotechs and social media stocks as likely “bubble” sectors that had popped in February-March, along with margin debt.
Since then, margin debt has made a bit of a comeback and is within spitting distance of its February high (as of July). Whether or not it makes a new high remains to be seen. If it does, it might largely be attributed to the biotech sector which has reinflated, surpassing its prior highs (much to our surprise). Social media stocks, however, are another story.
As judged by the Global X Social Media ETF (SOCL), social media stocks have not only been unable to approach their March highs, but they also are now failing in their attempt to do so. After dropping 30% from March to May, the ETF found support precisely at the key 61.8% Fibonacci Retracement of the 2012 to 2014 rally. (When a security does this, it gives us confidence that it is “respecting” the analysis, i.e., it is valid.) During September, SOCL has attempted to break above key resistance levels marked by the 61.8% Fibonacci Retracement of the March-May decline as well as the 50 and 200-day simple moving averages. As of today, SOCL is dropping below each of those levels as it is losing almost 3% and hitting 6-week lows. This not only confirms the false breakout, it also puts in place a lower high on the chart.
Most importantly, it casts major doubt on the likelihood that the bubble in social media stocks can be reinflated.
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Social Media Bubble Fails To Reinflate

We have discussed several times the tendency for sectors representing the bubble du jour — or at least the froth du jour — to top out (pop) ahead of the market, thus serving as a warning shot. Such froth is a result of over-crowding by investors as they chase the hot sector of the day. This behavior can be seen by following the level of margin debt, the behavior of which suggests much of the debt goes toward the bubbly sectors.

In a May 22 post, we pointed out how margin debt has historically topped simultaneously with the hot sector or bubble of the day. In the past few cycles, whether it was internet stocks in 2000 or financials in 2007, the bubbly sectors also peaked several months ahead of the major market averages. In the current cycle, margin debt peaked in February. We identified biotechs and social media stocks as likely “bubble” sectors that had popped in February-March, along with margin debt.

Since then, margin debt has made a bit of a comeback and is within spitting distance of its February high (as of July). Whether or not it makes a new high remains to be seen. If it does, it might largely be attributed to the biotech sector which has reinflated, surpassing its prior highs (much to our surprise). Social media stocks, however, are another story.

As judged by the Global X Social Media ETF (SOCL), social media stocks have not only been unable to approach their March highs, but they also are now failing in their attempt to do so. After dropping 30% from March to May, the ETF found support precisely at the key 61.8% Fibonacci Retracement of the 2012 to 2014 rally. (When a security does this, it gives us confidence that it is “respecting” the analysis, i.e., it is valid.) During September, SOCL has attempted to break above key resistance levels marked by the 61.8% Fibonacci Retracement of the March-May decline as well as the 50 and 200-day simple moving averages. As of today, SOCL is dropping below each of those levels as it is losing almost 3% and hitting 6-week lows. This not only confirms the false breakout, it also puts in place a lower high on the chart.

Most importantly, it casts major doubt on the likelihood that the bubble in social media stocks can be reinflated.

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V-Bottom Update: Current Cycle Still Following The Template
On August 19, we noted that given the recent action in the stock market, “V-Bottoms” were still in fashion. By that we meant the recent propensity for the market to rebound sharply from a short-term sell off and immediately bounce to previous highs. Based on the criteria we laid out in that post, the S&P 500 had just achieved the 8th V-Bottom since the beginning of 2013 — this, after forming just 38 such bottoms in the prior 62 years, or 1 every 1.7 years.
Our August 21 Chart Of The Day looked at the 7 V-Bottoms since 2013 to get an idea of what we might expect from the current iteration. The general tendency following the V-Bottoms was for the market to grind its way higher for another month or two, with very little in the way of drawdowns along the way. The current cycle has tracked that template over the past month since the post.
Since hitting a new high on August 21, the S&P 500 has generally moved sideways, with a slight upward bias, i.e., a grind higher. The high for the S&P 500 was set last Thursday, September 18. That marked the 29th day since the V-Bottom low. The average duration from the low to subsequent short-term high following the 7 prior V-Bottoms was 36 days, so the S&P 500 is near that benchmark. That said, the duration of the post V-Bottom rallies has varied widely. Of the 4 cycles that went further than the current one, 2 of them lasted 57 and 58 days respectively. In the present cycle, that would equate to another 5 weeks beyond today. So there is precedence for the move to persist for awhile longer.
In terms of magnitude of gain, the high on September 18 was 1.18% above the prior cycle high. That is the 2nd weakest post V-Bottom rally of the past 2 years. Interestingly, the only cycle that saw a shallower new high, at just 0.93%, occurred during the same seasonal period last year, from August to September. Perhaps that is coincidence, perhaps not.
What would be a tell that the current cycle has topped? Based on the previous 7 cycles, we see that drawdowns have been extremely limited following the move to a new high. The worst was a mere 1% below the previous cycle closing high. The high of the prior cycle was 1987.98 on July 24. Should the S&P 500 drop below about 1968, representing an approximate 1% drop below the prior high, it may be a head’s up that this V-Bottom cycle has run its course.
Based on alternate analysis, we see key support on the S&P 500 at 1970-1975 so that would support the notion of the 1968 level as relevant.
Of course, the S&P 500 could break that level and proceed to form yet another V-Bottom and head back up again. We will address that possibility should it arrive. For now, the S&P 500 continues to follow the V-Bottom template laid out by the previous 7 occurrences. While we have plenty of concerns about this market (other broad indexes are not following this pattern), as long as price continues to conform to the template, we will assume the present V-Bottom cycle is still in force.
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V-Bottom Update: Current Cycle Still Following The Template

On August 19, we noted that given the recent action in the stock market, “V-Bottoms” were still in fashion. By that we meant the recent propensity for the market to rebound sharply from a short-term sell off and immediately bounce to previous highs. Based on the criteria we laid out in that post, the S&P 500 had just achieved the 8th V-Bottom since the beginning of 2013 — this, after forming just 38 such bottoms in the prior 62 years, or 1 every 1.7 years.

Our August 21 Chart Of The Day looked at the 7 V-Bottoms since 2013 to get an idea of what we might expect from the current iteration. The general tendency following the V-Bottoms was for the market to grind its way higher for another month or two, with very little in the way of drawdowns along the way. The current cycle has tracked that template over the past month since the post.

Since hitting a new high on August 21, the S&P 500 has generally moved sideways, with a slight upward bias, i.e., a grind higher. The high for the S&P 500 was set last Thursday, September 18. That marked the 29th day since the V-Bottom low. The average duration from the low to subsequent short-term high following the 7 prior V-Bottoms was 36 days, so the S&P 500 is near that benchmark. That said, the duration of the post V-Bottom rallies has varied widely. Of the 4 cycles that went further than the current one, 2 of them lasted 57 and 58 days respectively. In the present cycle, that would equate to another 5 weeks beyond today. So there is precedence for the move to persist for awhile longer.

In terms of magnitude of gain, the high on September 18 was 1.18% above the prior cycle high. That is the 2nd weakest post V-Bottom rally of the past 2 years. Interestingly, the only cycle that saw a shallower new high, at just 0.93%, occurred during the same seasonal period last year, from August to September. Perhaps that is coincidence, perhaps not.

What would be a tell that the current cycle has topped? Based on the previous 7 cycles, we see that drawdowns have been extremely limited following the move to a new high. The worst was a mere 1% below the previous cycle closing high. The high of the prior cycle was 1987.98 on July 24. Should the S&P 500 drop below about 1968, representing an approximate 1% drop below the prior high, it may be a head’s up that this V-Bottom cycle has run its course.

Based on alternate analysis, we see key support on the S&P 500 at 1970-1975 so that would support the notion of the 1968 level as relevant.

Of course, the S&P 500 could break that level and proceed to form yet another V-Bottom and head back up again. We will address that possibility should it arrive. For now, the S&P 500 continues to follow the V-Bottom template laid out by the previous 7 occurrences. While we have plenty of concerns about this market (other broad indexes are not following this pattern), as long as price continues to conform to the template, we will assume the present V-Bottom cycle is still in force.

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