Yom Kippur Bottom...Or Just More Volatility?

Trend Model signal summary
Trend Model signal: Risk-off (downgrade)
Direction of last change: Negative

The actual historical (not back-tested) buy and sell signals of the Trend Model are shown in the chart below:

here ). The index incorporates a number of sentiment and short-term technical indicators to arrive at a composite score.

Conceptually, I am having some trouble with the scaling. Is last week`s extreme reading, which is associated with a minor pullback of less than 5%, truly comparable to the Eurozone Crisis of 2011 and Taper Tantrum of 2012, which were far more substantial corrections? While it is true that many market breadth indicators reached deeply oversold conditions last week, I believe that we have to put those readings into some perspective.

The chart below shows the SPX in top panel, bullish point and figure % in the middle panel and % above 200 dma in the bottom panel for the last four years. While the two indicators reached levels that are consistent with market bottoms seen in the last two years, I would also point out that the stock market has more or less risen in a straight line with only minor pullbacks in the same period.

Moreover, the SPX appears to have breached an uptrend line last week, which may foreshadow a deeper corrective period. The key question then becomes: "Is this the start of a bounce or a much deeper correction?"

 A tradable bottom?  and reiterated in The Big Kahuna Korrection, or buy Yom Kippur?, above). They consist of:

1. The combination of TRIN greater than 2 AND an inversion of the VIX term structure; and
2. An oversold condition in my favorite overbought-oversold indicator  and it starts to mean revert back to a neutral reading.

As the chart below shows, past instances of this trifecta of conditions, which are marked by the dotted vertical lines, have yielded buy signals with a 100% success rate. Currently, we saw TRIN rise above 2, but the other two conditions, namely VIX term structure inversion and an oversold reading in the OBOS model were not achieved. To be sure, the absence of these conditions do not necessarily preclude a market bottom, but the success rate of such a call will be less favorable.
Dash of Insight ):

If your head is spinning, it’s not your fault. The world’s major economies have taken different paths and are headed in different directions as the third quarter comes to a close.

• The United States’ leadership has been reinforced by the sluggishness in most other major economies that is helping keep inflation, oil prices, and interest rates low.
• China’s solid start to the quarter deteriorated quickly. The most dramatic example was the 6.9% growth in industrial production in August, the worst reading since the financial crisis of five years ago.
• Japan’s economy suffered from the aftermath of the April tax hike. However, the economy showed some improvement during the quarter as the impact of the tax hikes began to fade and the aggressive economic stimulus supplied by the Bank of Japan was increasingly felt.
• Europe remains stuck in a negative spiral on the brink of the third recession in six years and is dangerously close to deflation with the year-over-year pace of inflation coming in at just 0.4% in August.

Markets tend to respond to how actual data compare to expectations, rather than whether that data is strong or weak in an absolute sense. For example, even a weak data point may inspire a lift to stocks if it was better than generally expected. The chart below depicts how actual data has been faring relative to expectations over the past three months and in what direction the data is trending relative to those expectations for the world’s major economies.

h3 Major economies on different paths/h3 h3
Given the current environment, increased volatility appears to be a reasonable bet.

My inner trade remains bearishly positioned, with tight stops. I could be wrong on my tactical market call and this could turn out to be a short-term market bottom, but that's why risk control is important at times like this.

My inner investor is cautiously looking to dial back some risk by raising cash in rallies, but he is not in panic mode as the current episode is, at worst, likely to be a relatively minor correction.

Disclosure: Long SPXU, TZA

Written By: Cam Hui