When investors buy a bottom like this, they are running the risk of finding themselves in a so-called “bull trap.” It’s called that because investors get long at a low, expecting prices to rise, but are then trapped in a losing position when the market continues to fall. The holy-grail of investing would be to be able to tell the difference between a true bottom and a bull trap at this point.
Unfortunately, time and confirmation are the only things that can confirm a true bottom versus a bull trap, and that is what we are looking for right now. Confirmation can appear in the form of improving fundamentals, bullish-divergences, or a comparison with economic sectors like transportation and manufacturing.
Improving Fundamentals? – Not so much…
Unfortunately, this earnings season has been a bit of a disappointment. Economic data has also been soft. This isn’t like 2008 when companies were actually losing money on average, but growth rates have definitely slowed. The earnings growth rate for the latest quarter was 2.1%, compared to 3.3% and 4.2% for the two quarters before it. Based on that alone, we would add a little weight to the argument in favor of a bull trap. Something similar took place in early 2012 before the big dip.
Bullish Divergences? – No luck yet…
Bullish divergences can appear in technical indicators (no luck there yet), or in asset classes that are similar enough to be correlated — but not identical. If one asset class is moving higher while the other is flat or a little bearish following a pullback like this, it is usually a good sign. For example, in the next chart, you can see the S&P 500 (candles) compared to the yield on 10-Year U.S. Treasuries (line). These two indexes normally have a very strong positive correlation, but sometimes yields will lead stocks.
For example, during the May drop in stock prices, yields continued to rise. Unless there is a general market panic, this is usually a good sign that stocks will find a bottom and begin to rise again in the short term as well, which played out as we would have expected. As you can see in the chart, yields have been choppy during the last week or so, without any significant gains. Bond investors don’t seem to be pricing in much additional growth.
What About Transports? – Talk about a flat tire…
Technicians also look for confirmation of a true bottom in economic sectors like transportation and manufacturing. The Dow Jones Transportation Index led stocks higher in December of last year and in early July of this year as well. However, today’s bounce in the S&P 500 has not been accompanied by a rise in transport stocks.
As you can see in the next chart, transports (black and white candles) have led the decline, and have lagged the S&P 500 significantly on today’s bounce. This isn’t a sell signal, but it’s not a positive sign either. If investors really are becoming more bullish and are finding a bottom, we would see the prices between these two indexes move together much more closely. Transports often lead a legitimate breakout, which is not happening right now.
To be clear, these signals merely represent a lack of confirmation that the market has found a true bottom. This increases the risk of a bull trap, but does not constitute a strong sell signal either. This is the kind of market environment where short-term option traders continue to take a balanced approach to their trades.
The bottom line is that the market is not showing true conviction for a new bull run, so we remain more neutral to bearish in our short-term outlook as well. The primary trend is still positive, so an outright bearish forecast isn’t justified. This also means volatility will likely still be elevated in the near term, which can be disconcerting for some traders. However, that kind of market action can also lead to some big profits like we have seen recently.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.