If you’re feeling stressed about the market right now, you’re not alone. Since the beginning of the year, oil dropped below $30 per barrel, the Chinese stock market hit new lows, Japanese stocks officially reached bear market status and currencies in emerging markets are destabilizing the flow of capital around the world.
Adding to the uncertainty in the global economy are fourth-quarter earnings that will be streaming in over the next few weeks. For example, the big banks like Citigroup Inc (C), Bank of America Corp (BAC), Goldman Sachs Group Inc (GS) and Morgan Stanley (MS) have already reported, and their negative outlooks have hurt valuations despite beating analysts’ profit expectations.
A market like this isn’t great for buy-and-hold investors, but it can be very productive for shorter-term options traders because volatility can work in our favor. Regardless of what kind of trader you are, this market should be monitored for signals that bearishness is continuing to gather momentum, or that a reversal is becoming more likely.
We have put together five charts based on our latest research and analysis that provide the most reliable insight into where the market may be heading next. Sure, the evidence is biased to the downside in the short-term, but there are also two important charts that may give us an early heads-up before the market finds support and begins to bounce once the selling is done.
With these triggers on your radar, you’ll be poised to take advantage of the big market moves we see ahead and profit along with us for just $39 for your first two months as a member of Slingshot Trader.
Now, on to those vital charts:
The S&P 500 “Completed” a Head-and-Shoulders Pattern
The head-and-shoulders reversal pattern is a reliable signal indicating that the market is going to drop further. One appeared in 2007-08 that completed during the financial crisis, and another immediately preceded the technical bear market in 2011. An inverted head-and-shoulders pattern (bullish) kicked off the rally in 2009, and in 2010 after the “flash crash.”
As you can see in the chart below, the SPDR S&P 500 ETF Trust (SPY) (lower chart) is forming a nearly-complete head-and-shoulders pattern. However, if we equalize the index through the Guggenheim S&P 500 Equal Weight ETF (RSP) to reduce the impact of the so-called “FANG” stocks — Facebook Inc (FB), Amazon.com, Inc. (AMZN), Netflix, Inc. (NFLX) and Alphabet Inc (GOOG, GOOGL), which was the “G” back when it was just Google — then the S&P 500’s head-and-shoulders pattern has been complete for nearly two weeks.
At this point, it is reasonable to assume that the bias is still going to be to the downside over the next several weeks as the head-and-shoulder pattern completes and the market gives additional ground. We have a provisional target of around 1,720 on the S&P 500 — assuming things do not deteriorate further in China.
What Happens Next in China
It used to be that “when the U.S. catches a cold, the world gets the flu,” which is probably still true, but also could be applied to China in 2016.
As you can see in this chart, the Shanghai Class-A index has already completed a head-and-shoulder pattern, and the ripples from that decline are hurting everyone.
The real issue with China is leverage. Chinese stocks had such a long way to fall because they were driven by individual traders using margin. Banks are now loaning to investors who are using the proceeds merely to pay interest and meet margin calls. Excessive debt isn’t a problem for just individual traders either. Non-performing loans among commercial borrowers in China are rising, which could lead to a cascade of defaults if they continue to grow.
The decline in Chinese equities and assets has the secondary effect of destabilizing the Hong Kong dollar. Speculators are making bets that the long-standing peg to the U.S. dollar will have to be abandoned, which could lead to significant losses for Chinese, U.S. and European banks. We expect that the Shanghai Class-A index will drop back to early 2014 levels, but if momentum continues to be strong, the problems could spread. A similar set of circumstances in Thailand started the Asian financial crisis of 1997.
Watching for a “Flight to Quality”
Normally, if we were concerned about the potential for a larger decline, we would keep a very close eye on U.S. Treasury bond prices and the U.S. dollar. Investors tend to “flee” to safe, high-quality assets (at least on a relative basis), and that usually manifests itself through rising Treasury prices.
However, trouble in Asia has motivated China’s government to sell Treasuries at an increasing rate. That has distorted the market, and may disguise capital flowing into bonds.
An alternative measure of the flight to quality is the Japanese yen. Despite conventional economic theories that may have predicted otherwise, the yen and Japanese bonds tend to do very well during periods of economic uncertainty. Unfortunately for the Japanese economy, a stronger yen tends to be a drag on growth and could lead to a negative, self-reinforcing cycle.
As you can see in the chart above, the yen (top) has formed its own inverted head-and-shoulders pattern. The head and right-hand shoulder coincide with three major declines in the S&P 500 (bottom) in 2015. The easing campaigns by the Bank of Japan have pushed the yen’s value to its 2007 lows versus the dollar, so there is a lot of room to move to the upside from here. It is too early in the breakout to make a very large forecast; however, if the yen breaks its October 2014 lows, it should be considered a significant warning that investors are moving capital from risky to safe assets, which would increase the potential for a larger decline in U.S. equities.
Is the U.S. Consumer Dead?
The previous three charts are all fairly severe technical signals. They confirm each other and portend a rough first two quarters of 2016. How long that decline continues is uncertain, but there are two important charts that we suggest using to provide early warnings about when the bears might be running out of steam.
The U.S. economy is driven by internal consumption, which is an advantage that most emerging markets (including China) do not enjoy. We believe that part of the reason investors sold so quickly in January is that some cracks in the consumption story have started to appear. From 2009 through the middle of 2015, the leading sector in the U.S. was consumer discretionary. Strong retail stocks are a good thing during a bull market because it tends to be more stable with retail leadership.
However, consumer discretionary stocks (particularly apparel) took a big hit in late 2015, and the holiday-shopping season was dismal. Spending is down despite the decline in oil prices, which is weird because hiring has been fairly consistent. The bright side to this story is that retail stocks may be close to being discounted “enough,” and investors could start gearing up to drive prices higher.
As you can see in the chart above, the SPDR S&P Retail (ETF) (XRT) has hit long-term support. Based on the weekly bars, we may be looking at a bullish “reversal” harami forming, which could confirm this level as the bottom in retail stocks. While this signal is unconfirmed for now, it’s an important one to keep an eye on as we evaluate the likely depth of the S&P 500’s decline this quarter.
Just How Bearish Are Investors, Really?
The last chart is a little complicated, but we think it may provide the most compelling bullish evidence for a shallower decline in the S&P 500.
The line chart is the CBOE’s 30-day volatility or “fear” index (VIX) divided by the 90-day version of the same indicator (bottom), which is then compared to the S&P 500 (top). A higher ratio between the short-term and the long-term volatility index indicates a large difference between investor expectations for volatility this month compared to the current quarter. As you can see, extremes on this study tend to correlate closely with bounces in the S&P 500.
The reason this works is that investors tend to overestimate volatility in the short-term and are more rational about longer-term expectations. When short-term panic is at an extreme level compared to long-term estimates, it tends to correlate with the end of the selling. We would say that the difference between the two right now is “extended” but not “extreme.” However, if the selling in the S&P 500 continues into the next couple of weeks, the difference between the two will likely grow.
If we see the VIX/VXV ratio reach the same levels it did in January 2014, October 2014 or October 2015, it would mean the end of the decline is near. This signal has not completed yet, and it may not reach those levels if longer-term expectations worsen. Still, this is an indicator worth watching.
The evidence continues to look strong that selling in the market isn’t done yet. Assuming the major bearish reversal patterns on the S&P 500, Shanghai Class-A and Japanese yen indices are complete, the decline could take stocks down another 7% to 10% before the bears are done. As the market drops, we recommend watching consumer discretionary stocks and investor “fear” expectations to spot any early signals that the decline has finally concluded.