Six trading weeks into the new year, and the bear is growling ever so loudly.
Click to Enlarge Throughout 2015, I highlighted the negative divergence between smaller-cap stocks — as represented by the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM) — versus the the S&P 500, as well as divergences from other important parts of the market. Say, transportation stocks.
Such bigger-picture divergences have a tendency to take six to 12 months to finally come to fruition and bring down the entire stock market. This is exactly what began to take hold in January, and unfortunately (and as usual), few people were prepared for the “sudden” risk-off environment.
With the Russell 2000 off 25% from its 2015 highs, the index — along with many other pockets of the U.S. stock market — is well in bear market territory. Bear markets, however, have a tendency to see sharp counter-trend rallies, which is to say that those investors still holding on to stocks may be able to sell them into the next bounce.
In particular, there are three important exchange-traded funds that investors should look to sell on a better oversold bounce. Active investors could play these ETFs on both sides.
I expect the iShares Transportation Average ETF (NYSEARCA:IYT), Financial SPDR (NYSEARCA:XLF) and the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) to bounce to lower highs and ultimately see lower lows into the second half of 2016.
Here’s why, and the numbers to watch.
iShares Transportation Average ETF (IYT)
Click to Enlarge At least through the first half of 2016, I want to buy into deep selloffs for trades, but more importantly, I want to sell into bear market rallies.
The transportation stocks — as represented by the iShares Transportation Average ETF (IYT) — peaked in November 2014 and showed relative weakness versus the S&P 500 all throughout 2015. Dow theorists who believe in the leading indicator nature of transportation stocks at important turning points thus had plenty of time last year to heed this call.
This divergence is clearly visible on the chart, where we see that although the S&P 500 (lower part of chart) began slowing the rate of change higher in the first half of 2016, it did manage to rally to higher high by May before stronger headwinds arrived in the summer and autumn months.
In the bigger picture, we see a well-defined line of support (black horizontal) that needs to be retested before this first cyclical bear market since the 2009 lows has run its course. The IYT dropped about 30% from the 2014 highs down to the recent January lows and thus finds itself well into bear market territory.
Given the oversold readings from a momentum perspective that we are seeing in many parts of the stock market, a sharp counter-trend bounce that could last through the end of the first quarter looks likely.
However, the IYT should then find better resistance around the mid- to high $130s before resuming the downtrend, which has a price target closer to the $100 mark.
Financial SPDR (XLF)
Click to Enlarge The second part of the U.S. stock market that will likely see more downside later in 2016 is the financial sector.
The Financial SPDR (XLF) — and thus many banking and other financial services stocks — began to falter soon after the Federal Reserve’s interest rate hike in December. On the multiyear weekly chart, we detect a very similar pattern to that of the transportation stocks in the previous chart.
Note that after a long consolidation phase following the initial V-shaped bottom in 2009, the XLF finally managed to break past horizontal resistance in early 2013. The ascent continued in an orderly fashion until things turned rockier last summer as the broader stock market’s volatility also severely hit the financial stocks. The XLF then bounced to a lower high in November of last year, and once again began accelerating lower after the interest rate hike.
The big and obvious target area for the XLF to gravitate to is the black horizontal line (previous resistance around the $17 area). Here too, I do not foresee this target to be hit in a straight line and think that a better bear market rally into the end of the first quarter stands a good chance.
Ultimately, however, this bear market rally should only bounce the XLF to another lower high, as neither global economic growth nor inflation expectations support much higher interest rates.
Ironically, the financials already told us that higher interest rates are not sustainable, as they came under heavy selling pressure in late December and into January. Now that the Federal Reserve is easing off the hawkish tone, this will likely put further selling pressure on financials for the time being.
SPDR S&P 500 ETF (SPY)
Click to Enlarge It is a fact that bear markets have vicious rallies, which is why I expect 2016 to be a great year for active investing and trading. We already saw a first glimpse of this in January.
Sadly, many market participants present today have never traded through a bear market and thus continue to blindly buy every dip, until they at some point (likely much too late) end up bearish.
Looking at the chart of the SPDR S&P 500 ETF Trust (SPY), once more we see a picture very similar to that of the transportation and financial stocks. In 2013, the SPY managed to break past its previous all-time highs from 2007 and as a result confirmed the new secular bull market that was born out of the financial crisis lows. But the price action of the S&P 500 since the volatility in the fall of 2014 has been top-building and indeed last year the index completed a so called rounding top pattern.
In the near- to medium-term (i.e., through the first quarter and possibly into early second quarter) the SPY also is oversold and should bounce, but like the other two ETFs, it likely will bounce only to a lower high and find resistance — in the SPY’s case, the $200 mark.
Ultimately, the chances are high that before this bear market has run its course, the SPY and thus the S&P 500 will have to revisit its 2013 breakout point, which is the black horizontal on the chart. For the S&P 500, this means a move back toward the 1,600 area, which in SPY terms is $160. This area also matches up with a 38.2% Fibonacci retracement of the entire rally from the 2009 lows up to the 2015 highs, although an overshooting to the downside into the 1,550 area cannot be ruled out.
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