Mind The Charts: Internals Weaking, Divergences Growing, Volatility Rising

By Pater Tenebrarum at Acting Man blog

Back in mid September we presented an update of our chart comparing the stock markets of the euro area’s two largest economies with the S&P 500 (originally our main concern were the glaring divergences between them) and wondered aloud if the DAX and CAC 40 had just “back-kissed” their broken trend lines.

This is what the situation looks like as of Thursday’s close – we left our annotations from September 15 (in blue) on the chart – the added wording is in green.

1-Back-kiss-updateThe “trendline back-kiss” idea has in the meantime been fully confirmed – click to enlarge.

One thing we would like to point out here is that no divergence exists as of yet with respect to the recent lows – neither the European indexes nor the SPX have as of yet undercut the previous short term low made in August.

The same can not be said of the downside leader Russell 2000, which landed at a new low for the year on Thursday. Along similar lines, the broad-based NYA has undercut its August low clearly by now. It is also worth noting that market internals continue to exhibit significant deterioration – e.g. new lows expanded to 2 – 3 year highs this week, depending on the index one cared to look at.

Volatility Expands

Most remarkable is however the sudden big expansion in market volatility. Fairly large (by recent standards) down days and up days keep following closely on the heels of each other. As “trigger events” for both the moves down and the moves up many observers have blamed jawboning by Fed officials. The FOMC minutes were interpreted as dovish, but on Thursday, seemingly more hawkish comments were made by James Bullard, and the market reversed direction once again. Such a sudden increase in market volatility is at the very least a warning shot, even if – and that is by no means certain – it doesn’t result in an immediate breakdown.

Market psychology is becoming more fragile in this volatile environment. It wouldn’t take much for this to become a rout (many trading systems and other technically inspired traders are watching the same support/resistance levels after all). Also keep in mind that leverage in the market is still very close to record highs (combined margin debt and hedge fund leverage).

Even though the “dovish faction” at the Fed keeps reminding everybody that “tapering is not tightening”, this is actually not true. One can easily ascertain this by looking at it the other way around: was “QE” a loosening of monetary policy? If the answer to that question is yes – and it obviously is – then the removal of “QE” is a tightening of monetary policy.

In spite of the increase in volatility, the market has not yet shown its hand 100%.   Up until now, spikes in short term bearish sentiment (as attested to by rising put-call ratios) have always been sufficient to create tradable lows followed by rallies to marginal new highs. We cannot rule out that the same will happen again, but as we have noted previously, the deterioration of market internals and the emergence of negative leadership from an index that provided positive leadership throughout the better part of the bullish cycle are all reasons to be wary. After all, every single significant market reversal in history has been preceded by a confluence of precisely these types of warning signals.

At the moment, something is clearly different from the action over the past two years or so, and risk is therefore increasing, regardless of how things shake out in the short term. Another point worth noting is that while trading volume has steadily expanded in the recent volatile corrective period, it is still far from indicating panic or capitulation.

2-SPX-NYA-RUTVolatility increases – the SPX and the “weak sisters” NYSE Composite and Russell 2000. The RUT/SPX ratio also continues to make new lows – click to enlarge.

While this may not be overly relevant to the recent action in the bigger markets, the stock market that has been the downside leader in euro-land – namely Portugal’s PSI-20 – is making new lows as well. To be sure, this is a rather small market with its very own problems. It has been the downside leader for good reasons, as the bankruptcy of Espirito Santo Bank and the insolvency of the associated family-owned business empire has heavily weighed on it.

However, readers may recall that we have pointed the emergence of this downside leadership trend out well before other European markets turned down, and called it a warning sign at the time. The fact that this index is making new lows in spite of being strongly “oversold” strikes us as slightly ominous.

3-PSI-20Portugal’s PSI-20 hits a new low for the move – click to enlarge.

Conclusion:

Bond yields dropped on Wednesday, thereby not confirming the rally in stocks, but likewise didn’t confirm the stock market decline on Thursday. Put buying has been surging as well, so it may not yet be “panic time” (even though the risk of a bigger sell-off is certainly ever present and strikes us as higher than on previous occasions of this sort). What the recent volatility at the very least shows is that the end of “QE” and the possibility of Fed rate hikes are not as easily shrugged off by the markets as was hitherto assumed by many observers.

We have kept a close eye on the money supply, and the slowdown in its growth momentum since early 2011 should certainly be of concern to bulls – even if the recent volatility should pass without any significant additional damage being inflicted in the near term. So far the market has found itself in trouble whenever one of the Fed’s major inflationary programs ended. The end of “QE3” and the perception that rate hikes may be in the offing sooner than expected (regardless of whether that perception ultimately turns out to be correct) are unlikely to prove exceptions to the rule, especially as valuations and leverage have greatly expanded and market internals have continued to weaken.

 

http://www.acting-man.com/?p=33433

 

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