Circling Back Around

In my September 5th blog post after posing the question whether the DJ Internet index formed an intermediate term top, I stated I would circle back around to find the answer to the question. At the time the almost ideal head and shoulders topping pattern had developed and, if played out, pointed to a 12% (or more) decline in the index. I also stated “The two possibilities are 1) a completion move down to T1 or below; or 2) a failure confirmed by a move back above early August’s right shoulder high (before it has completed a move to T1)”.  Here is how the chart of the index looked at the time of the post.

Fast forward to the present and here is how the chart looks as of yesterday’s close.

With the benefit of the recent US Stock market weakness, the answer to my question was a resounding yes as the index met and eventually exceeded the pattern’s target, falling 20% peak to trough as measured from the pattern’s neckline. This is NOT a testament to the power of technical analysis being a predictive tool. It is not. What it is though, is a very good risk management tool. At the time of the post an investor in the index, armed with the knowledge of the possibility of a 12% or more decline in their investment, needed to ask themselves if they wanted to accept that risk. If so, welcome to investing, you just experienced a 20% drawdown. Now what? If not and you exited, congratulations, you have a bigger pile of cash to invest when the next opportunity arises. Not if it arises, but when

November 2018 Charts on the Move Video

As we wind down 2018 (where did it go?) with global stock markets struggling, I am beginning to wonder whether the normal positive seasonality tailwinds will show up and bring investors some year-end joy. Regardless, the markets have been sending some real clear messages on how best to invest. Were you listening?  My take can be viewed in November’s Charts on the Move video link below  

https://youtu.be/suT2WmaOr9A

Its (Almost) That Time

I have found models are a key component of managing money in the markets. Not only do they keep it very mechanical and easily manageable, they help to keep a human’s natural biases out of the financial decision-making process. For client portfolios, I have created a couple of models that attempt to strike a balance between risk/losses and trading activity. The shorter term your timeframe the more trading activity will occur in the account (more signals).  Whereas longer term timeframes help reduce the trading activity, but opens an account up to much greater drawdowns (signals are fewer and slower). And then there is the fact that no model is always correct which brings in a whole new set of problems but those are worthy of their own separate blog post and won’t be addressed herein.

My two longer term client models (one based upon weekly price movement, the other on monthly) are both within a cat’s whisker of providing a US stock market sell signal. Europe, Asia, the emerging and frontier markets all triggered sells much earlier in the year so the fact the US has held up this long is a testament to its strength. It appears as if we are finally looking at the potential for substantially bigger move to the downside.

My weekly proprietary model, Sightline, triggered last week but is waiting for a final confirmation before it becomes an official sell signal (a key rule within the model). With respect to the monthly model, I thought it worth posting the chart for review.

All 4 components of the monthly model, RSI momentum crossover and negative divergence, price moving average crossover, PMO and MACD moving average crossover have all occurred, the confirmation needed to reduce exposure to US stocks. While the trigger for each component is currently in place for a sell signal, one of model’s rules require that they all have triggered at the end of the month (intra month does not count). Since we have a few more days left in November (and a chance for the expected year-end rally to reverse and put this model on hold) we need to provide both models a bit more time to activate an “official” US stock sell signal.

De-Fang’ed

While we can debate whether we are at the end of the bull market, looking back, there is no question the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) had been the leaders of rising stock prices. But ever since the broad market’s peak in September, these same stocks have been leading the market lower. In fact, collectively they have lost more than $1T in stock market capitalization since that high was put in. Based upon my methodology 4 of the 5 have put in a long term sell signal, the most recent Netflix occurred last week.

Taking a look at the Netflix, NFLX, chart it should be obvious by now the head and shoulders topping pattern that has developed. Currently, price has fallen below the pattern’s neckline triggering a sell (or short if you are aggressive) signal. The pattern’s target is down at Q4 2017’s low, labeled T1. Notice how price has fallen and has, at least so far, held below its flat 200 day moving average.  In the upper pane RSI momentum warned of a potential correction/reversal as it formed divergence with price (momentum was falling while price was rising).  All of these signals point to the potential of much further future downside.

With so much current broad-based downside momentum this is an idea on the short side for aggressive, experienced traders only. The high probability reward-risk ratio is not as favorable to meet my needs as it is just slightly less above 1.5, well below the 3:1 target as such I will be just observing this from the sidelines.

Uh-Oh! A Death Cross

In case you haven’t heard “US Small cap stocks just formed a death cross”. Eee gads. Kinda grabs your attention as it sounds ominous, doesn’t it? The name conjures up thoughts of October 1929.  In technical analysis jargon a death cross is nothing more than when the 50-day moving average crosses under the 200-day average.  Those trying to grab your attention in order to sell advertising just love names like death cross. Fear pays. Another one that comes to mind is the Hindenburg omen.  Sell everything, run for cover and get into your bomb shelter we have had a number of recent Hindenburg sightings of late.  There are, of course, others but I digress.

Why make news of the death cross? There are some people (those that must not care about probabilities) that use the death cross as a signal to sell their stocks. Like all things involved with TA, sometimes it works and sometimes it doesn’t.  Either way … gotta have a plan and this is, well … at least a plan. As it turns out, not a statistically profitable one. A death cross on small cap stocks has not been historically threatening at all. In fact, it’s just the opposite. The good folks at quantifiableedges.com did a study that looked at what stock market returns had been after small cap stocks formed a death cross. Here are their comments and results regarding their death cross study …

“It is being promoted as a warning of a potential bear market. Of course, all bear markets will see this happen at some point, because a bear market is an extended decline. But the real question when considering the implications of the Death Cross are whether it serves any value in predicting a bear market. To answer this, I did an examination of past Russell Death Crosses, and what they meant for the S&P 500. Both of my data sources show Russell data back to late 1987. And since I need 200 days to calculate a 200-day moving average, the earliest the study could look back to was 1988”.

In their study, they purchased a hypothetical $100k in the SP500 stock index, each time a death cross occurred in the small cap index and sold the index once the 50 day moving average crossed back above the 200 day moving average. If the death cross were a viable stock market sell signal, this study should show a loss since we are doing just the opposite of the “signal” … here are the stats, profit curve of the hypothetical trade and ending comments. “

“Eighteen winners. Only three losers. So 86% of the “predictions” were wrong” and a total net profit of over $78,000 on a $100,000 investment. As such “I am having a hard time seeing the Russell 2000 Death Cross as a bearish indication. You would have a much easier time convincing me this is a bullish indication for the intermediate-term.”