Wow, That was Fast!

Back on March 1st I wrote about the inverse head and shoulders pattern developing setting the stage for a big rally in Beef prices in “It’s What’s for Dinner”.  At the time cattle future prices were hovering around $55/contract and the pattern’s upside target was some 45% higher at $80.  I am happy to say that last week that target was hit. While it is massively overbought, there is no divergence and as such looks like it may want to make another push higher after the current pullback is complete. Anyone who followed the call should consider taking at least partial profits. 

It’s important to remember pattern opportunities don’t always work out this well and when they do, it is rare they move this quickly.

A Retest or Bear Trap?

The 10 year Treasury bond yield found a bottom last July and rose almost 100% in 5 short months. Since topping and forming negative momentum divergence in mid-December, the yield chopped around in a sideways consolidation until mid-April where the 2.34% critical support eventually level failed. 

As we know, frequently when price (in this case yield) breaks below a critical support level, it will often back-test that same level immediately after the break. If that back-test holds, it will typically give the bulls a chance to exit their positions and then see the bears take complete control pushing it lower. Of course, nothing is that easy otherwise we would all be gazillionaires. In addition, there are times when the back-test slices right through the support line like it wasn’t there and climbs higher. This is a classic “bear trap” as investors who shorted at the breakdown are now holding a losing trade (“trapped short”).

As you can see, yields are currently back-testing the underside of critical support as it sits within a cats whisker of it. I pointed out the break down in a past blog post and called an “all clear” to get back into bonds expecting the market to normalize rates lower. We are within a week or less before we find out whether the market is going to prove me wrong and trap yield bear or reverse course and restart the fall in rates (or increase in bond prices since they move inversely)

Change

It is not necessary to change. Survival is not mandatory. ~W. Edwards Deming

The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails. - William Arthur Ward
 

While one could quarrel with whether Amazon is a technology company or a retailer, it would be very difficult to argue the investment world has not dramatically changed.

An All Clear (intermediate term) Signal for Bonds?

The US 30 year long bond peaked in July of last year and the combination of FED threats of multiple (4) interest rate increases and the Trump pro-growth election agenda had the effect of a proverbial “rug pull” out from under US bond prices. In 9 months the T-bond lost 17% (a huge amount for a so called “safe” investment) and shocked many investors as losses piled up.

It seems like political reality has finally set in, and the expectations for a FED rate increase next month is now down to just above 4%. Combine that with the fact that smart money (commercial interest) piled into bonds and are now at multi-year highs in their Treasury bond holdings provides all the reasons why we see bond prices bottoming, reversing course and moving higher. Price broke out of a double bottom pattern earlier this week and was precluded by an oversold divergent low, a high probability “buy-me” signal.  The pattern will be confirmed by a hold above the red horizontal breakout level.

If this pattern plays out, it projects to a rally up to the very important support/resistance zone marked T1. Coincidently (and should not come as a surprise) it comes at a time that retail bond investors turned overly bearish (a theme we see repeated over and over in investing – retail investors being on the wrong side of the trade).  As always after a major correction, investors patience will be tested as only time will tell if this reversal goes on to eventually form a lower high or instead on to make new highs. Until that is determined, it appears as if the market is giving the “all clear” signal to be long US T-bonds and because the institutions are buying again, at the same time their appetite for equities is weakening

Eyeing Small Caps

With the recent methodical (and much needed) pullback in the US stock market, I have been amazed at how orderly it has been. There has not been the type of volume patterns or fearful unloading of stocks that normally occur …. Yet.  The couple of days where the indexes were down big early in the day, the bulls stepped in at the end and rallied prices.  The question I keep asking myself is this due to the unusually strong market (and is this as bad as its going to get) or are we biding time waiting for the other shoe waiting to drop to kick off the next, much deeper correction?

No matter where I look when I scan the market, I see the same story, overbought conditions combined with negative divergence warnings and sitting right on or just above support. Small cap stocks are no different as you can see in my chart of IWM below. At the price high in March, RSI momentum registered a divergent lower high (negative divergence). Since that time, price has formed lower highs and lower lows as it slowly grinds lower and sits slightly above (blue horizontal) support. It shouldn’t take much imagination to see this topping action is/has formed a head and shoulders pattern. Additionally, In the bottom pane, the ratio of small cap stock performance to the SP500 index shows it too, sits right on the supporting uptrend line.

If the bears take control and price breaks support with conviction to the downside, the first level of support is the 200-day moving average (T1), after that the head and shoulders pattern target (T2) is a potential place where we could find buyers reversing the trend. Beyond that if we really get a head of steam south, T3, last November’s low is where I would be looking for a counter trend bounce. I am not saying we are in for a much deeper pullback here because no one knows, but the current setup and market conditions (divergent overbought highs) almost always lead to a correction. What we won’t know until after the fact is if that negative divergence will be worked off over time (price holds support and we chop sideways) or via price (we see prices experience a much deeper pullback).

Whether it be first out of the gate higher after a selloff or the first to top out after a strong bull market run, small cap stocks can be the proverbial canary in the coal mine which is why I watch them so closely.