• Stocks formed a threatening 'island reversal' technical pattern last week
• This coincides with a potentially bearish 'double top' pattern with the prior all-time high
• We examine whether stocks are more likely to begin a significant downtrend or breakthrough to new all-time highs
Last week, the S&P 500 index may have concluded a five-month rally that saw the index recover from a sharp, -11% correction in February and March. But after bottoming at its 40-week moving average in mid-March, the S&P 500 gathered itself up and rallied more than 10% - last week once again touching the all-time high that it first set back on January 26 – nearly seven months ago.
In this article, we will briefly review the record-setting highlights of 2017 and 2018, setting the table for the paradox that currently confronts market participants. A binary outcome is possible in the coming weeks and months, one potentially very bearish – and one quite bullish. Let's see what the future holds...
Last year – 2017 – was a year of quiet, robust gains for the S&P 500. Multiple new records were set from the extraordinarily low amount of volatility. For example, the CBOE Volatility Index ($VIX) average daily close of 11.10 for the year was the lowest ever recorded, with prices rarely moving more than 1% during any trading session. The S&P 500 set another record last year – one that perhaps is surprising to many investors – when the S&P 500 was able to get through 12 consecutive months without a loss (the first time in the 93 years since it began). And by the way, it also recorded a gain of 20% – which is more than double the long-term average.
Then things began to come undone and reverse – as they are apt to do in an economic system that is dominated by the forces of mean-reversion. At the end of December 2017, another record was set when the Republican Congress passed and President Trump signing into law the most substantial corporate tax cut in the history of the United States, reducing the nominal tax rate by approximately -40%. However, shortly after that, the picture quickly became complicated for investors.
'FREE MONEY' FUELS RECORD-SETTING CORPORATE PROFIT LEVELS
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Chart 1: Corporate profits as a % of GDP have been at historically high levels since 2012 – 56% above the long-term average at about 6.4% and is now increasing again as a result of the Dec. 2017 tax cut. Source: BEA |
In January, many ordinarily conservative Wall Street firms began revising their first-quarter earnings forecasts upward to levels usually reserved for the outliers, with some of the highest quarterly-earnings growth estimates ever released. The consensus analyst estimate was that first-quarter 2018 profit growth would soar by 17% – with some estimates as high as 25% for the year, and investors became absolutely giddy at the prospect of the virtually 'free money' provided by the corporate tax cut.
Nearly 20% of S&P 500 companies revised their 2018 guidance upward in January, which established a new record according to FactSet. Many companies also announced new or increased stock-buyback schedules. As a result of all these developments, traders started purchasing shares hand-over-fist throughout January, mutual funds increased their purchases, ETF and equity funds-flow accelerated across the board, and the S&P 500 stock chart began forming a parabolic pattern – a development which never works out well for anyone.
Last year, the S&P 500 was apparently just getting warmed up with record-setting events, because this year there was a plethora of records set in just the first three months alone. As the world's premier stock index began accelerating higher in January, it extended to a level that stretched 13% above its key, 40-week moving average, and was accompanied by a Relative-Strength (RSI) reading of 92.27 on a weekly chart, which was the highest recorded in S&P 500 history – auspiciously – since the run-up to the 1929 market crash.
A RECORD-SETTING CORRECTION
As nearly everyone not under a rock is aware, stocks sharply corrected in early February of this year, dropping by about -12% in just two weeks from the all-time high set January 26, before recovering a bit and closing down -8.8% on Friday, February 9. During the following five weeks, the S&P 500 was frenzied, recording its most significant volatility in history (another record), which was a shocking mean-reversion from the smooth, steady growth to which many investors had grown accustomed during the prior year's exceptionally hushed performance.
Chart 2 below shows the SPDR S&P 500 ETF (SPY) with weekly candlesticks spanning the last 1.5 years. After those first two weeks of blistering decline in February woke investors out of their complacent slumber, the S&P 500 accelerated higher in fits and starts over the next five weeks to record an interim high at about 276 in early March. Shares subsequently declined, which established that short-term top at 276 as a new level of resistance (marked 'Resistance 1' in red in Chart 2) that would stretch into July before finally being broken.
Chart 2: Some analysts believe we have arrived at a bearish, double-top formation, and the ETFOptimize Market Trend Indicator in the lower window is now weakening. However, we could also see a short-term correction two support level, followed by a breakout to new highs.
Following the interim high at 276 in March, the S&P 500 plummeted once again by -7.3% over the following two weeks, finally returning stocks to their long-term, 40-week exponential moving average (dotted green line). This level is where we predicted – with nearly uncanny accuracy, if we do say so ourselves – in a (very unpopular at the time) mid-January article, stocks would end up in the coming months. We have marked this spot with a green arrow and the words "Support (Bottom of the Correction)" in Chart 2, above.
Whenever a correction begins, the long-term, 40-week EMA (or alternatively, the 50-week EMA) is invariably the most likely 'home base' that stocks must reach before a fresh rally can begin. The 40-week EMA was the immediate target that experienced investors identified when it became clear a correction had started, and they first looked down in the thin air from that January 26 all-time high at 284 on SPY. It had taken eight weeks, but stocks had returned 'home,' and could start over once again with a clean slate.
Investors habitually become over-exuberant during bull markets – apparently unable to stop themselves – and in the ensuing feeding frenzy, they bid share prices up too far–too fast from their long-term averages, with stock prices experiencing something similar to a modified-gravitational effect. However, the stock market version of the law of gravity would surely confound Newton, because the invisible, meaning-reverting force that operates on stock prices invariably increases in strength the further away shares stretch from their long-term averages. The center of the stock market's special 'gravitational force' is almost always either the 40-week (10-month) or the 50-week (one-year) exponential moving averages.
The interim low set in March at the 40-week EMA (marked 'Support – Bottom of the Correction' in green in Chart 2, above) officially ended the 'correction' phase of 2018's first-half market event and established a stable bottom that stocks would use as a launchpad for the upcoming multi-month uptrend.
The S&P 500 then proceeded to begin a five-month, robust rally, gaining 10.22% (22% annualized) and last week finally returned to the same level last seen at the January 26, all-time high at 284 on the SPDR S&P 500 ETF (marked by the red arrow on the top-right of Chart 2). So what should investors expect next?
HAVE STOCKS FORMED A DOUBLE TOP?
The end of last week and early this week (beginning Monday, August 13) is kicking off with an auspicious decline after touching the prior high at 284, which establishes a new resistance level (marked Resistance 2' with a red dotted line in Chart 2, above), and sets up what many advisors and analysts are identifying as a bearish Double Top reversal pattern.
Most of those analysts jumping on the 'double-top' bus were already bearish throughout most of 2018, worried about multiple potential geopolitical risks facing the market, which for many, is led by the economic fallout from President Trump's aggressive tariff attacks that have been rolled out on both friend and foe, economic ally and economic competitor alike. Many Republicans, no matter how dedicated, find it difficult (for example) to justify punishing Canada for supposedly "taking economic advantage" of America. There are also additional, separate international economic risks, such as the meltdown of Turkey's economy, the implementation of Brexit as England formally separates from the EU, and the legal and political risks facing an American president in a criminal, counterintelligence investigation.
We won't regurgitate the details of all of those sordid stories, but Wall Street's Bears have had plenty of ammunition for their articles and editorials this year. The fact that the market has not set a new high in more than seven months lends some credence to the bearish arguments, and many investors embrace those explanations and are using the bearish forecast as the basis for their long-term investment strategy. Of course, some investors lean towards being conservative by nature, or perhaps as a result of prior economic injury, and are quick to latch onto any downbeat explanation of conditions as a reason to curtail market exposure.
On the other hand, perhaps the bearish/conservative advisors and investors have a good reason to have that position. When ETFOptimize sent out last weekend's communication to let subscribers know that we had completed their strategy update, we included a brief synopsis of market conditions. In that summary, we forecast a short-term pullback then a breakthrough of the 'Resistance 2' level at 284 on SPY, followed by new all-time highs and a strong run for some time to come.
However, we observed an unambiguous signal at the beginning of this week – or more accurately, the lack of a development that would negate last week's negative message, which could suggest we might be in for a significant batch of trouble. The market phenomenon that has developed is called an island reversal and usually signals a critical market turn.
A RARE 'ISLAND REVERSAL' PATTERN?
Chart 3 below shows the bearish island reversal pattern that formed at the end of last week and early this week. A multi-day event creates the configuration within the context of a broader trend. The first requirement is that there has been an uptrend in place for some time – perhaps too much time. In this case, the trend has been the aforementioned five-plus-month rally that began back in March at the 40-week moving average. The pattern starts with an exhaustion gap that occurs right at the end of the market move. It is called an exhaustion gap because it is considered to be the 'last gasp' in the uptrend.
Chart 3: At the end of last week and the beginning of this week, many stock indices formed a pattern that is known as an 'island reversal.'
Sometimes an exhaustion gap is followed within a few days by a breakaway gap in the other direction, leaving several days of price action isolation by two gaps – an island consisting of a few day's activities. This auspicious pattern is precisely what occurred at the end of last week – and which had follow-through this week in the form of bullish investor's inability to fill the gap. Those optimistic participants attempted to close the gap on Tuesday but were unsuccessful. Whether or not that gap is closed in the next few days will likely be a harbinger of the near-term direction of the market – and possibly its long-term outcome.
Investors demonstrated the last-gasp effort to keep prices climbing last week with a three-day attempt to close above the all-time high set last January 26 at 284 on the S&P 500 ETF (SPY). On Tuesday, Wednesday, and Thursday, SPY closed at slightly above 285 before dropping back below the all-time high to close the week at 283.16. This is one of the reasons we always use weekly charts – it's the week's closing prices that are important – not the inconsequential noise that takes place intra-week!
As long as the gap surrounding 284 remains unfilled, the bearish signal remains in place. Furthermore, because we are toying with the all-time-high at this level and have established what many are identifying as a bearish double top formation, the set up is a compounded in the bearish direction.
Sometimes we have to consider whether a chart pattern might be a mere anomaly. However, in this case there's no chance of that because the island reversal pattern also appeared in multiple market indices, particularly sector indices in the S&P 500, such as the Industrials SPDR (XLI), the Financials SPDR (XLF), the Technology SPDR (XLK), as well as the iShares PHLX Semiconductor ETF (SOXX), the iShares US Broker-Dealer ETF (IAI), and others.
...OR JUST A SHORT-TERM PULLBACK?
On the other hand, it is only natural for the market to back-and-fill a bit after the robust run its had since the March low some five months ago. Furthermore, the previously-established all-time high at 284 as a natural spot for stocks to take that breather once they revisited that level. So there is an alternative, bullish scenario that is available...
Chart 4 below shows a zoom into the final six months of Chart 2, providing a more detailed look into the S&P 500's technical set up and establishing a Pullback Target if any downturn we see is just short-term.
Most importantly to observe, is that there is a confluence of support that has formed at about 277 on the S&P 500 ETF (SPY). This consists of the all-important, 20-week moving average (dotted-pink line in Chart 4, below) – which also served as support and a launchpad for short-term rallies in early May and early July. The level around 277-278 also coincides with the 'Resistance 1' level that fell aside in July and therefore became 'Support' in green (Rule of thumb: broken resistance always becomes the first support level – and vice versa).
Chart 4: A 6-month zoom into the S&P 500 analysis in Chart 2 provides greater detail than is available from Chart 2. There is a confluence of support around the 277-278 level that establishes it as the most likely candidate for a near-term low before the market once again launches skyward.
We have marked this area with a green arrow and the words 'Pullback Target,' which, depending on the time required to reach it, would be in the 277-280 area, and which is nothing more than a garden-variety, -3% pullback. If, after reaching that level, stocks bounce higher, it's likely they will launch skyward once again with alacrity, breaking through overhead Resistance 2, and setting new all-time highs over the coming months (which are also the strongest seasonal months for equities).
So, here are the consequential questions facing investors today:
1) Are we facing a classic 'Double Top' chart formation – a pattern that is typically the precursor to an extended market decline? The tell will be whether or not support at about 277 holds firm. If stocks drop below that level, then it may be a sign of difficulty ahead for long-only investors. The ETFOptimize strategies will switch to the optimum ETF that will profit in a downtrend, and we urge our subscribers to follow their strategy to the letter. Overriding the recommendations will negate all the advantages available from your quantitative model.
2) Or will S&P 500 shares once again break through overhead resistance at the all-time high at 284 after a short pullback to gather steam, followed by a burgeoning climb in the weeks and months ahead to new, record levels for the US stock market? Because stocks are in a strong uptrend that remains in place, we believe this is the more likely of the two scenarios. But the determinant is not far below (-2.4% at the time of this writing).
Regardless of which way the market breaks, stick with your quantitative ETFOptimize strategy! The ETFOptimize strategies have never experienced a money-losing year (57 of 57profitable years), and produce an average return that is more than triple the performance of the S&P 500. Second-guessing or overriding the choices of your carefully-crafted strategy will negate all the benefits that accrue to quantitative investors.
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