Sunday, March 30, 2014

Is it time to short stocks?

Wow, what a show of strength by the bears! By the end of last week, the blogosphere came alive with buzz about the technical damage done to the major US equity averages. My inner investor is getting more cautious, though my inner trader thinks it may be premature to get aggressively short the stock market.

On the surface, the SPX didn't look too bad. It had descended to a major support zone and remained above the 50 days moving average (dma). The 5-day RSI (bottom panel), which is useful for short-term swing trading, showed fading momentum. Bulls could be comforted by monitoring how the index would behave in the support zone pictured in the chart below.

Widespread technical damage
Market internals, however, revealed a deteriorating picture. In particular, momentum stocks got crushed last week. Such market action is indicative of a reversal in overall risk appetite and flagging price momentum is often a sign of an exhausted bull (see my previous study at Momentum + Bull market = Chocolate + Peanut butter).

As an example, the post-IPO performance of King Digital Entertainment, the maker of Candy Crush, was highly disappointing. Down 16% on the first day of trading, the shares continued their descent the next two days.

The carnage was mirrored in the formerly red hot Biotech stocks. If it is any consolation, bulls can at least point to the fact that the Biotechs were testing a relative uptrend line that began about a year ago.

Unfortunately, the same couldn't be said of the NASDAQ Internet Index, which consisted of momentum technology names such as, Google, Facebook, etc. The chart of their relative performance to the SPX showed a violation of the relative uptrend line, with little support beneath current levels. There is a glimmer of hope as the decline could be arrested at one of the pictured Fibonacci retracement levels.

The damage was also evident in the NASDAQ Composite. The top panel of the chart below shows that COMPQ had breached its 50 dma and it was testing the the bottom of a support zone. The chart of the relative performance of COMPQ against the SPX is more troubling as it shows that these high-beta stocks had violated a relative uptrend line, which is indicative of declining risk appetite.

The chart of the small cap Russell 2000 also shows a similar picture of the violation of the 50 dma and relative uptrend line, as well as a test of the low end of the range of a secondary support zone.

The relative performance of the Consumer Discretionary sector against Consumer Staple sector, another measure of risk appetite, reveals a violation of the relative uptrend that began in early March. This pair is now testing the bottom range of a relative support zone.

Other measures of risk appetite, such as this chart of the relative performance of the SPX against long Treasuries, tells a similar story. This pair violated a relative uptrend line in January, consolidated sideways and now it is again testing an area of relative support.

I could go on about how market internals have deteriorated and risk appetite has waned, but you get the idea.

Time to get short?
With the bears swarming the equity markets like Russian troops in the Crimea, is it time for aggressive traders to get short this market? My inner trader is whispering, "Not yet."

Despite the carnage, stock prices seem to be following the script of a mid-term election closely. Ryan Detrick tweeted this chart on March 17 and the market seems to be still following the historical pattern of a rally into April/May. If history is any guide, late March and early April tends to be sloppy and the market stages one final rally in late April before topping out and decline into a final low in October.

Given the kind of technical damage that has been done, it's doubtful that stock prices are capable of making a new high in April or May. Bears should consider that high-beta assets are highly oversold and could stage / a counter-trend rally at any time. As well,.the market have experienced numerous breaks of uptrends or relative uptrends. However, trend breaks tend to resolve themselves in a period of sideways consolidation, rather than an immediate trend reversal. Consider this classic example of the relative performance of the NASDAQ 100 against the SPX in the last 15 years. NDX underwent both a relative uptrend and relative downtrend and, in both cases, the relative breakout and breakdown were followed periods of consolidation.

While I am tilting bearish for the next few months, I would be hesitant about making a major commitment to get short here. Consider what could go right for the bull camp:
  • Earnings Season is just around the corner and the results could be a wildcard. The Citigroup US Economic Surprise Index is near the bottom of its near term range and has started turn up. Such a reversal could translate into better company guidance as we move through Earnings Season, which would be bullish for stocks. The first key test for bulls and bears alike will be the jobs report on Friday. Anyone putting on a major bearish position here would be betting that the Economic Surprise Index continues to deteriorate and growth starts to decelerate to sub-2% levels - a truly non-consensus call.

Watching for the bearish trigger
In conclusion, the intermediate term bias for stock prices is down, but my inner trader remains wary of being overly aggressive in taking a short position here. He is watching the following trading model as one of the conditions to get short. The model is based on the readings of the SP 500 HiLo Index (real-time updates here):
  • SPXHLP is negative (indicates short-term negative momentum)
  • The 10 dma of SPXHLP is less than 5 (indicating that the trend is down)

The vertical lines in the above chart shows the past instances where these signals have been first triggered. In most cases, the signals have been a little late but they have been the precursors of further declines in stock prices. For now, neither the SPXHLP nor its 10 dma are at their bearish trigger points, indicating that it is premature to go short.

There are a number of caveats to the use of this model. First and foremost, it has not been tested in real-time and the chart is only based on back-tested performance, so take its output with a grain of salt. As well, the tests show that it is useful on timing the entry point to go short, but it is less useful on exit conditions.

I am offering this trading model to my readers for free. Its value is measured by the price paid.

Most of all, remember that the signals from this untested model should not be the only trigger for making a trading decision.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

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