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5 "Tells" that the Stock Markets Are About to Reverse

SPX Stocks Bear Market Technicals

Stock-Markets / Stocks Bear Market Aug 22, 2008 - 01:17 PM GMT

By: Zeal_LLC


Best Financial Markets Analysis ArticleBack in mid-July, as Fannie Mae and Freddie Mac teetered on the edge of collapse, the flagship S&P 500 (SPX) stock index plunged to 1215 on a closing basis. Fears ran high as the markets waited for the next shoe to drop in the ailing financial companies. The near-term outlook for US stocks seemed pretty bleak.

But how fast popular sentiment changes! In less than a month after these depths were witnessed, the SPX had rallied 7.4%. By mid-August the troubles of the previous month had been all but forgotten. Calls for a new bull market abounded, with the great majority of analysts expecting clean sailing ahead. And those that do remember mid-July now largely seem to think it was GSE-specific and not a broader issue.

With such a sweeping shift in popular sentiment, it is easy for the casual observer to forget just how ugly this past year has been for the US stock markets. The SPX is mired in the first cyclical bear it has witnessed since the early 2000s. These dangerous beasts tend to cut elite blue-chip stock prices in half before they return to their caves! But at worst in mid-July, this SPX bear was only down 22.4% since it awoke in early October.

While 22% probably feels plenty extreme to those on Wall Street, it still falls far short of the 50% this bear could ultimately maul away based on historical precedent . That would equate to climax lows near 785 on the SPX and 7100 on the Dow 30, vastly lower than the levels seen during the mid-July selloff!

With such massive additional losses quite probable, investors really need to research whether or not this young bear still prowls. Based on the answer to this critical question, the most prudent trading strategy for the coming year will vary radically. Trades that will thrive in the new bull Wall Street is boldly heralding will be crushed in an ongoing bear market.

So is the SPX bear still alive and well despite the rally off of mid-July's lows? The SPX technicals offer plenty of clues. Since a bear market is simply an ongoing decline in general price levels, its progress is readily apparent on a longer-term price chart. And bears are born in extreme greed and die in extreme fear, so analyzing prevailing sentiment in the US stock markets will offer even more clues to this bear's longevity.

It's best to start with technicals, or the SPX price action. In this CNBC era of a relentless moment-by-moment focus on the stock markets, it is sadly getting increasingly rare to see a chart extending back more than a month. Yet such a myopic short-term focus effectively blinds investors to profound market truths that eagerly leap out of longer-term charts. Proper technical perspective is exceedingly important.

As a student of the markets, to me even a one-year chart is short-term. But even at this scale, the SPX rally of the past month doesn't look all that impressive. What looks like a surging bull market considered in isolation is truly a rather inconsequential bounce when viewed from a longer-term perspective. With the SPX trading at such low levels, the burden of proof remains squarely on the bulls.

A bear is defined as a prolonged period of stock prices declining on balance. This means lower highs and lower lows, interim extremes on both sides gradually trending lower. We've certainly seen this phenomenon unfolding in the SPX. This index's 200-day moving average also rolled over in January. A 200dma deftly distills out all the day-to-day noise to point in the primary trend's direction like an arrow, and the SPX's is heading lower.

Wall Street, which is loath to ever declare a bear since it is so bad for business, waits for the last possible moment to make the proclamation. Thus its definition of a bear is a 20%+ decline from the latest interim high. This metric was officially hit on a closing basis on July 9th, so even Wall Street has no excuse to dance around disclosing this bear market. And since this 20% decline level is around 1250 on the SPX, it has already spent the better part of two weeks in official bear territory.

Over the past year this bear has unfolded in textbook fashion too. It emerged out of an all-time secular high in early October. Until the SPX's 200dma decisively failed, in early January, it was unclear whether the early selling was a bull-market correction or bear-market downleg. But the farther the SPX fell under its 200dma, which is major support in an ongoing bull, the more powerful the bearish case looked. I wrote about the increasing odds for a new cyclical bear in January when Wall Street scoffed at such a heretical notion.

By March, the selling was intensifying and the SPX was floundering farther and farther under its 200dma. The fear driving this selloff peaked on March 10th and the SPX bounced. It had fallen 18.6% in this initial bear downleg, nearly enough to achieve official bear-dom. Interestingly the financial stocks of the SPX, which are tracked in the XLF Financial Select Sector SPDR, fell 34.7% over roughly this same span of time.

Every bear has a leadership sector, such as the tech stocks during the early-2000s bear. This time around it is the financial stocks. They grew fat and complacent during Alan Greenspan's excessively-low interest-rate environment, feasting on easy money and leveraging themselves to the hilt. Today they are paying for their past excesses. And leadership sectors don't change once a bear commences, they keep leading and amplifying general-market losses all the way to the bear's final climax.

So in addition to the blue percentages in this chart measuring the SPX's big swings within this bear, I also noted the XLF's in red. While these don't always coincide exactly to the day (the XLF doesn't necessarily bottom or top the same day the SPX does), they are close (within a week). Thus the XLF swings noted are representative of the financial sector's performance during these big swings in the headline SPX.

After its early-March lows, the SPX entered a bear rally. Bears are exceedingly crafty and subtle beasts. They do most of their work when fear is relatively low and few are worried about them. But once prices fall far enough that the bear takes center stage and fear gets excessive, the bear wisely retreats for a spell so it doesn't scare its quarry away. The result is strong bear rallies that fool naïve bulls into thinking the bear is gone for good. Bear rallies are the biggest and sharpest surges higher that stock markets ever experience

This particular bear rally ended in May, with a 12.0% gain in the SPX and an 18.2% gain in the XLF. And provocatively, this rally failed right at the SPX's 200dma. Just as 200dmas are major support in ongoing bull markets, they become major overhead resistance in ongoing bear markets. This particular point as a technical failure in May was very telling. It was a clear technical warning we were in primary bear mode.

The next downleg erupted out of the complacency of the May interim high. It was fast and furious, a 14.8% selloff in the SPX in less than two months! And the financial stocks once again led the broader markets lower and amplified their losses. The XLF fell another 38.0% over this short span, brutal by any measure. And by early July the SPX officially entered bear territory with a 20%+ loss on a closing basis since October.

Despite achieving Wall Street's own bear metric, Wall Street still refused to call a bear a bear. You have to remember that the financial stocks are Wall Street. They employ the analysts we see on CNBC and pay the salaries of the great majority of the professionals involved in the markets. So for Wall Street, having the financials lead this bear is the worst possible scenario. Even if the financials fell to zero Wall Street would still hem and haw and refuse to acknowledge the reality and danger of this bear.

Since mid-July, the SPX has rallied 7.4% while the financials as measured by the XLF have soared 31.3%. Since the bear leadership sector is the most heavily sold in the downlegs, it also bounces higher and faster in the bear rallies. Radically oversold stocks can rocket up fast as sentiment changes, as the XLF is really illustrating today. Thanks to this big financials rally, Wall Street has boldly declared a new bull market.

From early October to mid-July, the SPX ultimately fell 22.4% on a closing basis. This alone should scare the heck out of investors, as these are the biggest and best stocks traded on the US exchanges. Over roughly this same span of time, the XLF plummeted 52.2%! This is extreme, but realize bear leadership sectors do much worse than the general markets. In the early-2000s bear, the leadership technology sector as represented by the NASDAQ 100 ultimately lost a staggering 82.9% of its value!

Historical precedent be damned, Wall Street is declaring this bear dead. After all, with the very Wall Street financial companies' stock prices more than cut in half, the selling must be over, right? Not at all. It is not absolute price levels, or percentage losses, that drive the end of a bear. It is sentiment. Bears persist until popular fear grows so great that everyone remotely interesting in selling has already sold out in disgust.

Prevailing fear is ethereal and impossible to quantify. But thankfully outstanding proxies exist to reflect fear based on price action. Among the best of these tools are the implied volatility indexes. By distilling down all options bets made on a particular index, like the SPX, they offer great insights into prevailing sentiment among traders. While the VIX is the SPX's implied volatility index, I prefer the old-school VXO which actually measures implied volatility for the S&P 100 (effectively the top 20% of the SPX's stocks).

The VXO is battle-proven, it existed during the early-2000s bear so we know what to expect from it during periods of extreme fear. Meanwhile today's VIX was born in September 2003 and uses a new calculation methodology, so no one yet knows exactly how it will react during the extreme fear episodes of a bear. For a deeper explanation of the VIX versus the VXO, check out our current newsletter and an essay I wrote last month.

Since the VXO effectively measures fear, and since bear markets end at definite VXO levels, it gives us a high-probability understanding of whether or not the July lows likely marked the end of this bear as Wall Street so desperately hopes. The red VXO is rendered under the blue SPX here. And the story this leading implied volatility index tells about general fear these days is very provocative to say the least.

Back in the earlier months of this bear between October and March, fear rose on balance as it should. The VXO's meanderings as fear flowed and ebbed over this period of time actually defined the nice uptrend rendered above. This is the way bear markets are supposed to work. The longer general stock prices fall on balance, the more popular fear grows. It starts unnoticed in the background but gradually takes center stage.

At major SPX turning points, the VXO extremes are noted as two red numbers. The top one is the level the VXO hit intraday while the bottom is the VXO close. For example, in January when fear grew too great to sustain the first big selloff of this bear, the VXO surged to 38.9 intraday while its highest close was 33.2. At the March bounce in the SPX, the VXO managed 37.2 intraday at worst while hitting a 34.3 close.

Interestingly, even back then it was apparent that there wasn't enough fear to end this bear market. If you study the VXO during the last cyclical bear of the early 2000s, it becomes evident that actual bears aren't likely to end until the VXO hits or exceeds 50 on a closing basis. And even early on in bears, individual downlegs aren't likely to yield to bear rallies until the VXO hits the mid-30s on a closing basis and the high 30s on an intraday basis. The first big downleg in that early-2000s bear didn't end until the VXO hit the lower 40s intraday and closed over 39.

Thus even back in mid-March, it was already clear that fear definitely wasn't high enough to end this bear. And it was even on the low side to merely end that downleg , although a rather anemic SPX bear rally did ignite out of the March lows. But after this, fear soon mysteriously disappeared. The VXO started plunging and eventually fell off a cliff. All the trepidation felt by traders in mid-March was soon forgotten.

Fear bled off a lot faster than it should have. By mid-April, the VXO had broken below its support line and fell into the lower 20s. By late April it was down in the high teens, which is extremely low for even the youngest bear. In mid-May the VXO plummeted to 9.4 intraday and 12.9 closing, which was significantly lower than its levels in early October at the start of this bear! While I suspect that day was some kind of mathematical anomaly, the high teens of the rest of May were still nearly as low as early October's levels.

With fear so unbelievably low in May, it is pretty obvious that most traders weren't taking this bear seriously. The Wall Street propaganda machine relentlessly beats the endless-bull drum, so investors and speculators consuming only mainstream financial news start to believe the hype. Throughout this whole bear, with the short-lived exceptions of the V-bounce points, Wall Street has ignored it and denied it even exists!

Prevailing fear levels fell so incredibly low in May that even during June's brutally steep SPX selloff the VXO lingered in the lower 20s. While fear in the financial sector ran high, general-market fear didn't. By the mid-July SPX lows the VXO finally spiked near 30, but these were still very low fear levels relative to what typically ends a bear-market downleg. Since then the SPX has rallied modestly while the VXO quickly fell back to the low 20s. Amazingly traders have been so complacent that the VXO is in a downtrend despite lower prevailing SPX levels!

And the relative positions of the SPX and VXO in the last couple weeks are very telling. The SPX bounced out of mid-July, but its rally appears to be failing at its 50dma. The 50dma is the most common point within ongoing bear downlegs where minor-bounce rallies peter out. This is in contrast to major bear-market rallies between downlegs, which tend to run all the way up to the 200dma before failing.

In addition, the VXO is now very low, equivalent to late-October levels, which shows little prevailing fear. Despite all the bearish technicals, the great majority of traders still aren't even close to taking this bear seriously! Not only has Wall Street misled them, but this bear is exceedingly crafty in not letting fear get out of hand. The fact that fear remains scarce and the mid-July fear levels at the latest SPX bounce were far too low to end this downleg strongly suggests that more selling is yet to come.

And this selling will drive new lower lows in the SPX, probably in the next couple months. Eventually general stocks will fall far enough to spark enough fear to generate a selling climax of sufficient intensity to end this downleg, but probably not this bear. Cyclical bears tend to run for a couple years or so before giving up their ghosts. We are just one year into our current one.

In addition to the lack of fear, other factors argue for lower stock prices in the coming months too. I've discussed them this year in our subscription newsletters. One example is the upcoming US elections. If the leading candidate wins, he wants to double long-term capital-gains taxes! As the likelihood of an Obama victory grows, investors will sell stocks in advance to lock in today's much lower LTCG taxes before the election and inauguration. Political taxation fears could intensify selling.

Thankfully there are tons of awesome new bear-market trading vehicles that didn't even exist during the last cyclical bear of the early 2000s. This brave new world full of ETFs and ETNs gives stock traders all kinds of innovative ways to bet on falling stock markets. In recent months I have been discussing some of the best, as well as trading them, in our subscription newsletters . Join us today to learn more about practical bear-market trading and to mirror our upcoming bear-oriented trades!

The bottom line is the price action in the US stock markets continues to look very bearish despite the endless stream of Wall Street assurances to the contrary. Not only are we seeing lower lows and lower highs, the technical definition of a bear, but popular fear remains quite low. Bear downlegs in history didn't end until general fear reached high levels as measured by the VXO. We aren't even close yet.

So stock traders ought to be very wary heading into the busy autumn trading season this year. The prevailing market trend remains down, and all kinds of nasty surprises have yet to emerge out of the financial stocks. They made countless bad bets, with extreme leverage, that we don't even know about yet. So there should be plenty of upcoming bad news in the financials to continue leading the SPX lower.

By Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at …

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit for more information.

Thoughts, comments, or flames? Fire away at . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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