Bull Looks Dead After the Fed

The Federal Reserve’s fear of raising rates may have doomed the market to failure. It’s now time to shift towards defensive and bearish strategies.

It’s a counterfactual we’ll never know but maybe if the Federal Reserve had hiked interest rates the expected 25 basis points stocks would have continued to the rally as they had during the week heading into Thursday’s decision. The notion was a ¼ point increase would have no real economic effect but would convey confidence the U.S. economy can maintain the slow but growth it’s shown over the past few years. Investors certainly seemed ready, willing and able to handle such a nominal increase and get on with the business of business.

Instead, the Fed’s failure to lift-off zero suggests the economy is not strong enough to withstand a mere gesture towards normalization. The Fed’s own fear of disrupting asset prices may in fact be what dooms stocks. Basically the Fed told investors we are still in crisis mode and stocks are now likely to enter into their first meaningful and full year decline since the bull market began six years ago.

To be sure the global economy, particularly slowdown in China, has and will have an impact on U.S. business and stocks. In fact it was strictly the problems abroad that Janet Yellen cited for holding off the expected hike. But if you wait for everything in the world to be perfect before undertaking any task nothing would ever get done.

The sad reality is we are now stuck with another few months of uncertainty and unwanted fixation of when will the Fed do something. This frustration manifested itself in the stock market reversal late Thursday and accelerated selling on Friday. Whatever benefit ZIRP had toward the real economy exhausted itself long ago. Investors now seem to be acknowledging its benefit on asset inflation has also run its course.

Indeed one of the reasons the global economy is weak is due declining commodity prices, from oil to agriculture, which has severely impacted export dependent emerging markets and slowed global growth. Yellen and the Fed want inflation but fear higher rates will lead to a stronger dollar further pressuring commodity prices. You can see the negative feedback loop we are starting to enter.

A Technical Tale Foretold

Two weeks ago I wrote about how technical analysis has unnerving ability to become self-fulling. As patterns and price points become identified an increasing number of people their outlook starts coalescing to create a consensus. While consensuses are ultimately made to be broken they can rule behavior for an extended period. And it can be especially powerful in the early stages of transition period such as we seem to be in now.

In hindsight one might point to the Fed meeting that “caused” the decline; but the technical picture had been deteriorating for months. As is often the case the “event” is merely the coincidental straw breaking the back.

The sell-off in late August that broke the S&P 500 Index (and other broad market indices) out of their historically narrow 7 month long trading range now seems destined to turn into a deeper and longer decline.

We already saw that aforementioned range represented a huge overhang of resistance; for the SPY it is the $203-205 level. The action on Thursday, which saw the SPY run up towards $203 and then a reversal left a bearish spike on the daily chart. Friday’s sell-off created a “shooting start” on the longer term weekly chart.

SPY Weekly chart 9.20.15

A shooting start is loosely defined by these criteria;

  • An intraday/intraweek rally of at least 1% has lower close on the day.
  • The close was less than 0.5% below the open.
  • The intraday high must set at least a 3-week high.

Everyone sees this shooting start and conventional wisdom of technical analysis accepts the pattern as bearish. But our good friend at Lyons Fund Management always make sure to check the data. They have recorded 33 instances of “shooting stars” since 1950. Surprisingly the performance actually has a median positive over the next 2 week to six month periods.

But Lyons digs a little deeper and breaks out the occurrences to those that occur above the 200 day moving average and those that occur below the 200 day moving average such as this past week. And there we see a very different set of results.

There have been 16 shooting stars below the 200-day moving average; which is where this week’s occurred. As you can see the performance over the following weeks and months has been decidedly negative.

Shooting Star Lyons stat 9.20.15

Since the initial breakdown in August I have been of the mindset the SPY would need to retest the October low near the $182 level. The low on August 24th was a nearly technically perfect notching a $182.40 low. But that price was achieved during the opening “flash crash” in which next on next to no volume in the first two minutes. Meaning there was no real distribution or wash out down there. The “real” low when stocks actually began trading was around the $190 level.

Meaning we have not had a true retest of $182 yet. That would be another 6.5% decline from current levels which would align with the median 6% decline over two to three months following a shooting star.

And based on the data above this could be just the beginning of a longer and deeper decline. It’s time to start looking at more defensive and bearish strategies.

— Steve Smith

You May Also Like

About the Author: Steve Smith