Whiplash

Investors may be forgiven if they are ending the trading day with a sore neck and a headache. For after a quiescent 2017, when Wall Street enjoyed one of the least volatile periods in its history, price volatility and uncertainty have returned with a vengeance.

Stocks started out the year in an exuberant mood, boosted by the recent tax cut act and high hopes for a surge in corporate earnings. Indeed, the market trend going into late January was nearly parabolic, as speculative fervor boiled over and a “get me in at any price” psychology took over. But after hitting an all-time high of 26,616 on January 26th, the Dow Industrial Average seemed to run out of gas. In early February, the Dow had two one-thousand point down days within the same week, resulting in a quick 10% correction from the top. By late February the major indexes seemed to recover their poise, rallying to within a percent or two of their highs (and the NASDAQ did, in fact, make new highs). But March brought no relief from the roller coaster, as worries of a trade war and Facebook’s privacy breach prompted investors to head for the exits once again. Underscoring the changeability of mood on Wall Street was action from March 22nd to 26th, when the Dow dropped 700 points on a Thursday, but rallied 670 points the following Monday, a mere two trading days later!

Global Volatility Graph

Investors have become unused to corrections, so current ups and downs may feel worse than they really are. One has to go back to January 2016 to find the last significant correction, over two years ago. Prior to that, it was the “Taper Tantrum” of 2013 that caused similar amounts of angst for investors. Helped by the Fed’s “quantitative easing,” normal corrections were likely blunted by a tidal wave of cash urgently wanting to get invested. Now that the Fed has reversed course to “quantitative tightening,” investors are realizing that the aberration in markets has been the remarkable lack of volatility over the past few years.

One characteristic of recent declines is the speed at which they occurred. February’s abrupt pullback, for instance, was one of the most compressed 10% corrections on record. In addition to human anxiety, of course, we can point to the prevalence of algorithmic and computer program trading for exacerbating the declines. Computerized trading is here to stay, so investors in index funds and ETFs should prepare for such drops to be a matter of course. But for those who don’t have the stomach for the type of volatility we’ve recently seen, perhaps it is time to revisit your asset allocation with an eye toward moving into more conservative securities.

It is a Wall Street axiom that volatility tends to markedly increase at major turning points. At bottoms, buying by long-term value investors runs headlong into the panicked selling of those just trying to cut their losses, leading to wild swings. At major tops, buyers who have been rewarded for buying the dips in the bull market are suddenly buffeted by those taking long-held paper profits, creating gyrations and uncertainty.

Conversely, a rise in volatility could signal a shift from one sector of the market to another. This phenomenon, called “sector rotation,” has a long history on Wall Street. Sector rotation occurs when one group, often a long-standing market favorite, loses its appeal and investors move into other sectors that are seen as greener pastures. Rather than a wholesale liquidation and move to cash, investors stay in the market, but move funds to areas that offer better value, less risk, or more attractive growth potential. Given the sheer scale of money involved in these moves, the effect of buying and selling can create quite a lot of volatility indeed.

The public can easily remember this happening before, as oil stocks have fallen in and out of favor over the decades. Today, it is the technology stocks that have dominated the bull market. Moreover, they have led the market for a long time, and so many investors have positions in at least one of these market darlings.

Amazon, Apple, Facebook, and Google have become household names, and there is no arguing with their successes. But their growth to gargantuan size has caused them to have an outsized effect on the indexes. For the NASDAQ 100 index, the top ten stocks account for 53% of the index, so when a heavyweight like Facebook or Microsoft goes down, it can skew how bad the “market” looks. Clearly, Facebook’s data breach has cast a pall over the whole social media and technology sector, providing a logical explanation for why a rotation away from this once favored sector may be occurring, and the super-sized weight of these components may be making the NASDAQ indexes look worse than they are under the surface.

How can we tell the difference between a typical correction and a more ominous change in the major trend of the market? We discussed several of these in recent Market Outlooks, and now would be a good time for a refresher course.

The first indicator to look at is the state of the NYSE advance/decline (a/d) line. The a/d line cumulates the net advancing stocks every day, and adds or subtract that from the previous day’s total. Thus it creates what looks like a mountain chart. By plotting the a/d line as a point-and-figure chart, however, we filter out a lot of the volatility and noise in the data, and are left with a clearer sense of its signal. Currently, the a/d line has had a major pullback, reflecting the weak action of stocks over the past 60 days. However, it is not yet on a sell signal (box), so we would have to rate this indication as positive
for the time being.

NYSE A-D Line

The second big-picture indicator we would track is the NYSE Bullish %. This indicator measures the percentage of stocks on the NYSE that are on buy signals, based on the point-and-figure charting technique. There are Bullish %s for the Dow, the S&P 500, NASDAQ 100, etc. The idea behind these indicators is that in a bull market, a rising number of stocks will give buy signals, causing the percentage to rise. The converse is true in a bear market, as a declining number of stocks are able to stay on buys. The table below lists the Bullish % status for major indexes, and it is worth noting they are all “bear confirmed,” i.e. on sell signals. The late March declines pushed them all into bearish status, and we would rate this as negative as the quarter comes to a close.

Bullish PCT Table

Third, we would look for “failure swings” among leading stocks. A failure swing is simply the failure of a stock to continue its trend. In other words, a rising stock that transitions from making new highs to tracing out a pattern of lower highs is probably making a failure swing. It is easiest to visualize as the transition from an “up staircase” pattern to a “down staircase” pattern, and indicates that the forces of selling are starting to overwhelm the forces of buyer demand. The chart of Honeywell (HON) is a case in point, as the reliable uptrend of 2017 has now traced out a pattern of lower highs and lower lows. If most stocks start to develop this pattern, it indicates a bigger decline is in the cards. As of this writing, this measure is mixed, with enough of them maintaining a higher high-higher low pattern that argues for only a correction taking place.

Honeywell Failure Swing Graph

Finally, as investors get more worried about the bear returning to Wall Street, they will turn to more conservative securities. Thus, one should see the “relative strength” of these securities improve and give buy signals. This view gave early warning of trouble ahead of the bear markets of 2000 and 2008. Relative strength buy signals in utilities, food and consumer staples stocks, and even bonds would argue that investors should expect a broader decline than a mere correction. So the chart below should give investors pause: it shows a relative buy for the Treasury Bond ETF (TLT).

Relative Strength Buy Signal for T Bonds

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