January 23, 2016
Trades & Tutorials
By Geoff Bysshe
It’s no secret that the plunge in U.S. stocks this year has been blamed on only a few primary factors so in this latest Trades & Tutorials blog post, you’ll discover a concise look the top two negative forces plaguing U.S. equities.
China and crude oil have been plunging and U.S. stocks have followed them almost in lock step.
The easiest pattern to identify that would indicate U.S. stocks have bottomed would be for China and crude oil to continue lower while U.S. stocks diverge and move sideways or up, however...
We may not be so lucky as to get a nice divergence pattern.
Plus, all three markets rallied sharply on Friday.
Quite frankly, I’m not a big fan of trying to catch a “falling knife” market, so I tend to look for market bottoms that have at least two qualities - long-term support and evidence of a turn up.
The evidence of a turn up is not yet complete, but Friday’s close in the S&P 500 and NASDAQ crossed an important starting line.
So I think it’s a good time to look at few long-term measures of China, crude oil, and NASDAQ since it has been the strongest of the U.S. stock markets over the last year.
It’s not a new story, but I think you’ll like the charts and perspective.
Plus, I guarantee this will be very timely, because if you read the entire post (it’s not long), you’ll discover that the key markets in this analysis (stocks) are at very powerful long-term market inflection point.
Before we start you should know that our free daily newsletter, Mish’s Market Minute will also keep you abreast of what’s happening with crude oil, China and many other key markets, so if you’re not already receiving it – request it here!
Did Market's Just Begin A Short-Term Turn Up?
Every big reversal has to start somewhere, and for this analysis that first step is for the market to close over its simple 10-day moving average (DMA), and then continue higher in subsequent days.
There are several nuances to defining entry points and stop levels for trades around this tactic that are beyond the scope of this post, but for a short-term definition of a market turn a close over the 10 DMA with confirm works very well.
Therefore, in all the markets below, the turn up over the 10 DMA is required to consider the market as having ‘turned up’.
Since we have the first part of this in place in the SPY, QQQ, and NASDAQ Composite it’s time to look long-term.
Note I’ve included the NASDAQ Composite because it has longer historical charts than the QQQ.
Is There Long-Term Support That Will Turn "Short-Term" Into "Long-Term"?
If China and crude oil are driving U.S. stocks lower, then the first question to ask is...
“When do they all hit long-turn support?”
Here are three tradeable instruments that follow different Chinese markets. The big caps (FXI), Hong Kong (EWH), and the Morgan Stanley Shanghai A-shares Fund (CAF).
The FXI tracks the FTSI China 25 Index. The CAF tracks the CSI 300 Index, and the EWH tracks MSCI Hong Kong Index.
CAF is not an ETF, but it trades like a stock and it has higher average trading volume and it has more history than ASHR which is an ETF that tracks the CSI 300 Index.
The only China related market near the 10 DMA is FXI, but they are all near very big long-term support.
FXI Monthly Chart: Stopped right at 2011 lows
CAF Monthly Chart:
EWH Monthly Chart:
So China is near long-term support from several different perspectives.
Next, let's look at crude oil...
USO is the ETF that tracks crude oil, but I used charts of WTI oil in order to get longer-term data.
There isn't an obvious price to expect crude to stop its decline, but it's in the area of a lot of support.
WTI Crude Oil Chart:
Crude Oil Chart Source: MacroTrends
And when you adjust for inflation, it's even more compelling that a low should be near.
WTI Crude Oil Chart Adjusted for Inflation:
But when can you expect the bounce to be real?
WTI Crude Oil Chart: Hasn't been able to close over the 10 DMA and moved higher since about $15, and that time was a head fake. However, that pattern is a reliable first sign of a potential reversal.
This time may be different because high volume like we've seen over the last couple weeks often occurs at market lows.
Now consider the support area that the
SPY and QQQ and COMPX bounced off of last week.
The QQQ is even stronger than the $COMPX, but I used the COMPX for this analysis because it has a longer history.
The COMPX Daily Chart: It is back over it's 10 DMA and over the prior support area of the September lows after holding the August 2014 lows. In an ideal reversal pattern it would not trade under the Friday low, but the more important level to hold is the 4,500 area. Additionally, a move higher from here is still needed to confirm a "turn up".
SPY Daily Chart: The relative levels of support that have been recovered are the same as in the COMPX chart above, although it broke its August lows. In an ideal reversal it would not trade under the Friday low, but the more important level to hold is the 187 area. Additionally, a move higher from here is still needed to confirm a "turn up".
Finally the longer-term charts of the SPY and COMPX illustrate the significance of last week's test of support. In both cases, the support on a monthly basis is clear, and if broken, it would create a clear path to a 10%+ decline to the 80-month moving averages.
SPY Monthly Chart: $180 is clearly major support, but if broken the tops of the 2000-2007 range are the next big level the market will gravitate to and it's over 10% lower.
QQQ Monthly Chart: After looking at the SPY's 2007 long-term double top, it should not be hard to see the significance of this month's lows in COMPX.
IWM Monthly Chart: This has been the leader on the downside, but is it done?
The collapse in China's markets since April of 2015, as measured by FXI, has been a -45% move, and it's being viewed as bad for the world. Maybe that's correct, but has it already been priced into U.S. equities?
WTI began its most recent bear market in June of 2014 from a price of $106 a barrel, and last week it bounced from a low of about $28.50 - a drop of -73%! The drop in crude has been so big that, what was once considered good for stocks, is now considered bad for stocks.
I'm sure there is a wise man somewhere who said, "you CAN have too much of a good thing".
And maybe he's right, because...
At the same time (since June of 2015), one of the broadest measures of U.S. equities, the Russell 2000 Index as represented by the ETF, IWM, has declined from $129 to $95 or -26%. And, the NASDAQ Composite has declined from 5,230 to roughly 4,300 or -17%.
However, after down moves of this magnitude in U.S. equities, driven by factors that have not resulted in recessionary data in the U.S., it seems prudent to approach the recent fear driven decline as an opportunity to look for good entry points into stocks rather exits.
The risk levels for prudent entry levels are very clear, the upside is not, but...
One of the biggest mistakes traders make is they assume they know both the risk and the potential upside. The risk can be easily defined, the upside however, when managed correctly can easily exceed expectations, and this is one way good trading discipline turns the odds in your favor.
If you're like most traders, you probably don't see stocks breaking out to new highs in 2016, but can you now see how you can anticipate (with the help of the 10 DMA) when and why they may bottom soon? And more importantly exactly where you can limit your risk if they don't?
If you trade against the long-term support with tactics that enable you to hold on to trades long enough to enjoy the 'unexpected' upside you'll find yourself in positions with surprisingly good prices!
This week the Fed will talk and rattle the markets. Earnings will also rattle the markets. But the key levels in the charts above are all you need to focus on.
With a systematic way of being long over the key inflection price points, and out below them, 2016 has just provided you a great start to the new year.
