Some big moves in commodities, China stocks, Japan, and a change in character in US equities whereby nothing is currently working for the bulls. It begs the question where we are in the topping process, specifically is the market going to fall apart from here, or do we yet get another rally back up to a lower high.
Dow Jones World looks like this:
Like other recent major peaks, it shows a topping price pattern with negative divergences on the second higher high. We can pinpoint the first peak in the topping process as June/July last year:
Junk bonds, oil and financial conditions all peaked out then too. The second peak in nominal equities was May 2015, making for a 10 month topping process. That’s not dissimilar in duration to 2000 and 2007.
If we look at near term clues, the triple confluence of spikes in CPCE, Trin and Vix:Vxv to current levels (specifically all three together) hasn’t been seen since the breakdown in 2011.
Their spiking could represent a near term low for equities, from which they get a decent bounce now. Or, they could represent the first stage of a large fear move, like in 2011. Right now the SP500 is just 4% off its high, whilst in 2011 it made a 19% correction.
If we look at the bigger picture, all major indices around the world are now off their highs, most topping out in May or June. Is this about news out of Greece and China? They are providing a narrative for short term buffeting, but we can see equities have been in a typical topping process for a year. The under the hood peak was around last year’s solar max, as it was in 2000. Then as now stocks continued to levitate for several months following, whilst internals deteriorated, and the writing was on the wall. We know that allocations, sentiment, valuations and leverage have all been at saturation levels for some time. I suggest that the worries about Greece and China have initiated a trickle of bulls over to the bear camp. At some point this will become a rush and that’s when panic selling will make for swift, harsh falls. If you don’t believe that, then this will be the first time from such levels of leverage, valuations, sentiment and allocations that we don’t see a crash period averaging around 6 weeks taking around 35% off stock prices.
A fairly common topping pattern at major peaks in the past was primary distribution – peak (shake out) – second chance peak – crash, normally lasting around 6-8 months, like this:
If we think of it as less of a roadmap and more of similar waves of crowd psychology playing out, it’s the ‘second chance’ which is my focus, namely are we though that or is it still to come?
If we are through it, then the market ought to quickly fall apart here, with any up days quickly engulfed. That’s kind of what we have been seeing the last 2 weeks. Plus, the heavy falls in China and commodities could be the initation of wider heavy falls. On the flip side, those spikes in near term indicators could provide a bottom here for stocks from which to rally back up into mid or late July, making a second chance peak ahead.
So what am I doing? Attacking but with stops (short Dow, RUT, IBB, long gold). If we are post second chance then there is no time to lose. The stock market should rapidly fall apart with increasingly big lurches downwards. On the other hand, if we have a second chance rally back up, I don’t want to be too exposed and save my big positioning for a little longer.
Lastly, might all this be way off and we are still safely in a bull market? Well, financial conditions just turned negative. The Ted spread is now higher than it was when stocks tanked in 2011. US economic surprises are still negative and ECRI leading indicators are flirting with zero. Earnings season starts this week with predicted 4.5% yoy falls in both earnings and revenues. With sentiment, allocations, valuations and leverage so extreme for such a prolonged period now, even a safe bull market is more likely to see a sharp correction here, something like 1987 or 2011. But I don’t believe that: the case is much stronger for a fully fledged bear market, within which Biotech retraces its whole move of the last 2.5 years.