foxex: How Weak is the Market Trend?

Chart Advisor | Focus on the Price

By John Jagerson, CFA, CMT

Monday, February 18, 2019

1. Trends have phases

2. Looking for confirmation of strength or weakness

3. Is 2019 likely the end?

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Major Moves

In the February 11th issue of the Chart Advisor newsletter I mentioned Dow Theory and the principle of confirmation. Another aspect of Dow Theory is a three-phase model of bull trends. Over time, this model has been expanded and studied; but, the core concept is helpful for creating rational expectations about when a trend may end. I want to use that model to answer some questions I have recently been getting from investors who are concerned that this bull market may be finally ending.

As defined by Dow Theory, the three phases of the trend are as follows:

Accumulation: The beginning phase of a new bull trend when risk tolerant investors are willing to buy stocks that are undervalued.
Participation: The second phase of the bull trend that tends to last the longest where more market participants are willing to take on new risks.
Distribution: The last phase of the bull trend is usually characterized by sudden price spikes and rising volatility. It is referred to as "distribution" because the so-called "smart money" is distributing the shares they have owned to new investors who are buying out of a fear of missing out.

In the following chart, I highlighted the three phases of the bull trend that lasted between 2003 and 2007 as an illustration of this model.

A key question that investors struggle with: where does the distribution phase start, and participation end? A technique that I have found very useful is to start with the Average True Range indicator to identify the point at which volatility starts to rise above its "normal" range. As you can see, volatility had started to spike well above its normal levels in mid-to-late 2007, well before the Bear Stearns and Lehman Brothers crises.

S&P 500: 2009-2019

The bull trend that has been in place since 2009 has been more challenging to analyze because many of the models we have used in the past did not play out as expected. A nearly $4 trillion intervention by the Federal Reserve and government stimulus programs probably did a lot to hide the normal signals that we rely on.

However, you'll notice in the following chart, that after the Fed announced it would begin pulling back from quantitative easing in 2013, the Average True Range was beginning to look more normal and provided a warning before the big drops in 2015 and the 20% decline in the fourth quarter of 2018.

Hopefully this can provide a little perspective for why some technicians are concerned that very wide price ranges have characterized the current rally. What I wanted to show using these examples is why even a bullish market can put traders on edge when it is moving very quickly and starts to look like a period of distribution.

Read more:

What is Dow Theory?

How Does Elliott Wave Theory Work?

The Principles of Trend Trading

Risk Indicators - All or Nothing Traders

In my view, the biggest risk when the market is behaving this way are traders who insist on a binary view of the market. In other words, rather than using appropriate risk control (diversification, hedging, etcetera,) they treat any potential signal of distribution as an exit point.

Binary traders seem to misunderstand two important factors:

Even a valid distribution signal usually takes months before turning into a long-term bear market. For example, the Average True Range indicator started to look like distribution in early 2007 well before the market began its true descent in 2008. That means there is usually time to start shifting a portfolio in a more conservative direction without moving entirely into cash.
There are always more "false" signals of a bear market than "valid" signals during a trend. In other words, there can only be one point at which the market hits the end of its trend and begins to decline. However, there are many points within the trend that can look like the end without breaking any long-term support levels.

In order to filter the bad signals from the good, most technicians will look for confirming evidence that distribution has begun. For example, an inverted yield curve (discussed in last Wednesday's Chart Advisor newsletter,) or a contraction in earnings growth rates could increase the odds for successfully identifying the top of market.

Although some indicators are getting close, overall we're not seeing a lot of confirming evidence besides rising volatility that the bull trend is likely to end this year. For example, as you can see in the following chart, quarterly corporate earnings growth rates are still positive. Although first-quarter estimates are low, most analysts still expect 2019 to be positive overall.

Read more:

What is a Bear Market?

A Beginners Guide to Hedging

Creating Highly Effective Hedges With Index LEAPS

Bottom line: Still Waiting for Confirmation

My goal in today's Chart Advisor newsletter was to address some of the questions I have received about whether the bull market is coming to an end. Based on the evidence that I have available to me, I think the trend still deserves the benefit of the doubt. What I hope I have accomplished is to explain why some caution is still reasonable, but, historically speaking, I don't think we have enough evidence yet to be overly concerned.

Read more:

What Does 2019 Hold for ETFs?

What is an Earnings Yield?

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