Correction or just the first leg of a big bear market?

With 2018 in the books, yearly charts are now available to help explore the question posed in the header and provide insight into the next big move.  Although the following seeks to explore possibilities concerning multiple quarters & years, last month's post provided thoughts pertaining to the potential short to intermediate direction of global markets by looking at the setups in currencies particularly the all-important US dollar.

Earlier this year, the USD broke its downtrend to the upside which was confirmed when it closed at a new six month high on a daily basis.  As has been the case since the beginning of the 2000s, periods of dollar strength have tended to coincide with weakness and volatility in risk assets along with rising credit spreads.  Thus far, 2018 has followed this pattern albeit much more violently in emerging markets.  Given the above, the purpose of this post is to highlight critical support and resistance areas in specific currency pairs that have exhibited clear risk-on and risk-off behaviors as a way to understand whether or not this phase of dollar strength is likely to continue or dissipate.  To be clear, the USD is still very much in an uptrend within a multi-year sideways consolidation.  Risks remain elevated until the greenback breaks down.

Even though December saw a very sharp move down in domestic equity and private credit markets that broke below the October & February 2018 lows, it also saw the USD fall in the middle of the month.  The latter enabled emerging markets to begin to outperform (EEM put in a higher low for now).  This minor USD decline (as of today) proved to be a precursor for the eventually year end rally.  As long as the dollar continues to trade lower vs a broad range of currencies, the rebound is likely to continue for the time being.  Nevertheless, yearly charts show that there are major risks to global risk markets should this rally falter and undercut the 2018 lows.

Before looking at yearly charts to gauge long-term trends, it's useful to first point out a major difference between bull and bear markets.  Corrections in bull markets tend to remain above the low of the prior year whereas bear market declines undercut them.  For example between 1982 & 2000, the DJIA always traded above the prior year's lowest price (even after 1987 which was still positive).  This streak ended in the first quarter of 2001 when price corrected below the 2000 bottom setting off a warning.  From 2003 to 2007, the DJIA price also remained above the prior year's low during the multi-year advance.  January 2008 saw the downtrend breach the 2007 bottom which was a precursor to a much larger decline.  With that said, the 1949-1966 secular bull market witnessed years where corrections did trade below a bottom made in the previous year that did not lead to much larger equity price declines.  Yet, even these instances coincided with US recessions (1953, 1957, 1960).  Therefore, market participants have more reasons to be concerned whenever downtrends start to violate bottoms made in prior years.  

1.)  From a long-term perspective, the Dow Jones Industrial Average is still holding up, while SPX, NASDAQ, IWM, NYSE are all signalling caution.

• First is a long-term look of the DJIA trend.  In 2013, after roughly 17 years the DJIA broke out of the trading range highlighted by the big box.  Moreover, since 2010 the DJIA has yet to violate a prior year's low.  Therefore, despite a rocky end to 2018, the multi-year trend is still up for now even if questions about its durability are rightfully being asked. 
• Also highlighted here are the two circled areas, 1984 & 1990.  Each presented similar situations to 2018 from a technical perspective judging by the yearly candle.  Each resolved themselves to the upside for much bigger gains and in the process price action in both 1985 & 1991 stayed above the previous year's bottom.  This also occurred after 2005 & 2015 red years.
• On the other hand, 2000's yearly candle is also similar to that of 2018.  As mentioned above, Q1 2001 breached the 2000 low and led to large declines that either caused or worsened the subsequent recession.   

• The three quarterly charts above of the major US indices feature a 12-quarter (3 year) 2-true range multiple volatility stop.  Whether over one quarter or several, a large volatile move to the downside will flip the stop negative whenever it exceeds a price limit set by the parameters.  The purpose is to identify a potential change in the quarterly trend using volatility after a quarter's close is in.  This is certainly not a full proof method and is intended to serve as a risk management (rather than predictive) technique.  Yet, it has been robust in the DJIA going back to 1915.    
• The close of last quarter turned both the S&P 500 & NASDAQ 100 negative.*  This is also the case for IWM & NYSE.  The DJ transports and DJ industrials are still positive, but a sustained move below last quarter's low will see each also convert to negative.  This is to be determined.

2.)  Global markets are a major source of risk.

Unlike US indices, many global equity markets have been much weaker.  Some are on the edge of potentially much lower prices should important support levels fail while others have already been experiencing multi-year downtrends.  Frankly between Germany, Italy, and the UK, Europe poses a big threat and needs to be monitored closely.  A destabilizing Brexit and/or renewed Eurozone fears could be an unneeded and dangerous catalyst for what has already been a challenging global situation.  Germany has largely avoided the European malaise of weak aggregate demand by selling to the rest of the world to sustain their economic activity as can be seen by their large current account surplus.  This makes them particularly sensitive to global growth concerns.

• MSCI Germany Index flashed a big warning in 2018 and is now sitting on a multi-year trendline after trading below its 2017 lows.  Bulls will be hoping for a repeat of 2012 while bears can look to 2000 & 2008 for what happens when negative momentum spills into the next year.  

• Unlike Germany, MSCI Italy Index has been in a bear market since it traded below the 2007 bottom in early 2008 (top red line).  Similarly to its European cousin, Italy too is just above support where a break below the 2017 & 2018 level (bottom red line 23.2/23.13)) sets up a possible next leg lower.  The Italy index also features three lower highs (2007, 2010/11, 2014, 2018).  It would likely take a big multi-year move up to negate that much downward momentum.  

• Much like Germany, 2018 saw the MSCI United Kingdom Index decline under the 2017 low.  That type of price action could result in a test of the 2016 bottom.  A break there may lead to a retest of the 2009 support.  It also features three lower highs (2007, 2014, 2018).

• As is the running theme, MSCI Japan is also sitting right near major support (48.99/48.93).  It goes without saying that bulls will not want to see Japan trade or especially stay below this level.

• The FTSE China 25 Index Fund has been trading sideways for a decade.  A break below 37.85 would work to confirm the double top (2015 & 2018) and set up a retest of the 2011 & 2016 support line at the bottom of the multi-year trading range.

• In 2011, MSCI Brazil broke below the 2010 low before trending down for five years which culminated with a big bounce in 2016.  2018 marked a year of indecision.  It did traded slightly under 2017 support only to rebound in the fourth quarter of 2018 while the rest of the global equity markets suffered.  

• Unlike Brazil, MSCI Mexico's bounce in 2017 off the back of a four year bear market was already undermined by the end of 2018.  Trading under 37.50 would not be a good sign as the next major support level is the 2009 bottom. 

• The MSCI Canada Index has already put in four lower long-term highs (2007/8, 2011, 2014, 2018) and is below the 2017 low.  A retest of the 2016 rebound could be in the cards in quarters/years to come.

• The RSX Russia ETF has been in a bear market since 2008.  A move below 18.18 would confirm a third lower high (2008, 2011, 2018) that may see Russian equities trade toward long-term support (lower white line).

3.)  From a long-term perspective, oil is still in a downtrend while gold is only now just showing signs of a potential confirmed bottom.

• Unsurprisingly oil's yearly price action mimics that of Russia.  Should it fail to hold 42.36/42, negative momentum could draw it to the 2016 low over time.   

• Interestingly enough, gold has held up well on a relative basis following its rebound in 2016.  However, it is now coming up against major multi-year resistance.  The Japanese yen & gold tend to move in opposite directions to long-term treasury yields when market participants begin to anticipate the potential for easier US monetary policy.  Is this what we could be seeing?
• A rejection at resistance and a break of the 2018 low (111.06 red line) would not bode well for this view that the Fed will become much more accommodative going forward.  Conversely, a Fed pause (whether via rate expectations or a deceleration in the pace of balance sheet reduction), weaker dollar, and renewed nominal global growth should provide gold with the necessary conditions to move much higher following years of down to rangebound trading (reflation trade).  

4.)  US domestic growth does not show signs of recession in early 2019, but long-term treasury rates suggest that nominal growth is likely to decelerate.  

• The above business cycle alert which can be used to gauge the probability of a US recession was created by Ed Lambert.  By taking into account labor share, capacity utilization, and the unemployment rate, this measure attempts to estimate the effective demand limit of the business cycle.  This writer uses it as an early warning signal along with market price trends.
• Amid all the negative trends deriving from abroad, the US economy itself judging by this gauge is unlikely to go into recession anytime in 2019 as it would require a huge negative swing in economic growth after a strong 2018 for this to flash yellow or red.  Keeping this in mind, multi-year bear markets do not typically occur outside of recession.  

• While the probability of recession is still remote as of today, treasury yields are certainly pointing to slower expected nominal GDP growth.  The week ending 12/7/18 (orange down arrow) marks a 3-month closing low on a weekly basis for 10-year treasury yields.  This was soon followed up two weeks later with the 10-year yield making a 6-month low (red down arrow) and it now looks poised to test the 2018 low (red line).  Should yields move below that level without resistance, it would suggest that market participants are beginning to anticipate a sharp deceleration in US nominal GDP growth.

Concluding remarks:

The May post The Bull & Bear Case for Risk Assets highlighted both a potential optimistic & pessimistic outcome for the back half of 2018.  With last year now history, the end of 2018 followed the bear script much more closely as each bullet point was checked although the dollar is still in the middle of its long-term range. 

Bear Case:

• Long-term treasury rates reverse and begin to decline as market participants price in the increasing possibility that growth and inflation expectations may have at least temporarily peaked.
• Equity markets break their first quarter lows after three to six months of sideways price action.  This would signal caution and perhaps indicate that the earnings picture going forward may be weaker than currently anticipated.
• Credit spreads start to widen after compressing for over two years. 
• The USD's ongoing rebound marks the start of a new intermediate uptrend rather than simply a correction in the downtrend that began following the December 2016 peak.  Foreign currencies and risk assets remain under pressure.  Eventually the dollar's ascent begins to weight on commodity prices and by extension inflation expectations.

The question now is whether we are seeing signs of the "beginning of the end" in a correction or merely the "end of the beginning" phase of a new big bear that will eventually reassert itself.  Right now this remains inconclusive.  The violent moves below the October & February 2018 lows should have warned market participants to reduce their risk even if holding some risky positions is still appropriate for certain investors (always with stops/exit strategy!).  However should an array of global markets start to trade below their December bottoms with long-term treasury yields continuing to decline along with a further widening in credit spreads and a rising VIX, a risk is that panic starts to set in.**

Even in that case, it is certainly possible that this risk-off period could eventually resolve itself with a long-term bottom below the 2018 lows that eventually sees global markets rally to new highs much further down the road.  Without ignoring that possibility, from a risk management point of view a coordinated break of the 2018 lows in global markets would have this writer rotate even further into defensive positions and away from risk.***

That all remains to be seen and it's in the spirit of this blog to follow and not predict market price trends.  That being said, it's important to use these weeks (days?) of relative calm to plan for a variety of outcomes.  As of now, it could go either way.  One thing is for sure, whether global equity markets have already put in their respective lows for a prolong period or if panic does occur, this environment has the potential to wrong foot inflexible bulls and bears alike creating the tinder for explosive moves in either direction.  Maximum flexibility required!


*A 6-quarter true range period for the volatility stop (not shown in this post due to too many charts as is) is used to corroborate the story being told by the 12-quarter.  Although the 12-quarter stop was triggered in SPX & NASDAQ 100, it has yet to for the 6-quarter period in either indices.  A quarterly close below the Q4 2018 lows will cause this to change.

**The VIX, credit spreads, and safe long-term treasury bond prices have been rising.  However, none reached levels usually associated with panic.  That could be a sign that the long-term trend for risk assets is still up or that market participants are simply too complacent.  TBD

***What would get this writer back more aggressively on the long side of risk assets?  A weekly close above a new six month high in the major indices.  At that point, the coast should be clear to add to longs or take new starting positions in the assets/equities that have held up the best over this period.  Otherwise, entering aggressively too early will increase the risks of buying during a bear market rally.  If anything, those that have been caught too far on the side of risk may find this rebound as an opportune time to lighten up and remain nimble to a variety of possible outcomes.