"Unlimited Downside Risk" - Trader Warns 'Passive Permabulls' Of Dangerous Divergences

Authored by JC Parets via AllStarCharts.com,

The thing about the market is that there is no holy grail. No matter how hard you try, you’re not going to find it. The holy grail does not exist. We have to weigh the evidence knowing full well that we’re working with incomplete information. The idea is to accumulate all of the data and make a conclusion based on all of it, not just some of it.

Today, I want to go over a few of the divergences that have put the bulls in a precarious situation. There is a large crowd of permabull “passive” investors that are taught just to buy stocks and hope for the best. They are shown all of these sexy equity curves and told again and again how much they would have made had they invested in the S&P500 in 1950 or 1982 or whatever cherry-picked date is forced upon them.

It doesn’t make these people good or bad. It’s just what it is. I think it’s important for market participants to understand the way things work. Based on the tiny tiny sample size of a 100 years or so, sure a lot of these theories could make some sense. We’ve had less than a handful of secular bear markets during this time, so if you’re making decisions based on the outcome of a few short periods, then go for it. But it’s not something I would ever do.

We need to reevaluate the market constantly as the data comes in and understand that we have no idea what the stock market is going to do. In fact, I’m willing to bet that it will do something it’s never done. You know why? Because the market does something it’s never done all the time. There are only 100 years of history. It’s easy to do something that’s never been done with such little data and such an irresponsibly small sample size. It’s not just different this time, it’s different every time.

I want to reiterate that there is unlimited downside risk in the market right now and I don’t think it’s being respected. It’s not until afterwards that they ask, “what happened??”. And that’s when the blaming game begins: The fed, the trump, the ebola, or whatever excuse du jour is being regurgitated on the various media outlets. The only one to blame is ourselves. It’s ourportfolio at risk. We are the only ones who profit when it goes up and the blame is 100% ours if we lose money on long positions when the market goes down.

The first divergence that I think is worth pointing out is the global situation. The S&P500 made new highs in the 3rd quarter back above the January highs. Meanwhile, the rest of the world did not even come close. This chart shows the S&P500 compared to the next 40 Stock Market Indexes around the world equally-weighted. The divergence is telling. Last time we saw this was at the 2015 market top:

When stocks are rising, Consumer Staples underperform for a variety of reasons including their defensive characteristics and lower beta components. When stocks fall, Staples get a sympathy bid and outperform due to that very same lower beta and their defensive qualities. With new highs in stocks, bulls want to see new lows in relative strength for Staples. That’s a normal environment. It’s when they diverge that it is evidence of something changing. With higher highs in the S&P500 last month, Staples did NOT make new relative lows. In this chart, I flipped it and made the S&P500 the numerator and Staples as the denominator. So when it’s falling, Staples are outperforming. That’s the divergence that stands out here. The last two times we saw this was at the 2007 market top and the 2015 market top:

We can take this analysis one step further. Included in the sectors with defensive qualities are also Utilities and Healthcare. The more offensive sectors include Financials, Technology and Consumer Discretionary. What I like to do is equally-weight a basket of the Offensive sectors and equally-weight a basket of the Defensive sectors in order to compare them. This is what we have here. Again, with new highs in the S&P500, we got lower highs, and now lower lows, in the ratio between Offensive and Defensive Sectors:

Dow Theory is arguably the oldest strategy in Technical Analysis. Whether it’s the oldest or not isn’t the point. The idea is that Industrial stocks make the goods and Transportation stocks deliver the goods. When one makes a new high, the other should as well to confirm that it is in an uptrend. When they don’t confirm, something is wrong. We saw these divergences lead to collapses in 2000, 2007 and more recently a severe sell-off in 2015. You can see that with new highs in the Dow this month, Transports put in a lower high, typical behavior at market tops:

Some people use Dow Theory as a “sell signal”, which I don’t necessarily agree with. I think the bigger point is that both indexes are stuck below overhead supply. To me, this is the real issue. If we’re below the January highs in the Dow Jones Industrial Avg and Dow Jones Transportation Avg, this is a market where we want to sell strength, not buy weakness:

So should we expect a U.S. Stock Market crash? Yea I think so. If it doesn’t happen, then so be it. But why not be aware that it is certainly on the table and the evidence is piling up. What if we just grind sideways for 6 months and don’t collapse? Do you want to be long in that environment anyway? I’d say no way, Jose! Either way, crash or long sideways grind, I still don’t want to be long.

We’re watching credit spreads to signal that things could get much worse very quickly. Until now, there is little evidence of stress in credit, which supports more of a sideways range, not a crash. But this could change overnight and we’ll be watching for growing spreads between yields of Junk Bonds and Treasury Bonds to confirm that there’s a bigger storm out there:

We’re always trying to think about the future market environment and what we’re going to do about it. At this point, it’s up to the bulls to step up and do something, anything. They’ve dried up and haven’t shown up when they’ve been called upon, particularly in financials and homebuilders, and now it’s spilling into other areas. We will be looking for similar divergences, but flipped upside down, as a heads up that things are improving.

I personally really like the percentage of stocks in the Russell3000 showing bearish momentum characteristics, as defined by a 14-day RSI below 30. When prices of the indexes are making new lows, but the % of stocks with bearish momentum is decreasing, it’s evidence of improving breadth. We want to buy stocks in that environment. This is what it looked like at the 2016 bottom:

It also worked beautifully at the low earlier this year:

That’s what I’m watching. Until then, we want to keep selling stocks, not buying them.

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