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Market Opens With Severe Declines

The market opened this morning with one of the most severe declines since the bankruptcy of Lehman Brothers in 2008.

 

By Lance Roberts

However, if you have been reading my missives for any length of time, it should not come as any real surprise.

In March of this year, I began discussing the various warning signals being exposed in the overall market. This was despite an abundance of the usual “don’t worry, be happy”mantra’s of the mainstream media. However, portfolio management is about more than just sticking money into risky investments, the other half of the process is knowing when to take it out. As I stated:

The effect of momentum is arguably one of the most pervasive forces in the financial (NYSEARCA:XLF) markets. Throughout history, there are episodes where markets rise, or fall, further and faster than logic would dictate. However, this is the effect of the psychological, or behavioral, forces at work as ‘greed’ and ‘fear’ overtake logical analysis.

There have been many studies published that have shown that relative strength momentum strategies, in which as assets’ performance relative to its peers predicts its future relative performance, work well on both an absolute or time series basis. Historically, past returns (over the previous 12 months) have been a good predictor of future results.

The chart below, which is a monthly analysis of the S&P 500 versus its 12-month moving average, shows that the above statement is true. When the S&P 500 (NYSEARCA:SPY) is trading above its 12-month moving average forward returns have continued to be primarily positive and vice versa. The Price Momentum Oscillator (PMO) at the bottom confirms substantially the same. However, as seen in late 1999, the PMO triggered a sell signal while the markets continued to trade above its 12-MMA. It was several months later before the market failed and began a serious mean reversion event.”

SP500-PMO-12MMA-082415

It was at that time I began to issue a regular series of instructions in both my daily blog and the weekly X-Factor report (subscribe for FREE E-delivery) to take profits from winners, sell laggards and raise cash as risk was substantially elevated. To wit:

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“Short-term bounces are important to use to rebalance risks in portfolios particularly in the face of waning monthly momentum.

While it is not yet time to become exceedingly conservative in portfolios by sharply reducing equity exposure, it is important to be aware of the underlying deterioration in price action. Over the next month, the market needs to break out to new highs and restore price momentum before we enter the seasonally weak summer period. Otherwise, given the dearth of a correction greater than 10% over the last few years, it will likely be a summer best enjoyed from the sidelines.”

Since those early warnings, the deterioration in the underlying dynamics of the market has continued EVEN THOUGH the bullish trend of the market remained intact. However, as I stated earlier this month that “tug-of-war” between the bulls and bears would soon be decided.

“Currently, the ongoing battle between the bulls and bears has yet to be resolved. However, I suspect that a victor will be declared soon. As shown in the chart below, by analyzing the longer-term trend of the market we can make an assumption of the potential magnitude of the price move when the current compression is resolved.”

SP500-PotentialOutcomes-081115

“If the ‘bulls’ are declared the victor, a run to 2300 from current levels would not be surprising. This would be a roughly 9% gain by year-end and would return the market to the top of the bullish trend channel that has evolved following the 2011 market decline.

However, a defeat of the ‘bulls’ would see a potential retest near the October 2014 lows. The current bullish trend support should be around 1900 by the end of 2015 with the October 2014 lows as support just below. This would entail a roughly 10-12% decline from current levels.

You should recognize that a potential 9% gain is outweighed by the potential for a 10-12% decline. With the risk/reward ratio negative, investors should err to the side of caution currently. (i.e. there is more to lose than potentially gain from being aggressively invested currently.)

With the internals of the market continuing to show signs of deterioration, a realization that the economy is on fairly weak footing, and the potential of a China mishap; the risk to the market currently is to the downside. However, the market will soon make its decision and investors would be wise to react accordingly.”

Of course, what much of the mainstream analysis dismissed the potential impact from the China “market bubble” collapse, the potential “Asian contagion” was quite evident.To wit:

“The recent plunge in the Chinese market may, or may not be, the sound of the latest bubble popping as I write this missive. However, there are two very important warnings be given here:

  1. The current bubble will eventually end, just as the last two have, in a rather disastrous plunge for those chasing returns.
  2. The plunge will also likely be coincident with an unwinding of excesses in the S&P 500.

China-Index-070815

“The current belief is that the economic environment is stable, and growing enough, to support and foster continued expansion in domestic markets for the foreseeable future. Of course, that was also the belief at the peak of the previous two bubbles as well.”

Was That The End Of The Bull Market?

The question that must be answered now is simple. Have we just witnessed the end of the bull market advance that began in 2009?

It is too early to tell just yet, however, the evidence is clearly mounting that such is indeed the case. As of this morning, the market has broken below the 70-week moving average support which has been the running bullish support for all three previous bull markets.

SP500-MarketUpdate-082415

What is critically important is that the market rebounds, and holds, above 2026 by the end of this week to keep the bull market advance alive. A failure will likely lead to a test of the long-term moving average at 1825 or a 14% decline from the peak. However, such a decline from current levels, and at this late stage of the cyclical bull rally, would likely blossom into a full-fledged bear market of 20% or more. In other words, if the market fails to hold support at 1825, the decline will be substantially worse as witnessed in both 2000 and 2008.

“But Lance, such a decline only occurs within the confines of a recession.”

That is absolutely correct. But here is the problem.

“Bear markets in equities are coincident with recessions which are only understood to have occurred in hindsight.”

NBER-SP500-RecessionDating-082415

Since economic data is subject to massive backward revisions, it is impossible to determine recessions in advance of their occurrence. Therefore, if you wait for the recession to become obvious, it will be far too late.

At this critical juncture, there are two things that are for certain:

  1. The Fed will not hike interest rates in September and most likely not this year at all.
  2. The majority of mainstream analysts will be looking to the Fed for an additional QE program to bail out the markets.

It will not surprise me to see the Fed in the markets this week “talking the game” to try and restore confidence to the markets. The risk is, as seen with China, is what happens if it doesn’t work?