Dow Theory “Lines in the Sand” Have Been Drawn

Let’s begin today’s note with a quick update on the S&P 500. Two weeks ago, on October 30th, I suggested that a possible short-term bottom was coming into view based on relative price action in the VIX and small-caps.

As it turns out, the October 29th bottom did hold, and the S&P subsequently rallied back up to where it began its second leg down (at approximately 2815). From there, we had three down days of increasing magnitude, followed by today’s attempt at a rally.

What’s interesting about this setup is that we’re tracing out an inverse head-and-shoulders pattern, which is indicative of a bullish trend reversal. However, the pattern is not yet complete, and this leaves us with two likely potential outcomes.

S&P 500 Large Cap Index

If the market can hold its ground today, and eventually rally above the neckline at 2815, it will complete the inverse head-and-shoulders pattern and transition the index back into a series of short-term higher-highs and higher-lows. This action would also take the S&P back above its 50-day MA, effectively turning the short-term trend bullish again.

On the other hand, we have not yet seen a retest of the October 29th lows. Therefore, if the right shoulder above doesn’t hold, I think a retest is the most likely outcome. Should that happen, it will be a crucial to watch because the fate of Dow Theory will hang in the balance.

So far, Dow Theory has remained bullish because the conditions for a bear signal have not been met. But as you can see below, we’ve now entered into a period where that could change.

Dow Jones Industrials and Transports

The declines from recent highs have now been large enough in both magnitude and duration to be considered representative of the primary trend. As a result, the initial correction lows are now in place and our proverbial “lines in the sand” have been drawn. Should both averages fall below their respective October 29th lows (24,443 for the Industrials and 9,896 for the Transports) it will trigger a Dow Theory sell signal.

It’s tough for me to believe that will happen, considering the strong U.S. fundamentals, where we sit in the presidential cycle, the fact that we’re in a seasonally strong period of the year, and the robust earnings that we’ve seen, but the discounting nature of the market cannot be underestimated. The market tends to sniff out problems well before we can, and it behooves us to listen.

As this situation evolves, it’ll also be interesting to watch what happens with market breadth. And to that end, I must admit that I think I missed a big tell.

If you look at the charts of the Industrials and Transports above, you can see that joint new highs were reached in mid-September, reconfirming the bull market. As we moved into October, however, the Industrials rallied to a new all-time high, but the Transports failed to confirm.

That was our first indication that something was amiss, and by itself, wouldn’t have meant much. But as you can see in the chart below, the A-D line also failed to set a new high in mid-September …

NYSE Advance Decline Line

So in effect, we had a flagrant upside non-confirmation that flew under the radar that could have potentially alerted us to the weakness that followed. I apologize for not pointing that out at the time.

The tricky aspect of this is that nothing regarding Dow Theory suggests that the averages have to confirm at the same time. Rather, they can and often do reach new highs weeks, even sometimes months apart. The key here, in my opinion, was to recognize that market breadth had actually turned bearish on September 26th, when the A-D line broke below its early September low. THAT was a key indication that something had changed.

At this point, I guess the best we can do is learn from our (my) mistake and move on. Market breadth remains bearish and as you can see on the right side of the chart above, is in the process of tracing out its own inverse head-and-shoulders pattern. That will be another key area to watch over the next week or two.

Moving on, I think we need to address what’s going on with both oil and the commodity complex in general. In the chart below, we can see that light crude is on one hell of a roller coaster ride, falling for 12 consecutive sessions through today. In fact, today’s action is not even shown, where oil collapsed another 7.1% to $55.69/bbl.

Light Crude Oil

As is always the case with oil, fund managers see big price declines and assume that global growth is grinding to a halt. We do know that global growth is challenged, but I would caution you against reading too much into this move. We know that the price of oil is heavily driven by supply as well as demand, and there are lots of positive knock-on effects from lower oil.

For one, because oil sits at the base of every supply chain, we know that falling oil prices will ease the upward pressure on inflation. As you can see below, it has been dragging the entire commodity complex down with it.

CRB Commodities Index

This should give the Fed some cause to reconsider their monetary policy outlook, because the inflation ghost that they’re chasing isn’t putting up much of a fight.

It will also result in lower overall transportation costs, which means higher margins and profits for the vast majority of companies. Home Depot was the latest company to mention higher transportation costs as putting downward pressure on margins during Q3.

Lastly, cheaper oil leaves more money in the hands of consumers, which is always a good thing. As a general rule of thumb, every one-penny reduction in gas prices puts over $1 billion a year into the hands of consumers. That, in effect, is its own form of economic stimulus.

So yes, the oil companies are likely to moan and groan, but thankfully, the HUGE collapse that we saw from mid-2014 to early 2016 forced most of these firms to tighten up their balance sheets (or go out of business). As a result, they should be able to navigate this latest bout of weakness without much issue. It’s also worth noting that during Q3, the energy sector posted the strongest earnings growth year-over-year, up 125%.

As we wrap things up, I want to briefly point out the action happening in emerging markets. The dollar’s strength this year has killed this group, but signs of some reprieve are now starting to show.

In the chart below, we can see that EEM has been in a textbook bear market, falling to new low, after new low. This has happened eight consecutive times this year …

MSCI Emerging Markets ETF

But as you can see, the most recent November low appears to buck this trend. I want to be clear that it’s still too early to assume the trend is changing, but you might want to keep this on your radar. If EEM can halt its decline here and rally above the most recent high, the short-term trend will shift to bullish. That could present an opportunity for those inclined.

That’s it for now. As always, let me know if you have any questions or topics that you’d like to see addressed. Have a great rest of the week and I’ll see you back here on Tuesday.

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