US Market Internals Indicate of Prospective Heightened Volatility

``In seeking wisdom thou art wise; in imagining that thou hast attained it, thou art a fool.”--Lord Chesterfield (1694 – 1773), British statesman

The dilemma which we described last week conspicuously manifested itself anew. Where we noted that the reaction of our Phisix would “highly depend on the degree of volatility in the US markets”, our market responded exactly to these events.

When the US markets made significant moves our Phisix followed its footsteps. When US markets closed with minor changes, the Phisix responded to the upside, see figure 1.

Figure 1 Stockcharts.com: Waltzing Phisix and Dow Jones Industrials?

The Phisix (candlestick in main window) has closely tracked activities in the US markets (line chart behind in main window), as much as the other pertinent benchmarks of the iShares Emerging Market (upper panel below the main window) and Dow Jones EX-Japan Asia/Pacific index (lower panel).

These, in my view, have been the push and pull factors weighing on the Phisix, as it struggles to follow the sentiment of the US markets while being buttressed by the declining US dollar, which appears to have recently accelerated (-.52% for the week, 2.1% year-to-date).

Nonetheless, our principal concern, to reiterate for emphasis purposes, is the “degree of volatility in the US markets”.

We broke down the industry components of the major US benchmark the S&P 500 last week and discovered that 6 out of 10 industries comprising about 61% of the index weightings had seen marked deceleration of their price actions.

Meanwhile, based on the Dow Theory, we observed a meaningful divergence where the price actions of the UTILITIES and TRANSPORT indices has deteriorated compared to the Dow Jones Industrials which has managed to maintain its sanguine composure. This digression could be indicative of a looming reversal for the key major index.

Essentially this degeneration in the market internals served as our basis for our bearish outlook in the US markets.

Again, let me remind you that, today’s potential decline in the US markets could simply be a transition to a normal “corrective phase” rather than an unfolding crisis as some bears suggest, unless proven otherwise.

Since we are not into the markets for vanity reasons, we adjust our views as the market depicts to us and react accordingly (where most of the time our reaction is simply to sit, read and do nothing).

We do not engage in wishful thinking or adopt rigid “convictions” as with most of the average investors, since we understand that our emotions are the principal determinant to our portfolio losses. We frequently like to blame/heckle others when we cannot control ourselves.

To quote one of our favorite market gurus Mr. Martin Barnes, managing director BCA Research (highlight mine), ``There are so many forces and imponderables that affect the outlook, that one must keep a very open mind and not get trapped in a fixed mindset. Too many people have locked themselves into either a bullish or bearish view and that undermines their willingness and ability to take account of a changing environment. It is important never to become overly confident that you have it all figured out.”

For this week the only notable change within the universe of benchmarks we previously cited was the Dow Utilities benchmark which has shown some signs of improvement. The rest of the other benchmarks retained their overall tones.

Because we understand the follies of cognitive illusions, we try to avoid from attributing events as having a causal relation to market activities. Instead we let the markets do the talking.

Despite the marginal weekly gains in the major US bellwethers, we noticed of the volatility building from within.

For instance in the past five sessions, the US Dow Jones Industrials sprinted to the positive side marked by notable gains during the early half of the sessions only to end marginally down, except on Wednesday wherein it managed to close significantly up.

In Friday’s session alone, the Dow Jones spiked above 130 points of advance at the first half, only to reverse itself by declining about the same degree (down 130 points) during the latter half; it ended the session 13.66 points down. That was over 260 points swing (from top to bottom to the close)!

These incipient signs of volatilities suggest to us that the US markets could be facing major headwinds which could rattle our own markets if our correlations with the US Dow Jones persist.

Figure 2: stockcharts.com: Declining Breadth in US Markets Foretells of Turbulence

Figure 2 conveys to us the market breadth conditions of the New York Stock Exchange (NYSE) and of the Nasdaq. This is the ratio of issues hitting NEW highs as against issues hitting new LOWS. Fundamentally, this ratio reveals to us of the overall market sentiment underpinning these exchanges.

In the two charts, we can take note that in both NYSE (above) and NASDAQ (below) bourses, the present trend has been that of a DECLINING ratio of NEW highs vis-à-vis the NEW Lows. In other words, market sentiment tells us that the bullish sentiment looks frayed and exhausted. And if history determines future actions, then the continuing downward drift (blue trend line) indicates accelerated deterioration in market sentiment which could most probably lead to equivalent declines in the major benchmarks, as represented by the S&P 500 above (line chart) and similarly shown in the past (blue down arrows).

Of course, we can never count on history alone; but the messages emitted in the context of the different behaviors of these market internal data (component trends, Dow Theory, New high relative to New Low) seems lucidly tilted towards an imminent corrective phase, even as the major benchmarks has yet to break their all important support levels.

One could probably take on short positions on the key US benchmarks if their support levels relent to a breach, where backed by the weakening market internals, could translate to a meaningful decline. To my recollection the US markets haven’t had a 10% correction since 2003, which means a 10% decline will be a norm for any trend.

On the other hand, if the markets remain irrational and does the unexpected; one could take the long end if such indices break above their most recent high. However, I would assign the latter with a smaller probability of occurring. This should apply to our end too.