Decision Time

It’s been a year since the fallout from the Lehman Brothers collapse that rocked the markets, pushing market volatility to an extreme. The market volatility that was witnessed last fall is not something many of today’s current market participants have ever experienced, a generational type collapse that one would have to turn back the clock to the Great Depression to find a similar environment. We’ve come a long way since then, in no small part due to the steroids the Fed has injected into the financial markets to bring down credit spreads, but how long will the Fed administer its steroidal cocktail, and can the financial markets stand on their own two feet? Is this a new bull market, or perhaps one of the greatest bear market rallies in history? We shall know soon enough.

Key Test Coming in FSO Financial Stress Index

Last year I developed a financial stress index based on the methodology developed by Bloomberg in which the health of the bond market, money market, and equity markets were all inputted into a composite. I recreated their stress index and made some of my own adjustments and calculations. For example, given the importance of global currency flows and the role of the government in the economy, I have added a currency stress component as well as US Treasury component to my composite, which I feel is a fuller snapshot of the overall health in the financial markets.

So where are we today and what are my stress indexes showing? The non-smoothed FSO Financial Stress Index (FSI) without the UST or currency component moved into positive territory for the first time since the market peaked in 2007. This is quite the feat given the record low seen in late 2008, but it is still too early to begin to celebrate given that the major bear market rallies in the 2000-2003 bear market were stopped dead in their tracks when the FSO FSI reached neutral to slightly neutral territory. The all-clear signal was not given until the FSO FSI breached into positive territory and then stayed in positive territory in 2003. If the FSO FSI can remain in positive territory and build on its recent gains this would have bullish implications for the equity markets. That is, so long as the Fed maintains its liquidity programs that have done the heavy lifting in improving credit and liquidity conditions captured by the FSO FSI.

Source: Bloomberg

While the simpler FSO FSI that measures only the health in the money market, bond market, and equity markets is in positive territory, my more complex FSO FSI that includes the UST and currency markets is not quite there, reaching -0.15 as of last Friday. I prefer to use the three month moving average of my full FSO FSI as it has less whipsaws than the non-smoothed FSI. The current reading on the smoothed FSO FSI was -0.51 as of last Friday and is now above pre-Lehman levels but still in negative territory.

Source: Bloomberg

Source: Bloomberg

Most of the improvement in the FSO FSI over the past year comes from the money market and equity markets, with two out of the five FSI components now in positive territory, with the currency stress index showing the most negative reading at -0.77.

Source: Bloomberg

Hurdles Remain for the S&P 500

The S&P 500 has rallied strongly off the March lows vaulting nearly 65%, and yet it is still down roughly 30% from its 2007 highs. One tool used by technicians in terms of gauging key retracement levels are the Fibonacci retracement ratios of 38.2%, 50%, and 61.8%. Often counter trend moves will recover anywhere from 38.2% to 61.8% of the prior move before resuming the primary trend. However, if the 61.8% retracement is breached a full test of the prior highs/lows often ensues. If the S&P 500 can not exceed the key retracement levels of 50% (~1117) or 61.8% (~1222) of the 2007-2009 decline, then the market advance from the March lows will probably be over and then either a significant correction or prolonged consolidation may take shape.

For a historical look at how significant the key Fibonacci retracement levels are, the 61.8% retracement level of the 1929-1930 market crash proved to be a hurdle the S&P 500 could not surpass as the S&P 500 rolled over into a devastating decline lasting until 1932. Another key hurdle that the S&P 500 could not overcome in the 1929-1930 decline was the 200 day moving average (200d MA), which the S&P briefly but not sustainable broke though on the upside.

Source: Bloomberg

In contrast to the 1929-1930 experience, the S&P 500 has broken through its 200d MA by a sizable margin, enough to actually cause the 200d MA to turn upwards which signals a rising market trend, which is bullish. However, the S&P 500 has not cleared the 50% retracement level yet as it did in 1930, and the 61.8% retracement level still presents another hurdle for the S&P 500 to clear before the rally off the March low could be considered something other than one massive corrective bear market rally.

Source: Bloomberg

While the 200d MA may be signaling a bullish primary trend as it has been rising since July, the primary price trend is still bearish. The 1100-1130 zone is likely to prove a key level for the S&P 500 as it will not only challenge its declining trend line that has been in place since 2007, but will also challenge its 50% retracement level.

Source: Bloomberg

While Hurdles Abound, Breadth is Still Supportive of Higher Prices

In the intermediate term it appears that the S&P 500 is heading higher as we have yet to see any negative divergences in terms of NYSE net new highs or net new lows which signal deteriorating market breadth. Each new high in the S&P 500 has been confirmed by NYSE net new highs and net new lows are virtually non-existent, coming in at 0.09% while NYSE net new highs reached nearly 10% on Tuesday.

Source: Bloomberg

The current market breadth in terms of NYSE net new highs/lows stands in stark contrast to the 2007 market top in which higher highs in the S&P 500 were not confirmed by higher highs in the NYSE net new highs, and there was actually an increase in net new lows which rose to nearly 20% at the July 2007 lows, showing considerable market deterioration.

Source: Bloomberg

Decision Time

While the markets have regained a considerable amount of ground from the devastating 2007-2009 decline, hurdles still abound that could prove to be too much for the current rally to contend with. Market character at these key levels needs to be studied in terms of loss of momentum or market breadth to signal whether they will be overcome or prove to be bull killers. As it now stands, breadth remains supportive of higher prices and the FSO FSI continues to improve. Deterioration in either may mark the final top in the markets, but calling a top at this stage in the market’s advance may be premature and the market deserves the bullish benefit of the doubt. The next few weeks to months will prove to be decision time for the markets, whether the bull continues its charge or the bear comes out from hibernation.

About the Author

Chief Investment Officer
chris [dot] puplava [at] financialsense [dot] com ()
Financial Sense Wealth Management: Invest With Us
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