Several Indicators Suggest Support Should Hold…For Now
There are several indicators and behaviors I like to see to suggest a trading bottom has developed. First, and most important, we need to see strong oversold conditions in market breadth indicators. One of my favorite is the McClellan Oscillator. It looks at the trend and relationship of stocks advancing and stocks declining. We saw extreme oversold readings that historically have a 90%+ efficacy at identifying market lows. We saw two 90% plus downside days last week too. That is where 90% or more of the volume traded (operating companies) on the NYSE were down.
We like to see a test of important support levels hold. Last week we saw a double bottom test of the 200-day average (S&P 500 futures). Historically, the 200-day average acts as an important psychological target. When all market corrections (5% or more) are measured historically, the average is 13.4%. The peak to trough correction last week was a bit more than 12%. Back in early 2016, we tested important support with a 14.5% correction. While it is clearly possible, we see markets move a bit lower still, there are enough signs that support should hold for now.
Finally, valuation and forward earnings expectations are strong. Far stronger than I expected from the tax bump and global economic momentum. Last show we noted the risk of a recession in 2019 is rising based on the shape of the yield curve. We’ll see how that plays out in the second half of 2018 (I still think that is a big risk). Markets tend to peak 6-9 months ahead of an official recession. At the lows last week, forward earnings valuation was closer to long-term fair value, so from that perspective we should not likely be seeing more intense selling until the market wants to price in the next recession. That next recession will depend on how aggressive the Fed (and other central banks) get this year and next and how inflation behaves. So it could be a risk for later in the year or in early 2019. For now, there should be enough global economic momentum to stabilize markets as we get past this volatility induced correction.
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