Thursday, 26 April 2018

Stock Market: A Much-Needed Healthy Correction

The correction we're having since Feb is much needed and healthy.

I know the major indexes (QQQ, SPY, and DIA) look bad right now. I agree. But is this the omen of something bad in the economy, or the opposite?

Below are some observations i made in terms of market breadth, Risk Appetite, and Volume.

1.  Market Breadth

1.1. Advance-Decline
If you look at A-D Volume for NYSE since Feb, it makes higher highs, and higher lows. The definition of an uptrend.

NYSE Advance-Decline Volume
(Click chart to enlarge)

1.2. RSP / SPY Ratio
Another way of looking at the market breadth is comparing the equal weighted index (RSP) to market weighted index (SPY). In the whole of 2017, this ratio is in the purple down trend channel.

This ratio breaks out of the purple downtrend channel since March, in the midst of market correction.

RSP to SPY ratio
(Click chart to enlarge)

2. Risk Appetite
If the market is fearful of some impending doom in the economy or market, it becomes risk averse.

2.1.  XLY/XLP Ratio
This ratio measures risk appetite because staples are considered defensive while discretionary is considered risky. Also, when the market thinks the economy is slowing down, money would move from XLY to XLP, and this ratio chart would start to trend down, not up.

This ratio just made all time high on Monday. If it makes all time high while the market is making all time high, i would be worried as it suggests blow up top. But the major indices was undergoing correction while this ratio is going up. This is not a risk averse behaviour.

XLY to XLP ratio
(Click chart to enlarge)

2.2.  Smaller caps
The smaller the caps, the riskier they're perceived, correctly i might add. So in a risk-averse market, the safety of bigger caps are more preferable to smaller caps. Especially during a severe correction.

During this correction, the major indices (SPY, QQQ, DIA) put in almost equal lows or bottoms, but the smaller the indices, the better they look. IWM looks better than SPY as it make higher low. IWC is smaller than IWM and looks even better.

2.3. Gold
Gold is the ultimate safe haven asset. And yet gold is going down as the last 4 days of equity market pull back, almost day by day.

None of these are telling me that the market is risk-averse.

3. Volume
This is an old fashioned indicator that not many people are looking at any more. Very much neglected, but still useful and valid.

As the market is correcting from Feb high, the volume is declining. This is saying that the next moves is more likely to be up than down.

Volume declines during Feb to May 2018 correction
(Click chart to enlarge)

Conclusion: If you look at all the facts/observation/analysis above, the only conclusion i can draw is that this is a HEALTHY correction. Not the start of something bad. But the start of something good.

In fact when we have a rising market - as we did in 2017 - while the market breadth is declining, that's an UNHEALTHY market. This correction, not just in price, but in market breadth is sorely needed. Instead of having a market advancing by relying on only a small group of mega caps, more and more of the market in the last 3 months of correction are actually going up. This is saying the economic fundamentals is sound, and that the mega-caps are over-owned, over-bought, and over-priced. So they simply need a price correction.

The QQQ/SPY ratio shows that QQQ is breaking out of the channel relative to SPY. This suggests the mega caps are very expensive  (actually excessive) relative to SPY and in need of the price decline adjustment. The neglected, under-owned smaller caps in IWM gets some loves during this correction, causing them to drop less than the over-owned mega caps.

Market breadths suggest that we had an unhealthy market last year with RSP/SPY decline the whole year, now we're having a healthier market. Investors may forget what "correction" mean. It doesn't simply mean a price drop. It means it CORRECTS market imbalances. In this case, we HAD a imbalance of a top heavy market, now we have a more even-keeled markets where not just the generals are advancing, but all the soldiers as well.

All theses observations tell me that the economy is going along fine, it's the market that WAS not fine. But after the correction, it's looking better.

What i can't tell you is that when this correction is going to end. I have a feeling that it's sooner than later.

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