Analysis: Rally or Dead Cat Bounce?

Key Points

• The major indices are testing their breakouts.
• Bulls: Sector ETFs have seemingly found bottoms at key supports.

• Bears: Inter-market analysis confirms bearish breakouts.

  You can read the blog, with charts, here: https://www.brtechnicals.com/analysis-rally-or-dead-cat-bounce/

The question on every investor’s mind is whether the recent rally in stocks is a bottom or dead cat bounce. Positive sentiment has been pushing stocks higher as of late, but is it enough to call a bottom? 

A Santa Claus Rally, a “blowout” jobs report, and the Federal Reserve have made the case for stocks, and have pushed the S&P 500 up by more than 7.5% over the last couple of weeks. 

There is compelling technical evidence that suggests we may have found a bottom, but there is also strong evidence that suggests this is a dead cat bounce. Investors now find themselves in a similar situation like we had in November.

The Case for a Bottom

Like in November, sector rotation and performance are pointing to a bottom in the major indices. Every sector ETF has found a support, and some of them are considered very strong. Many cyclical sectors have fallen to key levels such as the breakout points immediately after the 2016 presidential election. If any of the sectors had hit these key levels during a mid-cycle correction, it would be an excellent time to open new positions. 

In addition, sector rotation is also showing signs of a bullish cycle. The cyclical sectors are moving in the lagging quadrant towards improving, and the defensive sectors are rotating towards the weakening quadrant. 

These are the beginning signs of a new bullish cycle, and if they follow through, it indicates investors are bullish on the future of the markets and economy. However, the stock market will need to clear some hurdles before we can call this a bottom and not a dead cat bounce.

The Bear Case: Dead Cat Bounce

The three major indices have broken key support levels, with the S&P 500 breaking two. The breakouts are significant because it represents a reversal from an uptrend into a downtrend. The major averages are a large representation of the market, and it takes a lot of conviction and breadth to cause such moves. 

It is a lot harder for the averages to make false signals because it requires a lot of coordination from sector and individual stock performance. Although, fake-outs will occur.

There are a few other signs telling us stocks are still headed for trouble. For one, breadth is still extremely low. The Dow Jones has the highest percentage of stocks above their 200-day moving average with only 33%. Elsewhere, we use inter-market technical analysis to understand how other parts of the investment markets are behaving. These other charts can either confirm or deny what we are seeing in the stock market. To do this, we look at U.S. Treasuries and gold.

Safe Haven Assets

Treasuries and gold are considered safe haven assets. Investors allocate to these when they are not only worried about the stock market, but when they are concerned with the future of the economy as well. If we were in a period of regular stock market volatility, we wouldn’t expect these assets to make significant moves, but that is what we are seeing.

The 2-year, 5-year, 10-year, and 30-year Treasuries have all broken support levels, and are now forecast to continue lower. This is a major development because it is a drastic change from 2017 and 2018, when interest rates were expected to rise. 

Interest rates are no longer expected to rise because the economy is weakening to a point where the Federal Reserve is expected to either halt rate hikes, or lower rates in the future. 

In addition, this drop in rates is occurring after Treasury yields hit a long-term resistance line. The last time this occurred was after the Dotcom bubble and the housing bubble (you can read my hypothesis that we are in a liquidity bubble here). This is not good news for stocks.

Gold is also making significant moves. It has broken a long-term trend line during this market rout. Again, this doesn’t occur unless there is legitimate fear about the future of the markets and the global economy.

Conclusion

Right now, the stock market is expected to continue to fall. The current signal came when the S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite all fell below their February lows. Additionally, the S&P 500 also broke its long-term uptrend. 

The current rebound is classified as a technical pullback, which is a common occurrence after a breakout. The supports and rebounds we are seeing in the sector ETFs are the reason the averages are pulling back. 

However, there is always the possibility the breakouts were false signals, and the major averages can rebound. If the indices can move back above their failed supports, the breakouts would be considered false, and we would expect stocks to continue higher.

What to Watch

• Bullish if the major averages move past their February lows.
•  Bearish if the major averages fail to move past February lows, and start to fall again. This would mean the current rally is a dead cat bounce. 
• If this is a dead cat bounce, we can confirm it with the sector ETFs. Confirmation comes if the ETFs fall below their current support zones.

Submitted January 07, 2019 at 11:52AM by BR-Technicals http://bit.ly/2TwC4V5