The Bear Case For US Stocks

JC Parets
September 4, 2018

From the desk of Tom Bruni @BruniCharting

For most of this year we've been writing about the overwhelming amount of bullish evidence for US Equities, however, as part of our "weight of the evidence" approach we're always questioning our thesis (i.e. here and here).

In today's post I want to share that exercise as I perform it, outlining some current concerns and what the market would potentially look like in an environment where stocks as in the US as an asset class are falling. We're going to stick with our top-down approach and start with International Equities and inter-market relationships, then drill down into specific examples that help illustrate what we're talking about.

In early July we spoke about the slight deterioration in Global Equity Market breadth, but pointed out that shifts from uptrends to sideways in many of these markets was not inherently bearish. What we didn't want, and still don't want, to see is a resolution of those sideways consolidations to the downside, rather than the upside. Since that post we've still not not seen a decisive shift one way or another in total uptrends or downtrends.

First off let's start with Equities as an asset class. Since the US Dollar Index bottomed in mid February, Emerging Markets as a group have lagged behind their Developed Market counterparts. While this relationship's begun to stabilize over the last few weeks, the chart continues to suggest it's range-bound at best, or continuing its downtrend at worst.

Click on chart to enlarge view.

Within the Emerging Market's space, countries like Brazil that have Commodity exposure are being hit the hardest. Others like India that have a larger emphasis on IT and Consumer Goods have outperformed on a relative basis and continue to do so. If there's any group that's going to lead us to the downside, it's going to be those Emerging Markets with exposure to Commodities, like Brazil.

On the other hand, developed markets like the German Dax have struggled to make upward progress and are testing important support levels like the one shown here. In a market where US Equities are heading lower, we'd likely see many of these consolidations resolving to the downside.

Sticking with Europe for a second here. The relative performance of European Financials versus the EuroStoxx 50 is a risk appetite barometer that we want to see trending higher, not range-bound like we're seeing here. A break of the recent lows is something we'd likely see in an environment where stocks in the US and globally are breaking down.

For those markets like Taiwan that have been showing relative strength, a break below key levels (in this case former resistance dating back to 1990) would be another bearish development that would get our attention.

In the bond market we typically like to see High Yield Bonds out-performing Investment Grade Bonds and Treasuries to signal risk appetite, yet throughout 2018 we've not seen these spreads participate to the upside as Equity markets trend higher. The continued stagnation or a resolution to the downside is not something we want to be seeing. Bulls want these ratios to resolve their recent ranges to the upside and momentum hitting overbought conditions. We've not seen it yet.

Getting into US Equities now, one relationship we may see deterioration in ahead of an extended correction is the "Offensive vs Defensive Sectors" ratio which has been leading to the upside in 2018. 

Other inter-market relationships that we use to measure risk appetite include the Dow Jones Industrial Average vs Utility Average, S&P High Beta vs Low Volatility, and Consumer Discretionary vs Consumer Staples ratios. All three of these saw some deterioration throughout 2018, breaking significant support levels several months ago, and now have all reversed sharply higher to reclaim support. Bulls want to see this short-term improvement continue into the intermediate-term, with all these ratios making new highs at some point. 

Getting into the Russell 3000 on the daily chart. We finally got an upside breakout from its year-to-date range with momentum getting into overbought conditions. This is not bearish behavior, but what would be bearish is a reversal to the downside and closing back below the January highs, confirming a failed breakout.

So what could drive that reversal? Well, many are pointing to the potential bearish divergence in breadth. The Russell 3000 has made new all-time highs, yet we've seen fewer stocks in the index making new highs.

We're also seeing fewer stocks with momentum in a bullish range (we define this as a 14-Day RSI > 70).

What's important to recognize here is that these measures do not account for the sector rotation we're seeing under the surface. While some leaders rest, we're seeing new leadership emerge that might not yet be at new highs given its under-performance versus the index. With that said, if prices do reverse and we've not yet seen these breadth indicators make new highs, these divergences would be confirmed and warrant our attention.

We're seeing similar action in the Nasdaq Composite and S&P 500. Yes there are potential divergences in breadth, but until it's confirmed by price breaking their former highs then the information remains informational, not actionable.


Another potential red flag is the Dow Jones Transportation Average which is back at the January highs, however, momentum barely made it back into overbought conditions. This potential divergence from a leading sector would be confirmed with prices closing back below support at 11,115.

We're seeing a similar divergence in the leading Aerospace & Defense sector which made new highs, but has stalled and momentum has failed to reach overbought conditions.

Last on our list is the lack of participation from the broad-based Financials ETF $XLF which remains range-bound. This is an important part of the market, representing roughly 14% of the S&P 500 and a lack of leadership from this group remains a concern. While a consolidation through time is not inherently bearish, a resolution to the downside and momentum remaining in a bearish range would be.

U.S. Broker-Dealers have been the out-performers in this group, so a move lower from its year-to-date range would likely have bearish implications for Financials overall.

I'm sure there are other relationships like the declining performance of the Semiconductor Index relative to the Nasdaq and S&P 500 that are important and considered during our process, but I wanted to keep this post as brief as possible. Hopefully it's provided some insight into our thought process and the specific developments we're looking for in the current market environment that would change our bullish thesis.

In a falling stock market we'll likely see some or all of the conditions discussed above occurring. With that said it's unlikely that they all turn at once, so we'll see the shift in the weight of the evidence one chart and one data point at a time as we monitor and reevaluate our thesis each day.

Thanks for reading and let us know your thoughts!

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Allstarcharts Team

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