Is This A New Rally... Or Something Worse?

Amber Hestla's picture

Wednesday, February 20, 2019 - 12:00am

by Amber Hestla

For the fourth time since this market selloff began in October, the S&P 500 has successfully broken above its 200-day moving average (MA). 

If you've been following along with my recent commentary, then you know I've weighed in on this simple indicator several times in the past few weeks, due to its psychological significance.

The first three crosses (all during the last few months of 2018) are marked by arrows in the chart below. Each breakthrough was short lived, and selling pressure quickly pushed prices back below the MA.

Which brings me to this week's question: Will Friday's breakthrough be any different? 


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SPX 200 DMA

​To answer that question, we need to consider how the rally compares to the overall decline.

The decline, which lasted 65 trading days, was sharp. The S&P 500 fell 20.2% from its intraday high on September 21 to its intraday low on the day after Christmas. 

Through Friday, this most recent recovery has lasted 35 trading days and retraced 68.8% of the decline. 

Yes, I Want A Rally. But We Have To Go On Evidence 
Here's why that matters... Stocks never move in a straight line, and retracements (significant, countertrend price moves) within major trends are actually something we should expect. 

In the late 1800s, Charles Dow (who founded the Wall Street Journal) wrote that a typical countertrend move retraces one-third to two-thirds of the previous price move. The current rally is near the upper limit of that range. Dow also explained that retracements tend to last one-third to two-thirds as long as the original move. At 35 days, the current rally has lasted 54% as long as the original decline.

In other words, this recent rally may not actually be the start of a strong new uptrend... it could just be a normal upward retracement in a longer-term downtrend. At least, based on what we know so far. 

Now, I want to be bullish. I truly do. But despite the market's gains over the past few weeks, the fact is that the weight of the evidence points to continued market weakness. Among that evidence is the fact that earnings could decline this year. 

Analysts have already been cutting estimates for this year. The chart below shows that it's normal for analysts to cut estimates. Estimates for each year are shown as "squiggles," which is the term Dr. Ed Yardeni uses to track this data. Yardeni has worked as the Chief Economist of EF Hutton, Prudential Securities, and CJ Lawrence. He was also the Chief Investment Strategist of Deutsche Bank Securities, and his work is well respected. 

SPX earnings est. vs. actual

My concern is the possibility of an "earnings recession," which would be a year-over-year decline in earnings. This concern is shared by some economists. 

For now, analysts with Standard & Poor's are expecting earnings growth of about 7.8% in 2019. On average, earnings estimates are reduced by about 3% a quarter. If we see average reductions through the rest of the year, earnings would be lower in 2019 than they were in 2018.

The chart above shows four previous earnings recessions:

- In 1998, the S&P 500 dropped more than 20% in six weeks.
- 2000 marked the beginning of a 33-month, 50% decline in the index.
​- In 2007, an earnings recession marked the beginning of the most recent bear market.
- The most recent earnings recession coincided with an 18% decline and a trading range that lasted 77 weeks and ended in November 2016.

Stocks struggle during earnings recessions, and I believe problems with trade and increasing policy uncertainty point towards another earnings recession. 

Acton To Take
Here's the takeaway: I expect this to be a down week. The strength of that down move will tell us a great deal about what to expect next. 

The data I cited above is bearish for stocks, but, like I said earlier, prices never move in a straight line. That means we could continue to see strong, short-term rallies. But first, we should be on the lookout for a pullback. 

Regardless, my Profit Amplifier readers and I will be in position to make money whichever direction the market moves. We've made a number of winning trades (both bullish and bearish) in the past couple months, including gains of 10.4%, 58.9%, and 60% -- all in a matter of days or weeks. My readers will be prepared -- and you should be, too.

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Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.