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Market Summary

Though the S&P 500 index enjoyed the best day in over a week on Friday, it still posted four consecutive weeks of declines which is the longest since August 2011. The index is still off 6.2% from its September 18th record high, however the broad index this week steered clear of correction territory, a 10-percent drop from its high. For the week, the Dow and S&P were down 1 percent while the Nasdaq was down 0.4 percent. Previous commentary mentioned "...October is the last month of the "Worst Six Months" for DJIA and S&P...the Dow Jones Industrial Average followed through on matching the Russell 2000 index in negative territory for the year...the other major indexes are moving rapidly towards being underwater for the year with the S&P 500 index next in line to go negative..." The S&P 500 index was bailed out from following other indexes into negative territory by last Friday's oversold bounce. As you can observe in the chart below, if the market does not follow thru on the end-of-week price recovery all the indexes except for the Nasdaq 100 will have blown their yearly gains.

Last week we opined "...In the year-to-date S&P 500 index chart below we highlight the price falling below the long term uptrend line for the first time all year. This is considered a serious breach and the price is right at its 200-day SMA which is the next support level. If the S&P confirms a break below the 200-day SMA look out below as we are heading into correction territory..." The S&P 500 index had a strong bounce this past Friday, over next few days we should find out whether this is simply a 'head fake' with prices continuing downward. The S&P 500 needs to get back above its 200-day SMA to follow thru on Friday's move.

We also said "...Similar to the S&P 500 index above, in the Dow Jones Industrial Average chart below the index is priced right at its 200-day SMA which also serves as the long-term uptrend line. If the Dow index makes a confirm break below its 200-day SMA it will sink further into negative territory for the year..." As predicted, the Dow index sank below its uptrend line and deeper into negative territory for the year. The price needs to get back above its 200-day SMA to signal a trend change.

We pointed out last week "...Investors fled to the safety of government debt, with the 30-year Treasury bond's yield nearing the 3.0 percent level for the first time since May 2013. The graphic below charts the performance of S&P 500 index compared to Treasury bonds. As we have been saying the past few weeks "... It appears that investors are pulling funds out of equities as the market falls and parking the money into treasury securities...treasuries are at 52-week highs as the S&P 500 is moving toward correction territory along with other equity indexes..." If stock prices follow thru on Friday's bounce expect treasuries to pull back from 52-week highs as investors use the funds to bid up equities.

Gold's inverse relationship to the dollar is displayed in the chart below. Gold sank to yearly lows as the dollar strengthened compared to other currencies. Expressing recent concerns about how a world-wide economic slowdown might adversely impact the domestic economy the dollar has pulled back from record highs and conversely gold prices have recovered.

Market Outlook

With 81 companies in the S&P 500 already reporting third-quarter results, 64.2 percent have beaten expectations, a rate slightly below the average over the past four quarters but better than the past 20 years. According to the Stock Trader's Almanac, this year is the seventh worst DJIA October and fifth worst S&P 500 October since 1950. In 64 years before 2014, DJIA and S&P 500 have both declined 26 times in October. However, these October declines were followed by 23 DJIA November-December gains averaging 4.0%. S&P 500 November-December gains have occurred 21 times with a slightly softer average advance of 3.4%. So despite all of October's horrors, the market has historically finished out the year with a rally far more frequently than not. At the start of the final quarter of the year, the graph below confirms equities are getting hammered. The best performing stocks are 'risk-off' categories that benefit from low inflation and are considered 'safe bets' compared to investments that depend on high economic growth.

A standard chart that we use to help confirm the overall market trend is the Momentum Factor ETF (MTUM) chart. Momentum Factor ETF is an investment that seeks to track the investment results of an index composed of U.S. large- and mid-capitalization stocks exhibiting relatively higher price momentum. This type of momentum fund is considered a reliable proxy for the general stock market trend. We prefer to use the Heikin-Ashi format to display the Momentum Factor ETF. Heikin-Ashi charts are similar to the Japanese candlesticks charts you are used to seeing. Heikin-Ashi candlestick charts are designed to filter out volatility in an effort to better capture the true trend.

Last week we reported "...As noted, bearish momentum is getting stronger. However what is really sounding an alarm is bearish distribution shown in the chart. Bearish distribution is defined as falling prices on higher than normal volume. Multiple bearish distribution days occurring within a few weeks of each other is considered a sign of large institutional traders dumping stocks. Until we get a bullish accumulation day (higher price on above average volume) and/or the downtrend line is broken expect prices to continue falling..." As circled in the updated chart below stocks are grossly oversold and this past Friday may be the start of an oversold bounce. The chart is flashing a technical bullish reversal signal; however at this point this is merely a 'countertrend bounce' until the reversal signal is confirmed.

Most market watchers normally look at the S&P 500 or the Dow Jones Industrial Average (DJIA) to gauge market health, a more reliable measure might be the Russell 3000 index as this encapsulates 98% of publicly traded companies! The Russell 2000 index gained 2.8 percent for the week finishing its best week since July 2012. Recent commentary has discussed how the small cap Russell 2000 index led the large cap indexes lower during the current market pullback. This phenomenon also works in reverse as when the small cap index turns higher the other indexes usually follow suit. In the chart below notice how every time prices caved this year, the Russell 2000 recovered first and the market followed.

As circled in the chart below, the CBOE Volatility Index (VIX), the market's favored gauge of Wall Street anxiety reached a height not seen in several years as investors continue to buy puts for protection against further declines. As we noted last week "...recent history suggest that volatility is high, prior to the current long-term bullish leg the VIX regularly reached between 30's and 50's. Therefore, don't be surprised if the volatility gets to much higher levels..."

We recently said "...if stocks continue to slide investors will continue pushing the index higher...This indicates that investors are getting a little nervous about the market and are buying more put option contracts to hedge their long stock positions..." The five-year CBOE Volatility Index (VIX) graph below displays the relationship between the S&P 500 and the Volatility Index. You can see how over the past few years as the VIX languished at record lows the S&P 500 climbed unabated to record highs. The recent S&P 500 price crash has launched the VIX higher than it has been is several years. Obviously if the current trend continues you will see S&P 500 drop below the VIX.

Surprisingly the American Association of Individual Investor Survey (AAII) survey percentages have gotten more bullish as stocks crashed. We noted how AAII survey results are considered a reliable contra-indicator of near term price direction. We said last week "...Individual investors are usually wrong about the market and the fact they have become even more bullish in the face of falling prices suggests there is more downside to be had. It appears individual investors may be holding on to long positions and preparing to ride out the near term bearish move and anticipating a year-end bounce..." This prognostication came to fruition last week and may continue a bit longer as individual investors can be expected to lose as they become more bullish while institutional money managers are bearish.

Second-quarter National Association of Active Investment Managers (NAAIM) exposure index averaged 81.64%, the third-quarter average dropped to 71.09%. Last week the NAAIM exposure index was 33.14%, and the current week's exposure is 9.97%, this is the lowest percentage in the history of the index. Nervous money managers continue pulling funds out of equities until the trend changes.

Trading Strategy

The Stock Trader's Almanac talked about putting the market's current trading action into perspective. Earlier this year bullish sentiment reached levels not seen in years or even decades depending upon data source. Market volatility had also fallen to levels not seen in years as the market was steadily making new all-times highs. S&P 500 actually went 63 trading days without a 1% percent daily move higher or lower. A feat last accomplished in 1995. And it has been more than three years without a 10% or greater S&P 500 correction. This is four times the average duration of time between corrections. Not to mention the market shrugged off tensions in Ukraine, Ebola in West Africa, the rise of ISIS in the Middle East, slowing global growth concerns and the Fed slowly easing up on stimulus. Honestly the market had gotten ahead of itself and was in need of a cool-off period. More likely than not, that is what it is doing.

A few weeks ago we discussed the term "Octoberphobia" which is used to describe the phenomenon of major market drops occurring during the month. Market calamities can become a self-fulfilling prophecy. Our previous analysis is valid "...Money managers have scrambled to reduce big bets in stocks and other risky...Consumer Staples and Utilities retained their value compared to other sectors over the past month...it is prudent to avoid energy stocks as this sector continues to be decimated with no letup in sight. Even short positions on energy stocks would be dangerous at this point as most of the downside move may have already been gotten...'holding cash' is a viable strategy. Considering current market volatility, maintaining a high cash position is an excellent move because you can take advantage of 'buying the dips' when prices stabilize..."



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