Trade War…Again?

We’re well into the last half of 2019 at this juncture and this past week was interesting.  On one hand, Jerome Powell, Chairman of the Federal Reserve dropped interest rates by a quarter-point (as expected), but market participants didn’t like his tone and wanted to hear more certainty as it pertains to future cuts, as well.  However, it wasn’t a huge deal in the grand scheme of things, but then news broke that the U.S. will be imposing a 10% tariff on China come September 1st.  Is anyone else tired of “Trade War” talk, or is it just me?  So, today I’m going to show you a simple, step-by-step look at the health of the stock market today…

 

There are four important things that one should follow when determining whether is healthy and the sun is shining – or if there are severe storms and tornado warnings.  Now, stay with me here and trust that I’ll make this simple, but here are the four components:

 

  1. Price
  2. Volume
  3. Momentum
  4. Breadth

 

Again, to keep my promise in making this so simple that my 9-year-old could understand it, I’m going to explain each component 1-by-1, and then provide a picture of today’s market that illustrates where we are.

 

First, let’s talk about price, the simplest, yet most important component of a healthy market.  When I say “price,” what I’m talking about is the value of the market on any given day.  Rather than dive into all the details of different “markets” we can analyze, again, let’s keep this simple.  Some people like to use the Dow, but it only consists of 30 stocks.

 

Some like the NASDAQ because it represents such a vast amount of stocks, but it also has a heavy weighting of technology.  So I’m going to use the S&P500 because, while it does have a bias to the big companies within, I believe it’s a good compromise between the two and a great measurement of what “the market” is doing.

 

Alright, so when we talk about price, we want to look at where it is today, as compared to where it’s been in the past.

 

Some people use super-long timeframes and others (like day traders and swing traders) like to look back a few days and weeks.  I prefer a 6-12 month timeframe because it’s not too long for me (in which case, I’d experience too much loss when the market crashes), and it’s not too short, either (too short = too much buying, selling, whipsaws, and getting chopped up with the short-term noise).

 

When we analyze price, we want to see higher-highs and higher lows, we want to see rising, expanding trendlines, and of course, we want to see new highs.

 

Now, let’s put this into action.  Look at the chart below and answer these questions:

 

  • Is the price of the market experiencing higher highs?
  • Is the price of the market showing us new highs?
  • What about lows – can we find a recent higher low?
  • Now look at the trendlines in red and blue – are they sloping up?
  • Are the trendlines expanding (blue, faster line creating distance away from the slower red line)?

<Nerd’s Note:  To avoid confusion with the average reader, I’m using “trendline” interchangeably with “moving averages.”  If I remember correctly, it was Perry Kaufman who dubbed moving averages “trend lines,” but I personally don’t believe it’s a proper use of the phrase.  Trendlines are typically referred to as manually drawn, diagonal lines on a chart, connecting peaks to peaks or troughs to troughs.>

 

You did it!  You analyzed price on a chart, along with trendlines (moving averages) and using price alone, you can probably tell me whether the market looks healthy “on the outside,” right?  So let’s move on to the next component of market health…

 

Volume is simply the amount or number of shares being bought and sold at any given time.  We can analyze volume on any timeframe as well (minute-by-minute, hourly, daily, weekly, or monthly), but we’re going to focus on daily volume today, again, to keep things super simple.

 

What we want to see in a healthy stock market is:

 

  1. Low volume (weak selling pressure) on days when the market is down, and
  2. High volume (strong buying pressure) on days when the market is up.

 

Ideally, we want to see a trend that reflects these two things where, whenever the market has a bad couple of days, the volume dries up.  But whenever the market has good, strong days, we want to see lots of trading (buying in this case), which suggests the big money is gobbling up shares.  If we see the opposite (big volume on down days and weak volume on up days), that’s not good!

 

All that being said, volume can get tricky because if you try to eyeball volume on a daily basis, it’s pretty difficult to determine what the trend in volume happens to be at any given time.  So what I like to use is a little tool called On-Balance Volume (or OBV for short).

 

OBV is an analyst tool for nerds like me that makes life a whole lot easier.  It measures the buying and selling pressure I just mentioned and puts it into a simple line chart.  Every day, OBV adds the total volume on up-days and subtracts the volume on down-days. This information is then plotted on a chart, and what we want to see is an uptrend (which would indicate higher volume on up-days than down-days).

 

Alright, it’s your turn again!  I’ve added the same chart as I did earlier, and now I’ve added volume (in the middle pane, and as you can see, it’s kinda’ hard to see the good or bad), but I also added OBV in the bottom pane, which is very easy to read.

 

What can you observe on the chart now?  Are you seeing higher-highs (an uptrend) or lower-lows (a downtrend) in volume?

You’re officially past Step-2 and it’s time to move on to the next component…

 

I’m not gonna’ lie… Momentum is where things start to get a little confusing, but please don’t click away just yet.  Give me a chance to help make this comprehendible.

 

First, I want you to know that there are many ways to analyze momentum, and many of the different tools out there do similar things, but in different ways.  I prefer a momentum indicator called RSI (or Relative Strength Index) for three reasons:

 

  1. It’s bounded, which means that it can only move between zero and 100, and
  2. It has some simple rules one can follow to determine whether or not things are healthy, and
  3. It can also provide “warning signs” when things are good, but might get worse… as well as “heads-up signs” when things are bad, but might get better.

 

Now, allow me briefly explain RSI before we look at a chart of today’s market.

 

Again, RSI can move up and down from 0 – 100.  However, the first “rule” is that, whenever it moves below 30, that’s considered bad evidence and a weakening market.  On the other hand, the second rule is, when it moves above 70, this is considered to be a sign of a healthy market.  We’ll skip the “warning” and “heads-up” signs because I promised to keep this simple, so let’s take a look at the market again today…

 

You’re turn!  When you look at RSI in the bottom pane, below, what do you see?  Is it crossing above 70 on a pretty regular basis, over time?  Is it crossing below 30?  What do you notice when you compare the market this past 5-6 months as compared to the latter part of 2018?

While I obviously can’t interact with you in an article, I have this feeling of intense optimism that you’re “getting” this!

 

Alright, time to close this article out with the final piece of the puzzle when trying to determine if the market is healthy or not…

 

The last component is Breadth.  No, I didn’t say “breath!”

 

The breadth of the market is simply how much “participation” we’re getting from the individual pieces that make up the market.  Most people don’t know that the “the market,” whether we’re talking about the Dow, NASDAQ, or S&P500 – they’re all what’s called “cap-weighted” baskets of stocks.  What this means is, the bigger companies in each of these baskets of stocks move the index more than the smaller companies do, which can create some serious deception.  Think of it as if the market is “lying” to you.

 

Sounds strange, I know… but here’s what I mean.  The smallest, riskier stocks, are the ones that tend to crash first when the market starts to keel over and die.  Then, once the small companies begin to crash, the mid-sized companies tend to follow suit.

 

The problem is, if you’re looking at the Dow, NASDAQ, or S&P500… because the big companies in those baskets carry so much weight, you wouldn’t notice that these smaller companies are already throwing up big, red flags, warning you of a potential severe storm with possible tornadoes.

 

Using another analogy, when a doctor examines a patient, they might look healthy on the outside (i.e. – large companies making the S&P500 look good), but after doing some tests, we find that inside the patient’s body (i.e. – the smaller companies that we cannot see), there is a disease growing that needs to be respected and treated accordingly.

 

That being said, the biggest stocks in the market are considered “blue chips” because people believe them to be safer.  They typically pay dividends, everyone has heard of them, etc.  However, even stock in a bellwether like Disney vaporized almost sixty percent of investors’ hard-earned money when the market crashed between 2007-09.  These big companies tend to crash last, once everything else that was hiding under the surface has already plummeted.

 

So how do we tell if the market is lying to us?  Well, instead of staring at a chart of the market, we dive deeper into the breadth of the market, which tells how many stocks in the market are going up vs. down.

 

Here’s a political analogy that makes this concept even easier to understand.  When you think of the S&P500, NASDAQ or Dow, think of these indices like Congress, where each state in the union gets more or less congressmen/women, all depending on how big the state is.  The larger the state, the more representation… just like looking at the market on its surface.  However, looking at market breadth is like looking at the Senate, where each state only gets two…and that’s it!

 

So, when you think about market breadth, think about everything being split up equally, and what we want to see when we analyze the breadth of the market is simple:

 

  • More stocks going up and less going down.

That’s it… and market breadth indicators plot these things on a chart for us so as to make it easy to see whether our patient (the market) is healthy on the inside, or not!

 

Okay, so here we are.  This is the last exercise for you today.  The New York Stock Exchange (NYSE) composite index is in the top pane below.  This is a huge basket of all the individual stocks, bonds, and preferred stocks that trade on the NYSE.  In the bottom pane is the Breadth tool we’re going to pay attention to.  Regardless of whether the basket as a whole average is going up or down, we want to see the number of investments (in the lower pane) rising, which means more are going up vs. going down.  What do you notice?

Alright, I’m going to throw in one more BONUS chart that helps further illustrate this last lesson on Breadth.  The reason I’m adding it is because normally, the chart above works really well, but there’s something specifically unique about the current market that’s making it less reliable than normal.

Because the NYSE includes some bonds, preferred stocks, and other interest-rate sensitive investments, the recent drop in rates is making it look a little out of whack.  In other words, while there will be a time in the not-too-distant future when this changes, it’s hard to “trust” this tool because of the rate environment we’re living in today.

 

Remember how I mentioned that the S&P500’s big companies carry all the weight of the basket?  Well, we can take all the small companies out of the index by looking at the Russell 2000, which is all small companies and then compare the two.

 

What we want to see is what we call “broad participation,” which simply means, when the market is going up, we want to see big, medium, and small-sized companies going up, which gives us evidence that we’re living in a healthy market.  So, here’s the Bonus Chart, below.  The S&P500 is in the top pane and the basket of small companies in the lower pane.  What do you see?  Are small companies also participating in the uptrend?

Alright – do you feel like a pro, now?!  Probably not… but hopefully you learned something (or more than one thing, I hope) today.

 

When I look at all these pieces of evidence above, here’s what I see:

 

  1. Price = rising with trends pointed northward and expanding.
  2. Volume = more on up-days than on down-days, supporting rising price trends.
  3. Momentum = moving in a positive range, above 30 and 70.
  4. Breadth = Small caps not participating, which is not evidence of broad participation in the current long-term uptrend.

 

Price and Volume are the most important pieces of the components mentioned above, so just because we have a problem with small companies doesn’t mean the market is going to crash.  We should never, ever profess to know (or guess) what the market is going to do.  Our opinion is irrelevant – the market doesn’t care what we think!

 

However, these small companies either need to catch up with the rest of the market (which would not only be a positive sign, but would create opportunities to create gains in our retirement portfolios in this area of the market, which has been lagging), or we’ll start to see the other three components break down, which would suggest there is bigger trouble brewing.

 

But for now, the market looks pretty healthy to me, and we’ll continue to position our clients’ money in a way that aligns with this evidence!

 

Till next time…

Adam

Categories: Adam Koos, CFP®, CMT®, Market Commentary

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