Time to Sound the All-Clear?

Ever since the NYSE McClellan Summation Index (NYSI, bottom panel) broke support on the weekly chart, I warned that the stock market was at risk of a pullback. Indeed, stock prices did briefly weaken, but they have rallied and begun to consolidate sideways. In addition, NYSI has begun to turn up. Is the pullback over?

The answer to this question can be found in the 14-week RSI (top panel), which ended the week just shy of the 70 overbought level. In the last five years, the market has continued to rally whenever the RSI returned to an overbought, which I call a “good overbought”, condition. The episodes when stock prices continued to weaken were accompanied by falling RSI readings.

I am seeing signs of constructive healing in market internals and I am on the verge of a buy signal, but it may be too early to sound the all-clear just yet.
 

 

Signs of Healing

Breadth indicators, which had been weak and showing signs of concern, are starting to heal. The S&P 500 and NYSE Advance-Decline Lines had been moving sideways for several months while the S&P 500 slowly advanced. The S&P 500 A-D Line made a fresh all-time high last week and the NYSE A-D Line is not far behind.
 

 

I had been concerned about the lagging nature of the small- and mid-cap A-D Lines. Both have begun to improve, with the greatest recovery shown by the mid-cap S&P 400 A-D Line.
 

 

Risk appetite indicators may be bottoming. Credit market risk appetite, as measured by the relative price performance of junk bonds to equivalent-duration Treasuries, exhibited a minor negative divergence to the S&P 500, but the divergence is starting consolidate sideways. A similar pattern of consolidation and possible bottom can be seen in the relative performance of consumer discretionary to consumer staples.
 

 

I interpret these as constructive signs of a possible tactical bottom.
 

 

Key Risks

It may be too early to sound the all-clear signal. The relative performance of the Magnificent Seven and the equal-weighted S&P 500 have been flat for the past month. The improvement in breadth can therefore be explained by the sideways relative performance of the equal-weighted index. The glass half-full explanation is a constructive consolidation in market breadth. The glass half-empty explanation is a market struggling for leadership, and the jury is out on whether the bulls or bears have control of the tape.
 

 

I highlighted this chart of the 10 dma of the equity-only put/call ratio as a signal of a pullback. Whenever this indicator reached a bullish extreme, which is contrarian bearish, a reversal had been signals of market weakness. In the past, the correction didn’t end until the ratio reached an upside minimum reading of 0.61. In other words, sentiment hasn’t grown fearful enough, and investors may not have passed the danger zone yet.
 

 

In addition, the relative performance of defensive sectors is bottoming, indicating that the bears are trying to take control of the tape. This is an unusual condition consider that the S&P 500 is at or near an all-time high.
 

 

 

Waiting for Resolution

While technical conditions are highly constructive and aggressive traders could choose turn bullish now, I would prefer to see the resolution of key event risks before fully turning bullish. The coming week will see a FOMC meeting, an APEC Summit during which trade disputes may either flare or be resolved, and the uncertainty of an ongoing government shutdown that could weigh on consumer sentiment and the economy.

The risk is market expectations may too bullish. The softer-than-expected September CPI guarantees a quarter-point rate cut at the October FOMC meeting. But the weakness in inflation is largely attributable to a deceleration in shelter inflation, which is a lagging indicator. Other core CPI indicators, including services ex-housing that isn’t sensitive to tariffs, are accelerating.
 

 

The White House announced that Trump would be meeting Xi on the sidelines of the APEC Summit in South Korea on October 30. Trump has signaled that he is willing to trade a pause on the 100% additional duties on Chinese imports in return for Chinese imports of U.S. soybeans, greater enforcement on fentanyl and fewer restrictions on rare earth exports. Chinese officials reported a constructive tone ahead of the Trump-Xi meeting.

However, an article from the Economist cautioned that the Sino-American trade relationship is dysfunctional. It attributed the “toxic cycle of trade talks” to the “lack seasoned interlocutors” and the “poverty of communication lines”. The Trump 1.0 era was characterized by back-channel negotiation, consisting mainly of Trump’s son-in-law Jared Kushner and Cui Tiankai, China’s ambassador to the U.S. Such back channels are non-existent today, which leads to greater difficulty in negotiations. At best, the market can expect an interim accord that dials down trade tensions rather than a comprehensive agreement.

An analysis of my trade war factor shows an extreme level of tariff anxiety, but stock prices are high, the 10-year Treasury yield is low, and tame levels of stock and bond implied volatility. While there is some political pressure from the farm lobby for soybean sales, Trump may not feel much pressure from the financial markets to play the TACO (Trump Always Chickens Out) card.
 

 

As well, the U.S. government shutdown is continuing with no visible signs of resolution. While the economy has experienced only minor damage during past shutdowns, the prolonged nature of the current episode raises the risk of a loss of consumer confidence and growing pressures on households and small business as government payrolls stall.
 

Lastly, a substantial portion of the Magnificent Seven report earnings in the coming week. Anything can happen.