A Counter View on “The Great Rotation”


February 20, 2013 (11:00 pm)

Sorry for the lack of posts over the past 10 days or so. We’ve been watching the markets closely, and have tweeted a few trades that we’ve entered. There just hasn’t really been anything that we’ve been compelled to post. The market was grinding slowly higher, and there weren’t many set-ups that were very compelling. But we’re back, and expect that the cracks we saw today are only the beginning.

The “Great Rotation” has been widely discussed by the financial media recently. In essence, it calls for a rotation out of the bond market and into equities. This rotation would be driven by two factors: (1) the artificially low yield in the bond market created by the Fed’s enormous asset purchases, and (2) the re-entry of the retail crowd to the equity market. Those that believe in this Great Rotation expect equities to continue to appreciate as demand increases for these securities. Likewise, they expect bonds to depreciate as investors sell bonds to purchase stocks. They are the new perma-bulls. If this rotation is actually happening, how could you not be fully invested in stocks?

There are a variety of charts we’ve been reviewing that lead us to believe that this melt-up rally (whether driven by an actual rotation out of bonds or not) will soon end. And that end will precede a much more significant market correction. Let’s start with our short-term views, and slowly work our way to the bigger picture.

SPY Rising Channel. Since the middle of November, the SPY has been in a very well-defined up-trend. Today’s break down marks the first significant crack since the fiscal cliff ordeal. We’ve illustrated levels of support to keep an eye on.

SPY Support

SPY Trend Lines. We’ve outlined three trend lines formed throughout this three-month rally. Importantly, note how the SPY is becoming oversold on the RSI as its reaching the middle trend line. The Chi-Osc is extremely oversold. It wouldn’t be surprising to see some additional downside tomorrow morning followed by a rally out of oversold conditions. This could be a re-test of the recent highs. Before a more significant correction, we would first expect to see a failed re-test of the highs.

NT Oversold

QQQ Consolidation. Similarly, the QQQ is nearing oversold RSI conditions on the 60 minute chart (and is also extremely oversold on Chi-Osc). An interesting trend is that each consolidation period is shorter in duration and tighter in price than the last (i.e. the green consolidation area is only a matter of days and a much smaller price range than the blue consolidation area, which lasted many weeks). Significantly, the current consolidation area broke down this afternoon and now is squarely within the previous one. However, we’d expect at least a brief rally out of oversold conditions in the coming days.

QQQ NT Oversold

SPY Rising Wedge. As we’ve detailed previously, the SPY has formed a very long-term rising wedge. The shares are currently butting up against the top trend line. Additionally, the price has formed negative divergence on RSI (meaning the buying momentum is not confirming the upward price move) and is taking place on falling volume. We expect this top trend line to represent very significant resistance, which supports our view of a coming correction.

SPY Rising Wedge

NYSE McCellan Oscillator. The NYMO has formed negative divergence, falling while the SPY is rising. This is a very significant development. This signal has accurately called a number of serious corrections in the past, and is also widely used to indicate market bottoms.

NYMO Divergence

SPY Potential Downside Targets. If the market does correct over the coming weeks and months, the chart below illustrates our view on where a correction could likely go. We’ve looked at two alternatives. The first examines a 100% measured move of the previous correction (green bar). The second uses a 61.8% Fibonacci retracement of the entire rally. Interestingly, both alternatives get us to the $140ish area, which represents very significant longer-term support (see the first chart above). It would make sense for this to be fully completed by the early May time frame.

SPY Targets

QQQ Head and Shoulders. So we broke out of the $67.75 resistance level only to fall back below it. This potential pattern is still squarely in play.

QQQ H&S

Near- and Intermediate-Term Recap. So lets quickly sum up our views. Since the downward momentum this afternoon was so strong, we expect a to see a lower low ahead, bringing us into oversold conditions. The market should bounce out of these conditions, which would represent a re-test of the highs. If this re-test fails to achieve a higher high, an intermediate-term correction will likely follow. This could see a completion of the QQQ head and shoulders pattern and it could bring the SPY to the lower trend line on the chart below.

Longer-Term Bear. This chart illustrates a very long-term 3 push up pattern that the SPY may be forming. The second peak established a linear trend line that the shares simply couldn’t reach during the third push up. The upward momentum is clearly slowing. This is magnified by the RSI. While the shares have made three subsequent peaks (none of which could even get near the trend line), the RSI hasn’t climbed above the level that it hit during the first peak. What may be more significant is that the RSI reached the same level on the downside during the second trough even though the price reached a significantly higher level. Both of these negative divergences indicate that buying momentum is decreasing and selling momentum is increasing as the SPY continues to rise.

SPY 3 Push

Conclusion. The Fed minutes that were released today indicated that a number of members are looking to reduce the Fed’s asset purchase program before the end of 2013. This could be the straw that breaks the camels back. As market participants look ahead to a world with less central bank intervention, cash will likely become king. We aren’t trying to suggest that this will happen tomorrow or next week. But it’s important to look sufficiently far into the future to think about portfolio allocations. As we continue to reach new highs on the S&P500, Dow and NASDAQ, it’s a great time to book profits and take some risk off the table. A slight decrease in long positions, additional cash and some longer-term puts are a good idea for conservative investors. Intermediate-term shorts may prove very profitable for those more aggressive traders.