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Bull Retest Or Bear Failure?

Submitted by Lance Roberts via STA Wealth Management,

Several weeks ago I suggested that we had seen the "Mark of the Bear" stating:

"The Bulls have remained firmly in charge of the markets as the reach for returns exceeded the grasp of the underlying risk. It now seems that has changed. For the first time since 2007, as we see initial markings of a potential bear market cycle."

I followed up that analysis by suggesting the markets would likely experience a "sucker's rally" which is extremely normal following declines in the market. These short-term reflexive rallies generally suck inexperienced investors into the market to "buy the dip," while more experienced investors use the rally to protect capital against further declines. As I stated then:

"One thing is for certain, if the market does muster a rally strong enough in the week's ahead to retest the previous bullish trend moving average, it could very well be a 'sucker's rally.' Any failure will likely mark the beginning of a new bear market cycle. And, just as before, there will be no warnings, no announcements by the media, or acknowledgment by Wall Street analysts. However, the consequences will likely be just as severe."

I began addressing at the end of August that the market collapse had gotten extremely oversold. As such, that set up the probability for a reflex rally back to previous support levels. 

The chart below is the orginal from the August 25th report mentioned above. It shows the oversold condition. The blue dashed line shows the potential short-term reflexive rally that would likely occur.

Here is that same chart updated through yesterday's close.

As you will notice, the reflexive rally, and subsequent failure, have tracked the original predictions very closely up to the point. 

With the market once again very oversold on a short-term basis, it is likely that the markets could manage a weak rally attempt over the next few days. The good news is that such an attempt will provide individuals another opportunity to reduce portfolio risk accordingly.

The Test Of The Bull

 The bad news is that the rally will likely fail due to the same factors I discussed last Tuesday: 

"The failure at overhead resistance, combined with a continued weak technical backdrop of momentum and relative strength, suggests that a retest of lows in the weeks ahead is a likely probability.

 

As shown in the chart below, the deviation from the long-term bullish trend line was greater than at the previous two bull market peaks. In both previous cases, a break of the market below the shorter-term moving average (red dashed line) subsequently led to a least a test of the longer-term bullish trend line. However, a "test" would assume that the current cyclical bull market is still intact."

"If the market fails to hold support at the long-term bullish trend, currently at 1860ish, such a failure will dictate a fully completed transition into a more destructive cyclical bear market."

Is QE 4 Coming?

While the mainstream analysis remains quite bullish on the underpinnings of the market, the ongoing deterioration of market internals and fundamentals suggests something more pervasive. The chart below shows the previous post-financial crisis corrections following the end of Central Bank interventions.

As you will note, each correction was contained within a Fibonacci correction band of either 38.2% or 61.8%. It was at these correction points that the Federal Reserve responded with some form of monetary intervention or support. 

With the markets currently at an initial 38.2% correction from the low that marked the beginning of QE 3, the question is whether the Federal Reserve will once again intervene with another monetary liquidity program? This was a point recently made by Bridgewater's Ray Dalio (excerpt via ZeroHedge.)

"That's where we find ourselves now—i.e., interest rates around the world are at or near 0%, spreads are relatively narrow (because asset prices have been pushed up) and debt levels are high. As a result, the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias. Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant.

 

While, in our opinion, the Fed has over-emphasized the importance of the "cyclical" (i.e., the short-term debt/business cycle) and underweighted the importance of the "secular" (i.e., the long-term debt/supercycle), they will react to what happens. Our risk is that they could be so committed to their highly advertised tightening path that it will be difficult for them to change to a significantly easier path if that should be required.

 

We believe the next big Fed move will be to ease (Via QE) rather than to tighten."

As I have addressed so many times in the past, the Fed is now becoming well aware of the dangers of being caught in a "liquidity trap." As Dalio correctly points out, the end of the debt cycle has significant long-term implications to both the global economy that is overly indebted in dollars and holding large leveraged long positions.

The long-term implications of a liquidity trap, and the end of a debt cycle, are significant. While many believe that the "financial crisis" was a "one-off" event that is now long past us, the reality may be it was just the beginning. While Central Banks globally have intervened to rescue the financial system by injecting trillions into it, they failed to use that support to restructure the debt problem that lay beneath. Now, more than six years later, the global economy is once again potentially on the brink of a recession and there have been few improvements in the structural underpinnings. 

The question is what will they do next time?

For investors, the markets have been sending a fairly clear warning signal. Market topping processes take time to develop fully and, unfortunately, are only fully recognized in hindsight. The problem in waiting for "recognition" is that the destruction of capital is already far larger than previously expected. This leads to a series of "psychological" responses that exacerbate the problem such as "hoping to get back to even." 

The last point is critically important. In the world of investing, "hope" has never been an investment strategy that one could profit by. It likely won't be successful this time either.