Jeffrey Saut: The Big "W"

The Big "W"

by Jeffrey Saut, Chief Investment Strategist, Raymond James

The big W?!
November 2, 2015

“It’s a Mad, Mad, Mad, Mad World” is a 1963 comedy film that begins when the occupants of four vehicles stop on the side of the road to help another motorist that has careened off the highway in a spectacular crash. With his dying breaths, Grogan (Jimmy Durante in his last screen appearance) tells the bystanders about $350,000 that is hidden in the nearby city of Santa Rosita “under the big W.” With that, Grogan expires, and when the bystanders can’t agree on how to split the money, a slapstick road race begins to the city of Santa Rosita in search of “the big W.” In the movie’s case the big “W” turns out to be a configuration of giant palm trees shaped like a “W.”

This morning we revisit the “big W,” except in this case we are referring to the big “W”-shaped chart pattern left by the bottoming process often discussed in these missives. According to Investopedia:

“The double bottom looks like the letter ‘W.’ The twice touched low is considered a support level. Most technical analysts believe that the advance off of the first bottom should be 10 – 20%. The second bottom should form within 3 – 4% of the previous low, and volume on the ensuing advance should increase.”

So let’s look at a chart of the S&P 500 (SPX/2079.36). The left side of the “W” pattern was formed by the decline from August 18th into the “capitulation low” of August 24th. We identified that selling climax low and said so on CNBC the morning of the 24^th, commenting that a bottom tends to be a process and not an event. What typically happens is that you get a “low,” followed by a throwback rally, and then a downside retest of the “low.” Studying chart 1 on page 3 shows that is pretty much what has happened. The “throwback rally” took the SPX from ~1867 to ~2020, forming the middle part of the “W” before the subsequent decline provides the rest of the middle of the “W” in a successful retest of the “capitulation low” at ~1872 on September 29th. Obviously, the right side of the “W” has been completed by the ensuing rally that lifted the SPX from 1872 into last week’s intraday high of 2094. That nearly 12% rally left the SPX some two standard deviations above its 50-day moving average for the most overbought reading in a year (see chart 2). Dovetailing with that “be more cautious” overbought reading, our model has been suggesting a “trading top” is due. We think you got that last week.

While the envisioned “W”-shaped bottoming sequence has played pretty much according to Hoyle, it has not, at least by my method of interpreting Dow Theory, negated the Dow Theory “sell signal” of August 24/25th. However, as we wrote in last Wednesday’s Morning Tack, the folks at the astute TheDowTheory.com organization beg to differ. And at the risk of quoting myself, I am going to reproduce those comments because many of you only read Monday’s letter and not our daily Morning Tack. To wit:

“I have often written that one of the great advantages I have is a vast readership that tends to be interactive. Accordingly, I received this from Jack and Bart Schannep, of DowTheory.com, late yesterday (October 27):”

I enjoy reading you whenever I get a chance, but in your current piece I believe you are overlooking what has happened since the Dow Theory sell signal. From today's piece "We remain optimistic on a longer-term basis, but realize the reality of the Dow Theory ‘sell signal’ has NOT been reversed." The requirements for a (re) buy have been met effective 10/9 for the Original Dow Theory. You'll see the bounce was “from 3 weeks to as many months” and the pullback met the 3% threshold as outlined by Robert Rhea in his 1932 classic book The Dow Theory. Incidentally, the other prominent Dow Theorists (Dow Theory Letters - Russell, and Dow Theory Forecasts - Moroney) are in rare agreement on this signal. We hope you will find this helpful.

Now I can’t speak to Richard Russell, whom I started reading in the early 1970s but quit reading a number of years ago because he missed what looked to me like numerous valid signals (still to me he will always be the dean of Dow Theory). And regrettably, I have never read Mr. Moroney, but I have studied Robert Rhea, and the Schanneps correctly highlight this subtle point from his seminal book The Dow Theory. But as I recall, this point was not proffered by the creator of Dow Theory (Charles H. Dow 1851 – 1902) in his original Wall Street Journal editorials, or by Dow Theorists William Hamilton and George Schaefer. Of course, I could be wrong, but I do not have the time to go back and reread all of them. All I can say is by my interpretation of Dow Theory, the “sell signal” of August 24/25, 2015 has not been reversed, yet I really hope the Schanneps are correct because I continue to ignore that “sell signal” for often stated reasons.

What I am not ignoring, however, is my model that is telegraphing a trading top for this week. Unfortunately, the weight of the evidence is confirming my model with the large capitalization stocks in “blow-off” mode, while the small/mid-caps are not confirming the upside. Meanwhile, sentiment is too bullish and Lowry’s Buying Power stinks and their Selling Pressure Index is not collapsing. All in all, this is not the backdrop for a new leg to the upside unless the FOMC rescues stocks once again.

And, last week the Fed did indeed try and rescue stocks with its policy statement, resulting in a Dow Wow of 198 points last Wednesday. While many pundits dissected the statement word by word, the most interesting thing about the missive was what it did not contain. As if it were written in invisible ink, gone was the phrase, “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” To me, that omission smacks of an admission that the Fed should never have used it in the first place! Yet while the Fed’s rescue attempt worked on Wednesday, it did not work on Thursday and Friday, leaving the major indices flat on the week.

On the economic front, the negative reports outweighed the positive ones by nearly two to one and on the earnings scene the news wasn’t much better. While the bulls are quick to point out in the S&P 500 roughly 75% of reporting companies have beaten their respective lowered earnings estimates, using a larger sample the numbers are not as pleasing. Indeed, using the S&P 1500 shows that 63% of reporting companies have beaten estimates, but only 46.9% have beaten revenue estimates (chart 3 on page 4). Importantly, forward earnings guidance continues to come down. As expected, the sectors showing the best earnings and revenue “beats” are Telecom, Technology, and Healthcare. From Raymond James’ research universe two of the companies that beat both earnings and revenue estimates, guided forward earnings higher, are rated favorably by our fundamental analysts, and screen positive on our models are Regency Centers (REG/$67.96/Outperform) and Simon Property Group (SPG/$201.46/Outperform). Of interest is that BAML’s head of U.S. Equity and Quantitative Strategy, Savita Subramanian, notes that companies that have topped analysts’ earnings and sales forecasts have seen their shares outperform the market by 3.2% on a trading day following the release, nearly twice the historical average of 1.7%.

The call for this week: I am in New York City seeing accounts, doing some media “hits,” and speaking at an investment banking conference with Bloomberg’s Tom Keene. To be sure, one of the topics du jour is going to be the shocking drop in stock buybacks by corporate America. This subject has been trotted out by the bears recently as just another sign of an eminent stock market “crash” since it predicted the 2000 and 2008 debacles (http://www.cnbc.com/2015/10/29/this-index-signaled-the-2000-and-2007-crashes-and-its-falling-again.html). While we do not think the stock market is in danger of “crashing,” we do believe a pullback is in order. And for those of you that “pinged” me about the SPX popping above my 2080 “pivot point,” it did not stay there long enough to matter. This morning the preopening futures are flat as better European economic data is offsetting weaker data from China. Look for a rally attempt on the first trading day of the new month, but then stocks become vulnerable. For the SPX 2080 – 2090 should keep a lid on the upside and if the SPX breaks below 2040 – 2050 the pullback should be underway.