A Surprising Signal Hiding In The Charts

While looking at my various assortment of data and charts over the weekend, I noticed something interesting. So, I decided to dig a little deeper into the details (one of my favorite things to do). What I found was even more interesting — and a hint at what the market may have in store for us next.

Let’s start back at the beginning, and I’ll walk you through my thought process.

Below is a monthly chart of the S&P 500 index. I’ve added the stochastics indicator to the bottom panel of the chart.

Stochastics is a popular momentum indicator that is, like many indicators, frequently misunderstood. Because of the way it is calculated, stochastics will always have values between 0 and 100. Traders often believe readings above 80 indicate the market is overbought, which means prices have climbed too fast and a reversal is likely.

Applying The Stochastics…

The chart above shows an interesting property of the stochastics indicator. On weekly and monthly charts, the indicator moves above 80 and stays there. At first glance, I thought this chart was simply confirming that the S&P 500 is in a normal uptrend.

But, as I was clicking to the next chart, I noticed the value of the stochastics indicator was above 98 — an incredibly high reading. This seemed unusual. I added vertical lines for similarly high readings and saw there were just three other occurrences in the past 20 years.

I added the rate of change (ROC) indicator to see which of the previous examples is most like the current reading. That chart is below, and the blue arrow highlights the most relevant example.

If history repeats, we will see a pullback soon. As the chart’s lower panel (blue bars) shows, the ROC is slowing. This is an indicator that investor enthusiasm for stocks is decreasing. That observation is confirmed by the latest data in the American Association of Individual Investors (AAII) weekly survey.

In an average week, 38% of investors are bullish, 30.5% are bearish, and 31.5% are neutral. Last week, there was a significant increase in the percentage of bears.

Source: AAII.com

This shows that investors are nervous. The survey used data through January 8, the day traders were reacting to the news about Iraq’s missile attack on a U.S. base. The next chart shows how nervous investors were that day. This is an intraday chart of S&P 500 futures, which trade almost around the clock.

The rectangle shows after hours trading during the time when Iran was launching missiles and analysts were assessing the damage from the attack and guessing what the likely response would be. Prices fell almost 2% and then quickly recovered.

As tension eased, prices rose. But the week still wasn’t over. On Friday, as traders turned their attention to economic news, the S&P 500 and other major market averages sold off again.

The monthly employment report showed the U.S. economy added 145,000 jobs in December. Economists polled by Dow Jones expected 160,000 news jobs for the month.

Slower Job Growth Leads To Slowdown In Wage Gains

Wages also disappointed, growing by just 2.9% on a year-over-year basis. Economists had forecast a gain of 3.1%. December was also the first month since July 2018 that wages grew by less than 3% from the year before.

Overall, the report seems to be lackluster, and, for now, there is no pressure on the Federal Reserve to act. This means the current market price mostly reflects the economic outlook. With little prospects of a catalyst for big gains, traders will most likely focus on downside risks. That increases the possibility of a big selloff.

For now, I expect major indexes to trade in a narrow range while investors and analysts assess earnings. Risks are growing. This is not the time to be aggressive, but it is also not time for panic. It is simply time to follow our indicators and stick with our disciplined approach to stock selection.