By Clint Sorenson, Chief Investment Officer for Sound Financial

The market, as measured by the S&P 500 is now down YTD (SPY is down -1.10%) after being up more than 7.2% just a few weeks ago. The drawdown is nothing to panic about on the surface. Drawdowns over 10% are regular occurrences in the market. What is shocking, however, is how quickly this correction has occurred. In an overvalued market environment, risk can happen and it can happen fast. This is exactly what we are witnessing so far.

In our note from yesterday (intended to address Friday’s market activity), we discussed that tops are typically processes that occur over multiple trading sessions. We displayed several market indices and measures of market internals, illustrating that the positive trends remained intact. Then yesterday happened. The Dow fell over 1600 points at the low of the day and finished the day down over 4%. In fact, during a ten-minute span the Dow fell over 1000 points. To the average bystander, this appeared to be complete insanity.

Market commentators were claiming that “something broke” on CNBC, looking for someone or something to blame. Quickly you saw reports of flash crashes and out of control “computerized traders” and “quant funds”. In my opinion, none of this was to blame. I think that the market broke a key technical level by breaching the 50-day moving average and this triggered the execution of a lot of stop-loss orders. The 50-day moving average is a commonly used, short-term trend indicator, the breach of which suggests further downside.

Now the question is whether this will alter the intermediate and longer-term trends in the market. Yesterday was the first day during the sell-off where we saw a preference for safe-haven assets like Treasuries (The yield on the 10-year bond fell over 10bps). This means that investors were scrambling for liquidity and protection, something that often suggests that we are in the early innings of a much larger decline. The trends and market internals, however, are still positive over the intermediate and longer-term time frames.

I have included several charts for your review. As you will notice most of the market indices and measures of market internals are still firmly above their 200 day moving averages despite most falling below the shorter-term 50 day moving average yesterday. This implies that the long-term trend of the market is still positive despite the scary sell-off of the past few days. Furthermore, a common measure of overbought/oversold conditions, the NYSE McClellan Oscillator (click here for a description), is signaling the most oversold condition since 2011. This is useful in that it suggests that a short-term bounce may be in the cards, and that is where the true story will be told. If the bounce fails, I expect the market to test the longer-term 200 day moving average. If this subsequent test is accompanied by a widening in credit spreads and a flight to Treasuries, we may be in store for a much larger decline. Right now, this is just a much-needed correction. I will make sure to inform you if the longer-term indicators suggest taking a defensive stance.

Chart 1: JNK/TLT
The ratio of high yield bonds to long-term Treasuries remains in a risk-on posture despite the recent pullback in equities.

Chart 2: NYSE Advance-Decline Line
The correction has taken this common indicator of market internals to below the 100-day moving average. This is a key warning signal that more downside may be in store for equities.

Chart 3: S&P 500
The correction has taken the S&P 500 down below the 50-day moving average changing the short-term trend of the index. However, the S&P 500 remains above both the 100 and 200 day moving averages suggesting that the long-term trend remains positive for now.

Chart 4: Nasdaq 100
The Nasdaq 100 remains above the longer term 100 and 200 day moving averages despite breaching the 50-day moving average yesterday. Therefore, the long-term trend remains positive for the technology heavy Nasdaq 100.

Chart 5: NYMO - NYSE McClellan Oscillator

The NYSE is now at the most oversold level since the August 2015 flash crash.

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