| Archimedes Methodologies

Introduction

As always, please permit me to remind you that most analysts (including myself) enjoy pontificating on everything that has occurred on the left side of the charts. The only thing we enjoy more than that is bragging about our good decisions while minimizing any discussion of our bad calls. I do my best not to be one of the latter-described analysts. When I am right, I am right, and when I am wrong, I am wrong, period.

When I am wrong, as all of us should, I figure out what I missed and try not to repeat mistakes. I share those lessons with you as openly as possible. Sometimes, being wrong is not anybody’s “fault,” but simply the consequence of a random, unanticipated event that intervenes. We need to be ready for that too, which is why stops and sound money-management principles are important. In the end, I am always humbled by the fact that there is an even chance of being right or wrong on any call about the direction of the market. So, I can never be sure if I was correct or just plain lucky. That tends to keep both of my feet planted firmly on the ground.

So, please recognize that the discussions on these pages make trading look easier than it really is in real-time. We don’t drive our cars using our rear-view mirror, nor do we trade similarly. We deal with the right side of our charts, not the left side. If you haven’t noticed, the right side is a blank canvas.

We use probabilities and not certainties to make our decisions. Thus, we must always remember that the behavior of price itself as it unfolds in front of us is the best indicator of the future. And we must always keep an open mind to possibilities outside the most likely outcome, staying flexible at all times.

Macro Narrative

We have been in the final stages of the latest intermediate leg of the bull market that began in 2009. This latest run began at the bottom of the China Virus low in March 2020. The March 2020 low was a nest of all nominal cycles of 54 months or less, so it was a very important trough and juncture. At that time and using quantitative analysis, we predicted that the nominal 18-month cycle in the broad market (S&P 500 index) would likely peak around May 8, 2021.

The computer does not distinguish between trading and non-trading days. May 8th was a Saturday, and the S&P 500 put in an all-time high of 4238.25 on Monday, May 10th. While the index slightly bested that high last week, it immediately rolled over into what I now believe to be the more obvious manifestation of the 18-month cycle intermediate correction. In reality, the correction started with Consumer Cyclicals (XLC) and Utilities (XLU) in late April.

There have been many signs that the intermediate trend was waning. We had the formal, Navigator sell signal on the S&P 500 on May 10th, with a second sell signal on the failed rally attempt on June 16th. There were momentum, strength and breadth divergences throughout May and June. Offense/defense ratios failed to confirm the marginal new high. Some risk-on and risk off measures had been weakening. Sentiment had grown complacent, even in the very short-term sell-offs. I have pointed these factors out as they unfolded.

The correction has slowly swept into the 11 Sectors of the S&P 500 Index. The earliest sector to roll over was Consumer Cyclicals (XLY) on 4/19. Utilities were next on 4/21. Industrials (XLI) and Basic Materials (XLB) peaked along with the broad market on 5/10. Health-Care (XLV) peaked on 5/21. Financials (XLF) peaked on 6/3. Consumer Staples (XLP) peaked on 6/4. Real Estate and Energy peaked on 6/10. Communications (XLC) peaked on 6/15, and Technology (XLK) peaked on 6/17, but neither the XLK or XLC has definitively rolled over as yet, remaining above or still in the vicinity of their 21-day means.

In the Founders Group, we had been trying to reconcile the market price action, bond rally, and early rollover of the reflation sectors such as Basic Materials (XLB) and Industrials (XLI) to potential inflation pressures. How does the behavior of these sectors make sense if inflation is out of the box and out of control? I would harken back to my 2021 forecast. I expected inflation to heat up and it did.

On the one hand, I think the rally in bonds, decline in reflation sectors, and rally in the dollar reflects defensive posturing in the financial markets, just like we confirmed in the SKEW and other indicators last week. However, with the Consumer Cyclical (XLY) sector being the first to peak in late April, one cannot exclude the possibility that the economy (and inflation) are peaking.

The heavy sovereign and corporate debt burden across the U.S., Europe and Japan stifles economic growth. And while the Fed has injected a lot of liquidity into the banking system, that is not the same as “printing money.” The Fed action is only the first stage. The actual creation of money comes when the banks make loans. That is step two in the velocity chain, and it is not happening.

We have to observe all of the sectors as the correction unfolds. Ultimately, fund flows off the bottom will tell us a lot about future inflation expectations.

Intermediate corrections along the lines of the nominal 18-month cycle can go on for several months and can take the S&P 500 index all the way to its 200-day line. Keep in mind that we are already a month into this correction, as we look in 20/20 hindsight.

The 200-day line sits at 3800 today, slightly more than a 10% correction from the top. The size of such a decline would be quite reasonable in the circumstances. The index won’t likely go straight there but usually zigzags down. Also, the 200-day line will continue to rise as the index works its way down or sideways, depending on the scenario.

The ideal low should occur in early August, but there is quite a bit of variance in which the low might occur in a nominal 18-month decline. It is best to let the correction unfold and use our usual measures, including the algorithm, to find the bottom.

Now, is it possible that the correction has yet to start, and we are simply experiencing some higher volatility while the NASDAQ 100 pulls the rest of the market higher? Yes, it is possible, but that is a minimal probability forecast.

Should we expect a crash, as some have forecast since the beginning of the year? Again, that is not the most probable outcome, but we don’t have to know that answer. You should either be in cash at this stage or consider shorting rallies. Obviously, shorting rallies is a strategy for more sophisticated investors. But there is no reason to get caught in a crash if you are in cash and patient.

I would also acknowledge that the divergence in the performance between the NASDAQ 100 and S&P 500 right now is very unusual, to say the least. Some would see an opportunity to short the NASDAQ 100, as it may catch up to the correction rather than pull the market higher. At the moment, I will choose to look at the indices independently. We have nine of the 11 S&P 500 sectors in full-blown correction mode. Tech and Communications are influential, making up a third of the index weight. Also, they have been consolidating since last fall. I won’t exclude the possibility that the two sectors will buck the trend. But I would not (and will not) bet on it.

Stay tuned…

A.F. Thornton

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