Short Covering Rally or a Capitulation Bottom?
- Peter Lee
- Mar 24, 2020
- 4 min read
How do we know if this is a short covering rally or if this is indeed a capitulation bottom?
Capitulation market bottom is a type of panic type selling that builds up with strong and persistent selling momentum. This selling causes a sudden, dramatic and precipitous decline to a “bottom.” The floor often coincides to a previous major support zone or a prior crucial technical level. Broad stocks have sold-off to a point that everything appears to be cheap. Extreme and widespread fear dominates the marketplace as the bulls gives up on their net long positions.
Short covering rallies occur when investors buy back borrowed securities in order to close out existing open short positions at either a profit or at a loss. This collective process of covering many short positions leads to a temporary short squeeze in the market. The market typically rallies sharply higher driven by good news but with lower than normal volume and the cause of the decline not yet resolved.
Most investors and specifically traders turn to the short-term daily charts to determine whether this is a short covering rally or a capitulation bottom. It is our belief that you will need more than the daily charts. Rather the daily charts along with the weekly and monthly charts are needed to uncover the underlining buying/selling forces that is driving the marketplace. Only when we have technical confirmations coming from the daily, weekly and monthly charts will this confirm a major market bottom and the start of a sustainable intermediate-to-longer term stock market recovery.
SPX daily chart:
A daily gap up on 3/24/20 (2,301-2,344) is the first positive reversal day in the past 4-weeks. Although a reversal pattern is technically constructive, today's sharp move remains an oversold rally as the primary short-term trend is in a downtrend. Also note the 50-day ma (2,935) has crossed below its 200-day ma (3,013) confirming a death cross sell signal. In addition, to confirm a potential bottom SPX still needs at the minimum to surge above its 38.2% retracement (2,651) from the 2/19/20 to 3/23/20 decline. Only then will this signal the start of a sustainable near-term rally toward 50% retracement (2,793) and then to 2,934.5-3,013 (61.8% retracement, 50-day ma, and 200-day ma). A breakout above the 61.8% retracement and above its 50-day/200-day ma are technically significant as this action solidifies a bottom and hint of a sustainable intermedia-term recovery. On the downside, key initial support rises to the 3/24/20 gap up (2,301-2,344), and below this to 2,191.86 (3/23/20). Violation below 2,191.86 is likely to signal the next major SPX downturn.
SPX weekly chart:
The weekly chart remains defensive as evidenced by a weekly death cross sell signal on 3/9/20 as well as the violation of the 2016 uptrend (2,618). The ability of SPX to close the week above last week’s high (2,562.98) confirms a positive outside week. This action coupled with the ability to clear above the extension of its recent 2016 uptrend breakdown (2,618) would convince the intermediate-term buyers to return to the marketplace and hence triggering the start of an intermediate-term technical basing effort. This technical base is often needed to repair the technical damages incurred during the sharp decline and to convince investors on the sidelines that indeed there is a major bottom developing.
SPX monthly chart:
The 10-mo ma (2,919.5) and 30-mo ma (2,789) are turning downwards. This is often a warning sign of more selling than buying in the marketplace. However, the spread (130.76) between the two key monthly moving averages have not yet converged to generate a monthly death cross sell signal. At the current pace of the spread contraction a major inflection point is likely to develop during the second half of the year. In the meantime, the bulls and bears will likely continue with its battle and we can expect continued high degree of volatility. We would like to refresh your memories and review the two monthly death crosses sell signals during Jul 2001 and Jul 2008 coinciding with the Tech/Telecom Dotcom bear and the global financial crisis, respectively. It is important to note the monthly death cross sell signals warned of the start of a major bear market. However, the confirmation of the bear occurred only when the SPX (price) failed to convincingly clear above these two key monthly moving averages on subsequent rallies. It is interesting that over the past few years SPX have violated both of its 10-mo/30-mo ma. However, the ability of the 10-mo ma to maintain above its 30-mo ma and most important, the ability of the two moving averages to subsequently trend higher that this negated a bear market. In fact, this technical action subsequently led to the resumption of the primary bull trend (i.e., Dec 2011, Mar 2016, and Jan 2019).
Conclusion:
In summary, although technical oversold rallies are possible given the deeply oversold conditions we suspect further technical developments are needed from a daily, weekly, and monthly technical perspectives to confirm a major SPX market bottom and the start of a sustainable intermediate-to-longer term recovery. If you believe, as we do, that this not a V-type stock market/economic recovery, then it is reasonable to expect a technical base is necessary to solidify the bottom and to convince investors and traders to return to the marketplace.
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