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Interpreting DeMark Indicators: All Trends Must End, But the When Is Key


What the DeMark counts suggest is that regardless of your time frame, the upside move in equities is extremely powerful, but it has also used up a lot of buying power.

A reader named Minyan Sol writes:
I just read a Buzz & Banter note [subscription required] of yours that says that the SPX (INDEXSP:.INX) is about to issue a Combo 13 Sell signal across many time frames shortly.

Since I have no idea how DeMark followers interpret these signals (if I'm not mistaken, Tom DeMark suggested a "13" Sell signal about four weeks ago when SPX was around 1470, and then conditioned it on it exceeding 1472, hitting a recovery high above 1475, and then spurting up to 1492, and despite doing all that, the market continues up), to me it sounds "ominous" and at least suggests a pullback of days, weeks, and possibly months. Yet you go on and suggest that as long as the Fed is pumping money into the system, the trend is definitely up. Can you amplify as to when you expect this pullback to begin, if you are expecting one soon, and if so, how far down, and how long do you expect it to last. I see that you end the Buzz & Banter note saying that you have a position in SPX, and I assume it is a short position. Please correct me if I am wrong.

Finally, several years back, you made a great call regarding Clayton Williams (NASDAQ:CWEI) based on a certain analyst opinion. That stock has retreated substantially lately. Do you/he have any opinion on it?

This is a great question because it gave me the impetus to explain in a bit more detail how I interpret DeMark indicators. Sometimes I think that my blurbs about a Buy Setup or a Sell Setup are misinterpreted to simply mean that a stock is ready to go up or ready to go down. That's partly true, but, as they say, it ain't that easy.

As Tom DeMark explains it, his mainstay indicators use times and levels – condensed into counts – to suggest when a trend may be exhausting itself. Trend exhaustion is very different from suggesting that the trend is somehow wrong. It simply recognizes that all trends at some point must end. Also, the counts alone may suggest when a trend is exhausted, but it's usually best to wait for other confirmatory signals before concluding that the trend has changed.

From that premise, it stands to reason that if a trend looks exhausted simultaneously on a daily time frame, on a weekly time frame, and on a monthly time frame, the probabilities that such a trend is long in the tooth increase significantly.

Another important element of counts is the associated risk level. Whenever we see a print of a Buy/Sell Setup, a Combo Buy/Sell, a TD Sequential Countdown Buy/Sell, or any other of those type of indicators, these counts tell us that based on the strength of the (arguably) exhausted trend, there is a margin of error up/down to the risk level. If the risk levels are violated, then we must accept that the trend is so strong that exhaustion notwithstanding, the trend will continue.

With those basic concepts down, let's look at the various charts of the S&P 500.

Click to enlarge

Above is the daily chart of the SPX. In Minyan Sol's question, he references some comments from Tom DeMark, which I believe were made around the time the index was printing the Combo 13 Sell signal in the white circle at around 1462. I suspect that the other prices he mentions were the related risk level and/or targets tied to other indicators he uses. Clearly, despite the Combo 13 Sell, the trend was too strong to reverse; after a brief pause, it moved on to complete a Sell Setup, shown in the green circle. That proved futile as well, and it led to yesterday's print of a new Combo 13 Sell at 1520. The risk level that goes with this new Combo Sell is 1533.45. So if 1533.45 is not exceeded, and we get a price flip (a price flip is defined as a close lower than the close four bars prior) and preferably some other type of indication that the trend has changed (a close below TD Reference Close Down, for example) within 12 bars from yesterday (another DeMark rule), then the Combo Sell signal remains valid. If we don't get the price flip within 12 bars and/or 1533.45 is exceeded, then the signal is invalidated.

With the daily trend strong enough to overwhelm several of the recent exhaustion counts, the momentum behind the price argues for looking at things in a bigger time frame.

Click to enlarge

By looking at the weekly chart above, we would have found several clues that the daily exhaustion signals were printing in the context of a much more ingrained move that was far from being exhausted. The bullish move shows its origin when the chart printed a TD Buy Setup back in June (green circle). The price flip happened the following week, and two weeks later we got confirmation of the change of trend when there was a valid break of the TD RefClose Up price at 1362. That ushered in the completion of the TD Sell Setup (red circle), a textbook pause lasting three bars, and a qualified break of the TDST Level Up (think of that as trendline resistance). A qualified TDST break argues for the trend to continue until a Combo or Countdown 13 Sell finally prints. Combos and Countdowns are far less time-dependent than Setups, so it can be a long time between when they start and when they end. But as long as under certain DeMark rules, they are not cancelled, and we can expect them to conclude. Sure enough, last week we printed a Combo Sell 13 at 1517.93, with its risk level at 1541.60.

Is this the end of the party? Again, given how powerful this move has been, it is prudent to wait for a price flip and/or a TD RefClose Down signal. These are objective signs that show that it is more likely than not that the trend has in fact exhausted itself. Within trends not as strong, I may be more inclined to step into a short position without waiting for confirmation; that's a matter of risk appetite.

With daily and weekly trends seemingly exhausted, and to avoid the kind of pitfalls encountered by not looking at the daily counts in the context of the weekly chart, let's take a look at where we stand on a monthly time frame.

Click to enlarge

Here you can see that the TD Buy Setup printed pretty close to the 2008 panic bottom and price flips and TD RefClose Up confirmation registered three months later (white circle). That began the Sell Setup, which completed in the red circle, and was followed by a period of consolidation. The concurrent Combo Sell count was never cancelled and concluded just about simultaneously with a new Sell Setup (green circle). Buying was exhausted at that point, and the SPX corrected about 20%. Because of the way counts are measured, there can be overlapping Combo counts working at the same time, so currently we are on Bar 11 of the latest Combo Sell and on Bar 7 of a Sell Setup. This suggests that we may have a couple more months of higher highs before the Combo Sell and the Sell Setup print simultaneously.

Now that I have you all confused, I'll go back to Minyan Sol's question and see if I can tie the above DeMark primer with an answer.

What the DeMark counts suggest is that regardless of your time frame, the upside move in equities is extremely powerful, but it has also used up a lot of buying power. This buying power has been mostly a function of the re-opening of the corporate bond market back in early 2009. (Read Corporate Bonds, Derivatives, and How They Wag the Equity Markets for an explanation of how and why). While the corporate bond market continues on a buying frenzy, there are times when it too must rest, and there is growing evidence that bond prices have reached exceedingly pricey levels. Exhaustion in multiple asset classes increases the chance of a negative feedback loop if one asset class breaks. So yes, I do believe that we are at levels where risk assets are way overextended and dangerous.

It is somewhat difficult to forecast the breadth of a downward move before the trend even changes, but what was previously resistance on the SPX monthly chart (the TDST Level Up at 1395.29) can now be seen as support, so a move back to that range (if it holds) would not dent the longer term trend for stocks. As for the timing of a trend change, again I am letting price flips and TD RefClose levels be my guide, particularly in light of the power of the current move.

Once/if we get a correction down to the 1395 area, we should have better clues as to its nature. My key "tell" will remain the corporate bond market. Have spreads widened dramatically? Is there new issuance when the price is right? Are late vintage bonds breaking par? What does the credit derivatives market look like? If things remain generally healthy in the corporate bond market, we can ultimately expect another ramp higher. Otherwise, we may have to consider the possibility of a more serious bear market.

Lastly on Clayton Williams and my SPX position: My guru analyst turned cautious on the stock many moons ago when management reverted to its old risky wild-catting ways and stretched its balance sheet too thin. With many other candidates to pick from, I never revisited the story, so at this point I can't offer much more than that. My SPX position is in fact short, but purely as a modest hedge.
Position in SPX.
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