The last several updates have cautioned that the verdict was still out on whether the bull market had expired, but that clients should be aware that volatility was likely to increase sharply. In the days, and weeks ahead, the stock market will likely give us sufficient clues to determine the health of the bull, and if indeed the bull has expired, and we are now in the early phases of a newly minted bear market. Please remember that the generally accepted guideline for a bear market is a decline of 20% or more from a new high. The S&P 500 all-time high was at 2941 and change, so the current volatile decline is a correction at this point. The remainder of this update will deal with how the stock market may tell us, if it just undergoing a normal correction to invigorate demand, or if it is likely the bull expired at S&P 2941, and then entered into a bear market lasting weeks, months, or years. Obviously any clues to make this determination are important for clients to protect their wealth from the ravages of a bear market, which in the last 35 years have seen bear declines in the range of mild bears in the twenty something percent range to really nasty bears approaching 60% in the NYSE, and 90% in the NASDAQ.
If the bull still lives, then once this correction has run its course a rally back toward new all-time highs will occur. The behavior of this rally vis-à-vis the supply and demand indicator, TATY, will be extremely important. This week TATY declined into the caution zone surrounding the 120 level, and then closed near the 125 level, which confirmed a “Big Chill Warning”. This means that the decline has been nasty enough in volatility, and price, to get the attention of normally perpetually optimistic investors, causing a bit of a chill to go up their spines. Such declines are often enough to make bull minded investors to consider taking some profit, or pulling back on new purchases, a shift in attitude from all out optimism, to a more sober outlook toward potential future gains in the stock market. This shift in attitude shows up in the balance of the supply and demand equation, which then shows up in the numbers being registered by TATY, which represents the strength, or weakness, in the balance. The change in the numbers for TATY can then be objectively compared to previous periods, when the market painted out major tops. At the moment all TATY is telling us is that the psychology of investors, especially institutional investors, is likely becoming more sober toward the prospects for further new all-time highs. The details of what to look for to re-confirm the bull case follows.
Once the current correction approaches an end, then TATY will very likely already be painting out a positive divergence with the price, and will likely be climbing above the caution zone surrounding the 120 level, as the correction is completing its final probes for a bottom. This behavior has been consistent over the last three decades, and recently during the February-April swoon (see attached chart), but of course there are no guarantees in this business that the past will always be prologue. The positive divergence in TATY to the still declining price will also very likely be repeated in the lower panel of the indicator, where the premium/discount indicator oscillates around its zero line in its never ending journey from premium above value, to discount to value. and back again. Corrections compress the price from premium to discount to dynamically fluxuating value, and currently this indicator is well below minus eight, which is significant compression signaling me that it is too soon to be a buyer. This indicator, like TATY, tends to paint out a positive divergence with the price, and when it rises above the minus eight level (red line) and then the minus three level (green line) then the odds have begun to favor purchases. This likely occurs because sophisticated investors are tip toeing back into the market, while the less informed are throwing in the towel keeping the price depressed. These kinds of conditions tend to be when the odds are most favorable for putting cash to work. However, there is still important indicator behavior needed to confirm a coming rally is a continuation of the bull trend, and not a bear trap. Read on for those details.
If the bull lives, then TATY will rally into the red zone, and then try to rally above the red zone while likely also painting out ever higher lows above the caution zone. In like manner, the premium/discount indicator will likely rally above its zero line and paint out bottoms above the minus eight level (red line), and usually episodes of weakness do not decline much below the minus three level (green line). When these conditions are in place the previous bull trend then slowly re-asserts itself, and presses the price toward new highs until the next “Big Chill” warning. This describes how this process has played out at major tops since the 1990s, and given the major tops contained in that sample, one may have a reasonable expectation that it may again, but with the caveat that the market can, and will do as it pleases, so one must consider this process as a stream of probabilities, and not a forecast of certainty. There is no certainty to be had in the emotional arena of the stock market. So now days, or weeks, in advance clients have been briefed on which clues the market may yield, which are important in the context of our supply and demand approach to confirm a continuing bull trend. This is an outlook not based on guessing about the impact of countless global events, but rather on information created by the stock market about its own health. If a bear market began at S&P 2941, then read on for the behavior, which will likely exist before the bear becomes seriously destructive to investors wealth.
If Mr. Bear has now crashed Mr. Bull’s party, then how will we know vis-à-vis our supply and demand approach? Well not to worry, the detailed explanation for the bull case above is almost exactly the same for the bear case with one important exception. The process described above, or a setup very similar in concept, but perhaps varying in a little here or there, will likely unfold in the days, or weeks ahead. However, the previous strength of the bull trend to push TATY consistently above the red zone surrounding the 140 level will not be in evidence, and TATY will struggle to reach the red zone, and then stall out in, or near the red zone. At the same time the premium/discount indicator in the lower panel will also show less ability to generate strength compared to its behavior during the previous bull trend. And, once TATY runs out of gas and stalls, which may occur near, or more likely below a new price high, then investors should slant their investment strategy from one of maximum gain, to one of defending accumulated profits, and the preservation of wealth. Supply and demand based indicators, because they objectify the bull/bear phenomenon, have a record of identifying when risks have risen too high for investors to continue to pursue diminishing returns. Properly applied, these tools can produce an investing edge, however they cannot tell us how deep a subsequent bear market may go in advance. Even so, the knowledge that risks have risen to a dangerous level can be key to preserving wealth, which in my world is objective number one.
So now clients have a rough road map of how the next bear market may announce its arrival, at least in the context of history vis-à-vis a family of supply and demand based indicators. So in the days, and weeks ahead, we shall see if Mr. Bear elects to travel his usual road to Mr. Bull’s party, or this time takes a road less traveled? In this business, one goes with the best odds, as there is no certainty.
TATY, a representative supply and demand indicator, is shown in yellow on the attached chart, and the S&P 500 is overlaid in red and blue candle chart format. Please note that the February to April 2018 decline (see the attached chart) was a correction, and not a bear market according to the 20% guideline.