Recent updates have been exercises in briefing our clients, and research customers, about the risks associated with bull and bear trends in the stock market. The former involves the implied costs of lost opportunities, and the latter the very significant damage to wealth represented by a mature bear trend during the recognition phase, as countless panicked global investors seek safety by trying to exit the stock market through a very small door, and all at the same time. Bear markets can develop in a multiplicity of ways, but for now we will look at only the most probable. We will save the topic of financial malpractice on the part of too many financial advisors, which unfortunately we discover in the portfolios of potential clients almost weekly, for a later date.
The Bull Case. As previous updates have stated, the holiday shortened market session on December 24, 2018 looms as a key date, both in terms of how we define a reversal day, and how TATY, a supply and demand indicator, has behaved historically following an excursion into its green zone surrounding the 90-100 level. This indicator spiked intraday to 101 on December 24, only one point short of the green zone. The previous ten excursions into the green zone were all followed by new all-time highs, albeit sometimes after a test of the low, so the one point miss on December 24 has positive implications. Following the eruption of demand on December 26, which set a one day Dow point gain record, the stock market has rallied to marginally above a 62% retracement of the decline from the all-time S&P-500 high at 2941 to the low of the leg down at 2347 (See The Chart Above). There is strong resistance at S&P-500 2888, and of course at the previous all-time high at 2941.
For the bull case to remain valid, a series of supply and demand indicators must continue to paint out higher highs and higher lows concurrent with the price doing the same. Should this occur, then at some point under-invested professionals will recognize the bull still lives, and a rush to get invested would likely follow, which would likely cause the price to accelerate higher. Investors positioned defensively in anticipation of a bear leg down would pay a substantial loss of opportunity costs for their error in this scenario. Currently the probabilities favor the bull case, but that could change as the market yields more information about itself, as we approach the resistance zones immediately ahead at S&P-500 2888, and the previous all-time high at S&P-500 2941. The rally off the December 24 low at S&P-500 2347 showed signs of needing to digest its gains this past week, so clients should not be surprised if the stock market settles into a trading range in the days ahead, before a resumption of the rally from the December 24 low.
The Bear Case. Most investors do not realize that a big bear market can make a new all-time high as part of the overall bear trend. I’ve drawn a crude representation of how “irregular” bear markets develop. For illustrative purposes, I’ve attached the bear example to the current chart of the S&P-500 (See Chart Above). The task of bear markets is to fool the majority of investors the majority of the time, as the bear goes about the business of correcting the excesses of the previous bull trend. Bull and bear markets tend to go to extremes as human nature tends to swing between extremes, and at the end of the day it is the perceptions of investors, which drive the price of markets. And, since we human beings tend to emotional extremes, then markets tend to do the same, as a reflection of our emotional journeys as a herd.
The chart above shows the most common Fibonacci retracement levels calculated for the rally off the March 2009 low at S&P-500 666 to the recent all-time high at S&P-500 2941. The October-December decline touched the 25% retracement level. If that leg down is only the prelude in an ongoing big bear market, then the rebound will likely assault new all-time highs before rolling over into a relentless and violent leg down in the big finale to the grand bear overture. Such an event may start with a “newsy” gap down from the territory of new all-time highs, which would likely be followed by a swift and accelerating decline driven by panic, as global investors recognize the mature phase of a big bear market has trapped them at all-time highs. Wealth literally evaporates in this part of a bear market, as panic drives the price swiftly in both directions violently, but mostly down. When a big bear gets down to business, then there is literally no place for equity investors to hide. The last chart above shows some reasonable Fibonacci retracement support levels for the big bear case are S&P-500 2078 (38%), 1808 (50%) and 1539 (62%). The decline could stop anywhere, but these are the popular math levels to watch. Please note that S&P-500 1808 is essentially the February 2016 low, so that one really gets my attention.
The big bear case is a relatively low probability at the moment, but probabilities are not static in the stock market, and as the market yields more information about itself, then the probabilities become subject to change, and perhaps dramatically.
Acceleration. The zone surrounding new all-time S&P-500 highs represents a danger zone in terms potential acceleration in the price up, or down. If the bull trend is real, then the remaining resistance zones at S&P-500 2888, and the previous all-time high at 2941 will be breached, perhaps more easily than currently anticipated? Should this happen, the rush to get fully invested to avoid a substantial loss in terms of opportunity costs may result in a brisk acceleration in the price higher. Under-invested institutional professionals lose their jobs for not being fully invested, or even leveraged during a bull trend. These conditions can lead to investors chasing a bull leg higher, even though the premium to “value” of the price may reach ridiculous levels. Remember the stampede into the internet stocks in the late 1990s, even though some of those stocks did not even have sales let alone earnings! So in the weeks ahead we may see an acceleration higher, even as values assigned to stocks by the market become ridiculous, if the bull case is real.
On the contrary, prices also tend to accelerate in mature bear markets due to recognition. Unfortunately, the acceleration is down, and in the mature bear case more in the mode of a meltdown, due to panic stampede conditions. So what will it be, an acceleration higher or a meltdown? Well given the multiplicity of options available to big bear markets, something other than the two options outlined above may be chosen by the market, but for now we will go with the probabilities and plan around these two strategic outlooks. This means as more information becomes known a tactical plan will be developed to address the emerging resolution of the current conundrum.
The Bottom Line. The odds remain favorable for the bull case, so in the days ahead we will hold our current longs, and possibly add to them should an attractive buy signal develop. An attractive buy signal may develop, if the market begins to digest its recent sharp gains, which could chew up most of February, and possibly into March. We will go with the bull case until it demonstrates it may be failing, at which point the issue of acceleration must be addressed correctly.
TATY, a supply and demand indicator, is the chart above in yellow, and the S&P-500 is shown overlaid in red and blue candles. TATY has found resistance just above the red zone, and may give up some ground, if the market enters a consolidation of its recent gains off the December 24, 2018 low. It will be important for this indicator to form a higher low and recover quickly off that low, to avoid a warning that the rally off the December 24 low is all the market can deliver before the resumption of an ongoing bear leg dating to October. When this indicator stalls out near, or in, the red zone, then the market may be vulnerable to a decline.