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Into The Danger Zone

The last two updates have been longer than usual in order to brief clients on the most probable paths the stock market has available going forward based on an array of supply and demand indicators. This week’s update will return to a more brief format, as the drill going forward will be to monitor the progress, and probability, that the three pathways outlined previously are still the most likely to emerge, or if conditions are changing and a new option(s) may be emerging.

Almost a year ago now in February and March the stock market took a sudden and swift plunge. Indicators were not warning that a major top was forming, but they did signal that the swift decline was likely an opportunity to put cash to work with relatively low risks. So episodes of panic like decline during that brief correction were used to buy into the stock market, as some indicators were flashing that the price had descended below “value”. Even during bear markets compressing the price below “value” tends to be fleeting opportunities demanding adroit trading. As 2018 progressed the decision to buy was rewarded as the stock market embarked on a slow and steady grind higher. During the slow move higher negative divergences began to build in an array of supply and demand indicators, which eventually resulted in a break in the rally beginning in October, which may have ended completely on Christmas Eve, or a significant leg of a larger ongoing bear market may have ended on the Eve of Christmas. The brevity of the decline suggests it may be only part of something larger.

Major stock market tops are usually tested often enough to give investors time to sell into residual strength, as the gossamer like euphoria attendant with major tops slowly diffuses and then dissipates. Although TATY flashed a classic sell signal in November, I elected to hold our positions purchased in February and March 2018, as the odds of a retest of the all-time S&P 500 high at 2941 seemed to have reasonably good odds of success. A retest of S&P-500 2941 would likely linger into the spring of 2019 giving our positions purchased in 2018 time to collect two more quarters of dividends, and also qualify the purchases for long term capital gains. These are the kinds of challenging market and tax implication decisions you pay a Registered Investment Advisor to make, as opposed to a market letter writer, whose job is to just analyze the market. So now that evidence that the correction may have ended, or at least the first leg in a larger bear market may have ended, the decision to hold our long positions looms as a potentially good one.

A critical period in the stock market lies directly ahead. The events of the spring and summer of 2019 may very well be a dramatic demonstration of why you do not want to try and do at home what Alexander and I do every day. The challenge ahead will be to hold client long positions, or to put new cash to work in the stock market, or conversely prepare for another topping out situation, which would demand maximum protection for client accounts. You see if December 24, 2018 was the end of the correction/bear market, then it is very likely that months of rally lie ahead in a new born bull market, or extension of the previous bull market. On the other hand, if the December 24th low was only the end of a leg down in a larger bear market, then the current rally will fail in the zone just below the all-time S&P-500 high at 2941, or perhaps marginally above it. The difference in the impact upon client wealth could easily be in the range of thirty to fifty percent, if a new bull market was born on December 24th. Why? Read on for an answer.

If the stock market remains in the grip of a large bear market, then the current rally is a counter-trend rally destined to fail in the zone surrounding the all-time S&P-500 high at 2941. Once the rally rolls over, then the bear market will very likely be recognized by increasing numbers of global investors, which at some point will likely tip over into a “recognition” stampede, a violent vortex of mindless program and panic selling. This is how major bear markets do business as they mature. In finance this is something like the “event horizon” in astrophysics, where nothing, not even light, can escape the exponential power of the pull of gravity in a black hole. So if investors posture for the remainder of the bear, and then the market dials up a bull, there will be an immediate problem of how quickly can the tactical positioning error be corrected. Will that be twenty, or more, percent later as the bull accelerates higher driven by under-invested money managers scrambling to buy into the resurging bull trend? Or, on the other hand, if investors position for the newly minted bull, and the market dials up the terminal leg of a large bear, you know the leg containing the violent vortex of mindless program and panic selling, how long will it take to reposition in an effort to escape the remainder of the panic driven decline?

Experience tells me investors, which mis-position their portfolios in the weeks ahead, will be looking at a potential loss of opportunity, or real potential losses in their portfolios of around 30% on the light side, to perhaps 50% on the heavy side. For example, last week’s update showed that one popular Fibonacci target for a retracement of the rally from the March 2009 low at 666 to the all-time high at S&P-500 2941 was the 62% retracement level at S&P-500 1535. If the current rally gives out of gas at a marginal new all-time high as part of a larger bear market, then that S&P-500 Fibonacci target sitting at 1535 falls into the range of a 50% bear plunge. And, here is how bear math works, should that happen, then investors would need a 100% gain just to get back to even! So bull trend or bear trend matters, and it matters most to those over age 50 with less time available to recover from serious losses. Now please do not take this representation of the possible worst case as a prediction, as I do not do predictions. However, Alexander and I must always be aware of the potential worst case in order to protect clients from it. At this point the worst case is a relatively low probability, but statistically large enough for us to brief clients about it. If the probabilities begin to move higher, then (quick?) defensive action will be required.

The bottom line this week is a critical time in the stock market looms ahead as the calendar turns from winter to spring, and then to summer. My advice to investors is do not attempt to do at home what Alexander and I will be doing as the stock market flies “into the danger zone”!

An old Asian saying goes like this: “May you live in interesting times”, and the odds favor the year 2019 being a year of very “interesting times” in the markets.

TATY, a supply and demand indicator, is shown on the attached chart in yellow, and the S&P-500 is shown in blue and red candle chart format.

 

Regards,

Gregory H. Adams

Senior Portfolio Manager

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