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Too Late To Sell And Too Early To Buy

The stock market is experiencing atypical weakness during what is historically the strongest seasonal period of the year. Powerful rallies sprint higher intraday only to encounter motivated sellers before the market close. The premium to discount indicator in the lower panel of the attached chart has descended below its deep discount to value line at minus eight, but so far has failed to develop a positive divergence with the price to suggest this episode of weakness may be nearing an end. TATY, a supply and demand indicator, has declined back into the caution zone surrounding the 120 level after stalling out marginally above the red zone confirming the recent bear market warning signal. And, all this has happened after the rebound in the price failed just above S&P-500 2800, and close to a 62% retracement of the initial decline from the all-time high at 2941. This objective evidence being generated by the market has now tilted the probabilities in favor of a developing bear market.

A bear market is the ultimate destroyer of wealth for the buy and hold type investor, as profits accumulated over months, or years, are erased in a relatively short period of time. Bull markets take the stairs on the way up, but bear markets usually take the express elevator down, so the power of a bear market must be respected, especially as a bear market matures. In the early stages, a newly minted bear can linger for weeks, or months, near the high before investors recognize something is wrong and become more and more motivated to sell. As recognition spreads investors become urgent sellers, and urgent sellers morph into panic sellers as the bear process begins its terminal phase. Unfortunately, this progression in the price decline can occur over a period of time lasting weeks, months, or in extreme cases years; the Japanese stock market after it peaked in 1989 comes to mind. So the damage done to the psyche of investors occurs not only in terms of wealth melting away, but also in terms of how much time it takes for Mr. Bear to complete his wealth destruction mission.

In my world wealth and risk management involves an objective assessment of the strategic big picture, a tactical plan appropriate for the strategic situation, and an accounting for the tax implications for any action taken to manage the risks to client wealth. During and after the dramatic and swift correction in February of this year, investors were given an opportunity to put money to work while the stock market was offering a fleeting discount to value. I took advantage of that opportunity to do some buying for clients, and during the subsequent rally clients have collected three quarterly dividends, and those purchases will soon qualify for long term capital gains in late February and March. When the bear warning was recently completed, I made the decision to continue to hold those purchases weighing the impact of the tax on the potential short term gain versus the potential for the early phases of a new bear to linger near the all-time highs until clients could collect a full year of dividends, and also for the purchases to quality for long term capital gains. In most cases the tax due on the short term gain would still outweigh the impact of the current market weakness. It remains to be seen if the stock market will soon put in a significant bottom for the current leg down from which a substantial recovery rally may emanate creating a long term capital gain opportunity?

The are multiple ways a bear market may develop, but history has shown that the most powerful rallies on record have occurred during big bear markets. In the current case it is likely too late to sell into this deeply oversold market, and too early to buy the discount to value currently being offered by this probably first leg down from the all-time high. It is also too early to tell if further decline will result in bringing an end to a brief but very nasty correction, or if the stock market is setting up for a long and devastating bear market. I am suspicious that the current decline is just the first phase in what may turn out to be a complex bear market lasting weeks, months, or possibly longer. This current weakness will end when the last would be seller has sold, and the supply and demand equation shifts back in favor of demand over supply. In the interim bear markets often create substantial albeit fleeting opportunities, so we will endeavor to take maximum advantage of those kinds of intermediate trading opportunities regardless of the tax implications.

So to summarize, the current decline may still be only a correction from which a new rally leg will be born, which will also have the potential to assault new all-time highs. However, given the lack of positive divergences in an array of indicators, and the lack of evidence for a cathartic bottom, then this move down likely has more to go, and the probabilities are turning in favor of a developing bear market. However, even if the stock market is in the early phases of a new bear market, then according to one discipline I follow only as tertiary information new all-time highs may still be touched as part of a complex bear market. If a bear market does develop along this path, then it will be particularly insidious, and will likely rip investors just as they feel it is safe to re-enter what will appear to be a continuing bull trend. Yeah I know new all-time highs and a bear market would appear to be mutually exclusive, but yes occurrences of these kinds of bear market phenomenon have been well documented down through the years. Please note that I’m not predicting such an outcome, I do not do predictions, but clients need to be aware that this is one possibility among several along which a complex bear market may develop. Such an outcome would likely create big profit opportunities inside the ongoing bear trend for investors with the tools and courage to navigate the volatility and implied risks.

All of us here at Optimist Capital want to wish all our clients, family and friends a Merry Christmas, Seasons Greetings and Happy Holidays!

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