In last week’s update, I discussed the fact the recent oversold condition of the market, combined with a massive short interest position, provided the ingredients necessary for a strong reflexive rally from the recent lows. To wit:
“While last week’s FOMC minutes gave the “bulls” some confidence that the Federal Reserve is not removing its accommodative policy, it was the massive amount of short-interest (people betting on markets to fall) that provided the fuel.
The massive jump in short interest has to be covered as stock prices rise. When players are ‘short the market,’ bullish reversals in prices force traders to close out their positions by ‘buying’ into the market. This fuels additional buying, which pushes prices higher, which forces more players to close out their short positions. This cycle continues until the “fuel” is exhausted. This is why market rebounds tend to be extremely sharp and fast, but also fade just as quickly.”
The markets now face a very tough position. The recent spike in prices, as shown below, has now taken the markets back to extremely overbought conditions as it approaches a cluster of price resistance around the 2040 level.
Importantly, as I discussed last week, the current technical backdrop of the market is far different than that of 2011 which is the current “bullish” forecast.
“In 2011, asset prices plunged on fears of a ‘debt default’ coupled with the lack of liquidity following the end of QE 2. However, price momentum and the relative strength of the underlying market internals remained bullishly biased.”
“Currently, the technical deterioration is more aligned with the previous bear market cycle as ‘sell signals’ have been registered for only the third time since the turn of the century. With only one ‘sell signal’ not registered, the moving average crossover, there is a minor ‘hope’ for the bulls at this juncture. However, given the steepness of the descent it is likely that signal will be registered in the weeks ahead if the ‘bulls’ are unable to gain solid footing and push markets to new highs fairly quickly.”
Seasonally Strong Period Of The Year
The technical deterioration of the markets, combined with weakening economic and earnings data, suggest the markets are likely to struggle in the months ahead. However, there is a reasonable expectation that following a weak summer performance, that there could be better performance as we enter the historically stronger period of the investment year.
As Stocktraders Almanac recently penned:
“To recap, we issued our Seasonal MACD Buy Signal after the close on October 5. Current investor sentiment readings do appear to be setting up in support of a year-end rally.There is a healthy amount of skepticism which leaves room for the market to work its way higher.
We are bullish again after spending much of the summer on the defense. However, our current bullish stance is not a strong as it was last year at this time or at the start of previous “Best Six Months.”
Economic data this time around is mixed at best and borderline gloomy at worst while typical pre-election-year forces have failed to prop the market up this year. Most economic data tends to be backward looking while the stock market tends to look forward. Earnings are expected to rebound next year, and the Fed is most likely going to remain accommodative in the face of recent labor market and inflation data. We do expect the market to make a run back towards its recent record highs sometime during the “Best Six Months,” but we do not see a tremendous amount of upside potential after that.”
The table below shows the statistics of the seasonally strong/weak periods of the S&P 500 from 1957 to present using the data from the Federal Reserve (FRED).
As noted above, there is a statistical probability that the markets will potentially try and trade higher over the next couple of months particularly as portfolio managers try and make up lost ground from the summer.
However, it is important to note that not ALL seasonally strong periods have been positive. Therefore, while it is more probable that markets could trade higher in the few months ahead, there is also a not-so-insignificant possibility of a continued correction phase.
Furthermore, the probability of a continued correction is increased by factors not normally found in more “bullishly biased” markets:
- Weakness in revenue and profit margins
- Deteriorating economic data
- Deflationary pressures
- Increased bearish sentiment
- Declining levels of margin debt
- Contraction in P/E’s (5-year CAPE)
(For visual aids on these points read: 4 Warnings)
How To Play It
With the markets currently in extreme short-term overbought territory and encountering a significant amount of overhead resistance, it is likely that the current reflexive rally that began three weeks ago is near its conclusion.
For individuals with a short-term investment focus, pullbacks in the market can be used to selectively add exposure for trading opportunities. However, such opportunities should be done with a very strict buy/sell discipline just in case things go wrong.
However, for longer-term investors, and particularly those with a relatively short window to retirement, the downside risk far outweighs the potential upside in the market currently. Therefore, using the seasonally strong period to reduce portfolio risk and adjust underlying allocations makes more sense currently. When a more constructive backdrop emerges, portfolio risk can be increased to garner actual returns rather than using the ensuing rally to make up previous losses.
I know, the “buy and hold” crowd just had a cardiac arrest. However, it is important to note that you can indeed “opt” to reduce risk in portfolios during times of uncertainty. As my colleague Jesse Felder pointed out recently:
“It was nearly a year ago that I looked back at times when stocks became ‘extremely overvalued’ and then the trend turned down. In every case, it paid very handsomely for investors to implement a system that either shifted to cash (and avoided major drawdowns) or actually got short the major indexes (to profit from major drawdowns).”
“The point is that an extremely overvalued and over-bullish stock market that shifts from uptrend to downtrend is the sort of rare environment that has led to the largest declines in history. For this reason, it presents investors with the most dangerous of all possible environments.”
For More Read: “You Can’t Time The Market?”
This is not a market that should be trifled with or ignored. With the current market and economic cycles already very long by historical norms, the deteriorating backdrop is no longer as supportive as it has been.
“Benchmarking” your portfolio remains a bad choice for most investors with a visible time frame to retirement. While it is true that over VERY long periods of time,“benchmarking” your portfolio will indeed lead to gains. The problem is that most individuals do not have 115 years to garner 8% annualized rates of return.
The index is a mythical creature, like the Unicorn, and chasing it takes your focus off of what is most important – your money and your specific goals. Investing is not a competition and, as history shows, there are horrid consequences for treating it as such.
Incorporating some method of managing the inherent risk of investing over full-market cycle is crucially important to conserving principal and creating longer-term risk-adjusted returns. While you will probably not beat the index from one year to the next, you are likely to arrive at your financial destination on time and intact. But isn’t that really why you invested in the first place?
Images: Flickr (licence attribution)
About The Author
Lance Roberts – Host of StreetTalk Live
After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.
Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.
Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.