Over the last few weeks, I have been discussing the potential for a seasonal year-end rally.
However, following the strong October rally, a correction was needed to provide a short-term oversold condition which would create a better risk/reward opportunity.
The markets did not disappoint. Despite Japan slipping into its fifth recession in the last 5-years, despite massive infusions of capital, and the devastating attacks in Paris over the weekend, the market rallied strongly off of support as expected.
With "bad news" mounting almost daily from weak retail sales, plunging imports, spiking inventories, geopolitical risks, etc., market participants are once again "front running" the Fed will not hike rates in December. At least for now, low rates remain bullish as the liquidity spigots in Japan, China, and the Eurozone continue to flow.
However, despite the rally over the last couple of months, there is little evidence that much has been done to reverse the more "bearish" internal deterioration that currently exists. Furthermore, the current market action may be more indicative of market topping process rather than the beginning of new leg of a bull market.
It is not just momentum measures that remain weak, but also the internal "breadth" of the market. Historically speaking, at the latter stages of a bullish advance, the number of stocks participating in the advance begins to weaken. That is much of what we are seeing currently.
Furthermore, "narrow" rallies are historically very symptomatic of market tops. As noted recently by Goldman Sachs, if it were not for just EIGHT (8) stocks, the S&P 500 would be negative for the year.
But it isn't just me, BofA also noted the same stating:
"A month-long bearish divergence for the US 15 most active advance-decline line has the potential to limit S&P 500 upside. The weekly global A-D line of 73 country indices in US Dollars peaked on September 5, 2014, vs. a May 15 peak for the weekly closing price of the MSCI ACWI Index, which is also based in US Dollars. The rise in the US Dollar has had a bearish impact on global equity market breadth (many equity markets have done much better in local currencies) and this A-D line has not confirmed the global equity market rally. This is a major bearish breadth divergence and a classic sign of diminishing breadth for global equity market indices."
"Big breakdowns in the most active A-D line preceded or coincided with big breakdowns for the S&P 500 in 2000 and 2007. The key for the US equity market in late 2015 and into early 2016 is for the most active A-D line to hold its support at the August, July, and December 2014 lows. A failure to do so would put in a top for this advance-decline line and increase the risk for a deeper US equity market pullback."
While the "seasonally strong" period of the year may present an opportunity for more seasoned and tactical traders willing to take on additional risk, it is not currently an ideal set-up for longer-term investors.
"As we progress through the last two months of the year, historical tendencies suggest a bias to the upside. This is particularly the case given the weakness this past summer which has left many mutual and hedge funds trailing their benchmarks. The need to play "catch-up" will likely create a push into larger capitalization stocks as portfolios are "window dressed" for year end reporting.
This traditional "Santa Claus" rally, however, does not guarantee the resumption of the ongoing "bull market" into 2016."
With the markets currently oversold on a very short-term basis, the current probability is a rally into the "Thanksgiving" holiday next week and potentially into the first week of December. As opposed to my rudimentary projections, the push higher will likely be a "choppy" advance rather than a straight line.
In early December, I would expect the markets to once again pull back from an overbought condition as mutual funds distribute capital gains, dividends, and interest for the year. Such a pullback would once again reset the market for the traditional "Santa Claus" rally as fund managers "window dress" portfolios for their end-of-year reporting.
This is only an expectation based on seasonal tendencies of the market. As I have stated repeatedly, the current setup is opportunistic for very short-term, nimble and disciplined traders. However, for long-term investors looking to managing risk and preserve capital, the current market environment is no longer friendly and is beginning to border on hostile.
As John Hussman recently noted:
"When investors are inclined to speculate, they tend to be indiscriminate about it, so strongly speculative markets demonstrate a clear uniformity across a broad range of individual stocks, industries, sectors, and risk-sensitive securities, including debt of varying creditworthiness. In contrast, as risk-aversion sets in, the first evidence appears as divergence in these market internals. Put simply, overvaluation reflects compressed risk premiums and is reliably associated with poor long-term returns. Over shorter horizons, investor risk-preferences determine whether speculation will continue or collapse, and the condition of market internals acts as the hinge that distinguishes those two outcomes."
Excessive market valuations, weak internal measures, and a deteriorating backdrop has historically been a "wicked brew" for investor outcomes.
While markets can certainly remain "irrational longer than you can remain solvent," the secret to "solvency" is understanding "when" to make an investment "bet." A professional gambler only goes "all-in" when he "knows" he has a winning hand. He also knows when to "fold" and minimize his losses. For long-term investors, the risk to "solvency" greatly exceeds the "reward" currently.
For short-term traders, the opportunity to speculate in the market has improved enough to increase equity risk exposure temporarily. However, gains will likely be limited and risk of failure is high.
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