In late April, nearly four months into a historic Stock rally that began in late December 2018, I tweeted some Summary thoughts and suggested plan for Q2-Q3:
I proposed two core ideas at the time. In this note today, I will focus on the first idea — Stocks. My reasoning is based on some charts that really stood out to me at the time:
First, Stocks were very extended in late April and likely to switch to a volatile mean-reverting regime. On April 29, I tweeted the below chart, showing the S&P Technology sector’s trend strength at one of the highest in history. I added that “a major corrective phase is likely to occur this year, lasting several months. Could be a topping process like 2000. Or (as I believe) a multi-month big volatile consolidation similar to 1991, 1995, 2004, 2012.”
Note the red boxes I drew above. When Stock prices move significantly in one direction for a relatively short period of time, they exhibit very high trend strength. Eventually, this reaches an extreme and the strong trend is vulnerable to exhaustion. The result is a return of two-way volatility, usually a violent sideways consolidation. This is what the red boxes show. And that was my best guess in April for what was coming.
Stocks are now correcting, but I believe we are still in a Bull market. One can never been 100% certain in markets, but I think a Bull market is still the most likely scenario. Note in the prior chart — in 1991, 1995, 2004 and 2012, Stocks rallied strongly and then consolidated bullishly for several months, ultimately moving higher.
I also think this is more likely to be a single digit correction, not another severe decline like last year. To illustrate why I think we’re in a Bull market, and why the correction should be relatively mild, I present the chart below: in late April nearly 80% of S&P stocks were trading above their 200dmas. The key condition to evaluate is: is Stock Breadth ABOVE or BELOW the 50% line?
At the time, I tweeted this chart and wrote it’s “reminiscent of the 2016 rally which reached 78% before two pullbacks that held above 50%. This is very positive longer-term. Market likely to correct through time, maybe 5-10% downside volatility next 3-6M.”
Further, notice above that the most violent declines of the last several years: August 2015, January 2016 and December 2018, all shared the same weak Breadth characteristics under 50%. (In fact this is a recurring feature of virtually every big Stock decline of the last 100 years.) Even late last year, note the red “X” in October-November 2018. That’s where Breadth failed to exceed 50% and soon after, the market collapsed in a second selling wave.
For reference, here is the same Breadth indicator from 2005-2009. Note the 2008 Bear Market began when the indicator failed under the 50% line. I marked it with a vertical line below. Soon after that, Stocks finished their topping process and began to decline in earnest. When I look back at the chart from April 2019, it’s a long way from any serious weakness and still looks like a Bull market.
I’ll add more charts next, but it’s important not to forget this simple concept illustrated above. In markets, I believe the simplest ideas are the most powerful. What is simple is often misunderstood. When I started in markets, I thought the most complex indicators would give the best results. I searched far and wide looking for answers. In those early years, my quest for more information led to an advancement in my theoretical understanding, but yielded few practical insights. When I decided to refocus on the right things, everything changed. The most important lesson I learned in those early days was: the market had been communicating the message all along, and simplifying my focus allowed me to listen.
Now let’s go one step further.
The next chart is from an idea I tweeted on May 7, where I noted the “Nasdaq Composite with roughly half its Stocks trading >200dma (red series), similar to where the initial rally topped in April 2016. Intermediate breadth weakening, just 56% trading >50dma (blue series). When this breaks below the 50% line, a correction is likely to be underway.”
Unlike S&P Breadth which as we just saw earlier, got very high at almost 80% of Stocks > 200dma, the Nasdaq Composite Breadth was much weaker and still under 50%. Below is an updated version of that chart. Note that 200d Breadth never did get above 50% and now 50d Breadth is moving back under the 50% line. Not surprisingly, we’re starting to see Volatility creep up again.
There are some striking similarities between the current market and some important prior periods. Let’s look at what they are, and what it could mean.
On May 2, Michael Santoli of CNBC noted the following on Trading Nation:
“As S&P 500 sits at a record, nearly a quarter of stocks are still stuck in a bear market […] at least 20% from 52-week highs.”
This weakness is important to study and discuss. I made this chart to illustrate the idea, with some of my own annotations and thoughts added. What we have is a market that rallied back to prior highs, similar to 2012 and 2016, but many Stocks are still more than 20% below their own highs. In other words, the Trend is strong but Breadth participation is weak.
What happened in 2012 and 2016? Stocks spent months basing near the highs, with two separate pullbacks each time. Exactly like the volatile “red box” consolidations from the very first chart, where we talked about the Trend strength being too high and the mean-reversion that ensued. Everything is tied together and related.
Corrections come when uptrends become extended and Breadth can’t keep up. In 2012 and 2016, the result was that Stocks needed time to rest and gather the energy to move higher.
First, let’s look at 2012:
Now let’s look at 2016:
And back to today:
What could this all mean, and what could we see from here? Following the Summary thoughts shared at the top of this note, here are some ideas I’m carefully balancing and considering, while remaining focused on the bigger picture (and keeping it simple):
- We may be more than halfway through this correction in terms of price. If the 2012 and 2016 interpretations are correct, and we remain in a Bull market as I believe, the S&P index could perhaps bottom in the low 2700s.
- Historically, Stocks went through mean-reverting phases that lasted 3-6 months and we’re still not even a month into this one. So it seems we could still be in the very early stages of this process, in terms of time.
- This could provide plenty of opportunity to slowly accumulate good Stocks as weak hands lose patience, get frustrated or shaken out.
- It seems the market’s goal here is to frustrate Bulls and Bears with a lot of erratic price movement, while ultimately making little net progress either way.
- Because of the extreme volatility of 2018, some may fear this will become another massive decline. Since Mr. Market never makes things easy, a sideways range could be equally if not more difficult to deal with.
- Looking back at history, the good news is that once 2012 and 2016 were out of the way, the following years were excellent for Stocks. The S&P advanced 30% in 2013 and 20% in 2017.
- Those great advances weren’t a coincidence. Stocks had worked off their extended condition through time, while Breadth improved gradually and individual names began to catch up.
- When Stocks had finally gathered the energy to rally again, the breakout came and they never looked back. Maybe we’ll see something similar later this year, when everyone becomes exhausted of the headlines and volatility.
Thanks for reading.
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