In
less than 8 weeks, the flagship S&P 500 stock index (SPX) has
relentlessly powered 12.6% higher. This big run has been very
unbalanced too, utterly dominated by long up-day streaks. And for the
most part, the occasional down days have been trivial. The SPX simply
continues to melt up day after day, its surreal levitation act making traders
nervous.
With
most technical and sentiment indicators pegged at very overbought states,
consensus naturally expects a sharp correction. One would certainly be
nice, as it would neutralize today’s stupendous complacency and erase
much short-term risk from the marketplace. But interestingly, there is
another thesis that traders ought to consider.
Perhaps
this SPX levitation act is actually righteous.
I know this sounds crazy, and in most market environments it would be.
But at today’s peculiar place in the greater bull-bear cycles,
levitating is actually what the stock markets do. And if the odds favor
the SPX continuing in this surreal course, the optimal trading strategies are
wildly different from consensus.
Knowing
where we are in the bull-bear cycles is like having a strategic roadmap for
the stock markets. There are two kinds of bulls and bears, secular and
cyclical. The secular variety last about 17
years each, and within them smaller multi-year cyclical
bulls and bears flow and ebb. We are currently in a secular bear that
started in March 2000, and
a cyclical bull within it that launched a year ago in March 2009.
It
turns out that starting around 6 months into cyclical bulls within secular
bears, the kind of SPX levitation act we are seeing today is typical. The stock
markets initially rocket higher out of their secular-bear lows, but then they
start relentlessly grinding higher without any major corrections.
Pullbacks are seen periodically, but these are pretty small relative to the
massive moves higher.
This
phenomenon is quite clear in past cyclical bulls within secular bears.
When you overlay today’s markets on those examples, they match up
remarkably well. Today I’m considering two such past
episodes. The first is the last cyclical bull within today’s secular
bear that erupted in March 2003. The second is a cyclical bull in the
mid-1970s that launched at the same point in that previous secular bear where
today’s cyclical bull was born in today’s secular bear.
Since
the cyclical bull that emerged in early 2003 was inside the same secular bear
we are drifting in today, it had a very similar trading range. In fact,
these cyclical bulls share a common SPX scale. The stock markets’
behavior in each is remarkably similar. Today’s SPX cyclical bull
in blue is superimposed over the 2003-to-2004 SPX action in red. This
chart is quite startling if you haven’t studied it before.
Both
of these cyclical bulls started rocketing higher out of deeply-oversold March
lows. Both had June interim highs followed by summer pullbacks.
Then both had autumn rallies punctuated with minor pullbacks. And after
these wickedly-fast early-cyclical-bull gains, both failed to see a single
full-blown correction. The many similarities here despite the 6-year
gulf of time are extraordinary.
For
our purposes today, check out the pullbacks. In our current cyclical
bull, we have really only seen 4 after that initial vertical surge out of the
lows. They weighed in at 7.1% over 19 trading days ending in July, 4.3%
over 8 days ending in October, 5.6% over 9 days also ending in October, and
8.1% over 14 days ending in February. This averages out to 6.3% over 13
trading days, which is really pretty mild as far as corrections go.
So
what makes a correction? Like much in the markets, the definitions are
varied. Many traders believe a correction has to hit 10%+, before then
it is simply a pullback. Others believe corrections drag a price back
down to its 200-day moving average, something that has never come close to
happening in today’s cyclical bull since its 200dma turned
higher. By both of these definitions, we certainly haven’t seen
any corrections yet.
Despite
this, since early August traders have been zealously looking for
correction-magnitude retreat events. I counted myself among this group
as well late last year, before I had done the initial research and
found out these levitation acts are normal
at this stage in cyclical bulls. Anyone who has relied on conventional
technical or sentimental analysis, and has been sitting out waiting for a
correction, has forfeited some awesome gains.
And
interestingly, this behavior tends to persist in the second year of cyclical bulls.
Note above in the red SPX series in 2004, the equivalent of 2010 in
today’s cyclical bull, that minor pullbacks continued to be the order
of the day going forward. Back then the SPX saw a 5.7% retreat over 29
trading days ending in March, 5.8% over 29 days ending in May, and 7.1% over
35 days ending in August. This averages out to 6.2% over 31 trading
days, which is nowhere near correction-magnitude.
Thus
across both
young cyclical bulls, we saw average pullbacks in the 6% range. The
worst ones ran 7% to 8% or so. Based on this precedent, perhaps the
odds for any full-blown corrections in the rest of this year are much lower
than most traders assume. If the rest of 2010 tracks like the rest of
2004, the same stage in these respective cyclical bulls, we will merely see
relatively mild pullbacks from time to time.
Another
interesting thing about the 2004 scenario is the SPX entered a high
consolidation after enjoying such awesome early-cyclical-bull gains.
Between March 2003 and February 2004, the SPX shot 44.6% higher.
Meanwhile today’s bull soared 70.0% between March 2009 and January
2010. While the latter’s gain is much larger, most of this was
due to the SPX starting off a lower base. The terminal plunge in February
and March 2009 was a lot more severe than its counterpart 6 years earlier.
Provocatively
in both these cases, the SPX initially stalled out near 1150 in the January
timeframe. After that in 2004, it generally ground sideways to
lower. While today’s path has instead taken it to new highs, they
aren’t materially above January’s (just 3.4% higher this
week). So there is a good chance we may very well see another high
consolidation for the next 7 months or so centered around 1150. Summer
tends to be a weaker time for stocks, so our high consolidation may have
another downward bias.
And
interestingly, this high consolidation in year two of a mid-secular-bear
cyclical bull holds true in the last secular bear too. It ran nearly 17
years, from February 1966 to August 1982. In rough
terms, 2009 is the equivalent of 1975 and 2010 of 1976 in that earlier
secular bear. This chart also highlights the giant sideways trading
ranges that make up secular bears. Most investors assume secular bears
go lower, but the truth is they grind sideways
on balance for 17 years.
Note
that after emerging out of late 1974’s stock-panic-like event, the SPX
rocketed higher in 1975. We saw this same phenomenon in 2009, the first
year of a mid-secular-bear cyclical bull at the same point in the bull-bear
cycles as this example above. But in 1976 this fast rally flattened out
and consolidated high. For most of 1976, the SPX generally meandered
within today’s equivalent of 1075 to 1175.
And
the largest retreat you can see in 1976 ran from September to November, 8.4%
over 35 trading days. While on the large side for a pullback, it was
still certainly no correction. And interestingly these numbers jibe
well with the pullbacks observed in 2004 and 2010. So there is plenty
of precedent from this particular stage in bull-bear cycles suggesting that
traders shouldn’t
expect major corrections despite the big rallies.
Why is
this the case? How can the SPX levitate near highs after such large,
fast, and unbalanced rallies? I suspect there are many reasons, but
several primary ones leap out in my mind. They are technical and
sentimental, with the latter psychological components likely playing the
greatest role in driving these surreal SPX levitations.
Note
in the chart above that secular bears have giant
sideways trading ranges. In our bear today, this runs between roughly
750 and 1500 on the SPX. Since 2000, the SPX has rarely fallen below
750 or climbed above 1500, and none of these outlying extremes persisted for
too long. In the context of this giant secular trading range,
today’s 1150ish SPX remains relatively low. It is merely in the
middle of its secular range.
So
while it is true the SPX has rocketed 75.8% higher in just over a year, an
amount which admittedly seems absurd on the surface, the SPX’s absolute
levels today are not extreme considered in their longer context. After
plunging 56.8% in its last cyclical
bear that ended in March 2009, the SPX had a lot of ground to make up.
And despite its gigantic early-cyclical-bull rally since, it remains far
under its October 2007 levels of 1565 at the top of its last cyclical bull.
Since
the SPX isn’t super-high by any means when considered in broader
context, this explains why it can consolidate at what looks like high
short-term levels technically. The absolute SPX levels are still
relatively low even within the context of our secular bear. Most of the
huge rally we saw in the past year was merely an offsetting bounce after a mind-blowingly
brutal stock-panic plunge that drove the stock markets to
ridiculously-oversold levels.
But
even more important than secular technical context is the psychology of early
cyclical bulls. As you know, most investors missed out on the great
majority of this past year’s humongous rally. Instead of being
hardcore contrarians and very bullish
on the stock markets in March 2009 like we were, they
bought into the whole mainstream end-of-the-world sentiment thing.
Despite one of the biggest stock-market rallies of the modern times since,
trillions of dollars sat out languishing in zero-yielding cash.
It is
really pretty sad. When everyone is bearish is the best time to be
bullish, and contrarians and students of the markets realized this. But
mainstream financial thought didn’t, and investors lost trillions in gains
because of this short-sightedness. As the post-panic rally grew larger
and larger, the psychological pressure on those investors who missed out on
most of it grew ever more intense. There was and is tremendous pressure
to get out of cash and get invested.
Thus
every time there is a pullback in the SPX, legions of investors and
speculators are waiting on the sidelines eager to deploy on any sign of
weakness. Their collective buying pressure is immense, and this
buy-the-dips dynamic is probably why we only see relatively mild pullbacks at
this stage in a mid-secular-bear cyclical bull. Catch-up buying short
circuits every pullback before it can snowball into a correction. I
don’t expect this to abate until the vast majority of the mountains of
cash on the sidelines get deployed.
And
while the psychological pressure of missing out and rushing to catch up is
intense for individuals, it is an order of magnitude worse for professional
money managers. If you are running a fund and find your performance
lagging your peers’ because you weren’t fully invested in this
cyclical bull, your investors start pulling capital out of your fund.
Underperformance in a strong market kills funds. You can’t sit in
cash if your peers aren’t, thus you have to aggressively buy every
minor retreat to attempt to get fully deployed.
So
there are great technical and sentimental reasons why these SPX levitation acts
are plausible at this particular stage in the bull-bear cycles. Stock
prices aren’t high in the grand secular scheme and investors who
weren’t contrarian enough to ride most of the early-cyclical-bull rally
are desperately buying whenever possible to attempt to catch up. This
dynamic will likely persist throughout the rest of 2010.
Thus
as traders, we have to realize that we probably won’t get that major
correction that looks so desperately overdue by many technical and
sentimental measures. This makes short-side bets look a lot less
attractive despite the short-term overboughtness pervading the stock
markets. It also means that traders waiting for a major correction to
deploy are likely to continue to be disappointed. A high consolidation
with minor pullbacks doesn’t create any deeply-oversold buying
opportunities.
At
Zeal we are actively playing this SPX-levitation environment in multiple
ways. First, we continue to look for relatively-oversold
commodities-stock sectors and individual stocks. The best example today
is the gold and silver stocks, which we have been deploying in aggressively
in recent months. After having recently weathered a giant 27.6%
correction ending in early February, they are cheap relative to gold
itself. We just published a comprehensive new
report detailing our dozen favorite advanced-stage junior
golds. Buy your copy
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Undervalued
individual stocks have the best potential to thrive in this ongoing high
consolidation. We are also avoiding the temptation to short stocks and
indexes that look overbought. It is hard to make money on the short side
without serious corrections. If you want to grow your knowledge of the
markets and greatly increase your odds for trading success, subscribe today to
our acclaimed monthly
newsletter. Our subscribers know about these
trends and how to trade them long before the mainstream.
The
bottom line is today’s surreal SPX levitation act is probably
sustainable. Yes the markets look overbought and a sharp correction
would do wonders to rebalance sentiment. But at this stage in the
bull-bear cycles, all that is likely is high consolidations interrupted by
periodic mild pullbacks. This is primarily driven by psychology, the
need for investors late to the rally to chase the gains they missed.
While
it flies in the face of conventional analysis not to consider today’s
stock markets ripe for a plunge, as traders we must adapt to prevailing
conditions. And emerging out of deeply-oversold lows in a young mid-secular-bear
cyclical bull, the odds don’t favor major corrections. In fact
they don’t exist in history at this stage in bull-bear cycles. So
prudent traders have to hold their noses and go with the high consolidation.
Adam Hamilton,
CPA
Zealllc.com
March 26, 2010
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Adam? I would be more than happy to address them through my
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more information.
Thoughts,
comments, or flames? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that I
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