The stock market fell in decisive manner this week, prompting much fear, uncertainty and talk about the end of the bull market. I received a number of concerned emails this week from clients wanting to know “why” stock markets fell the way they did.
When it comes to the stock market, try not to worry about the “why”
Please remember that the “why” really doesn’t matter when it comes to the stock market.
Yes, markets had a dramatic selloff, so we naturally assume there must have been a cause that we can identify. Unfortunately, that’s just not the way financial markets tend to work. Rather, lots of things are happening all at once and in real time, and markets react however they like.
Take your pick: The trade war, the Fed raising interest rates, inflation fears, bond yields…trying to pick what sparked the selloff is a fruitless waste of your energy and it won’t make you a better trader or investor. Far better just to accept the realities of the market and make the most of what it gives us.
Markets have been very calm and very happy for several months, so some sort of volatility was almost inevitable. The precise timing of these (over)reactions by the stock market is unknowable, which is why I always advocate having some short positions in your trading book, even in a bull market.
Where to next?
I continue to give this bull market the benefit of the doubt, however there are some developments that have made me a little more cautious.
Let me get my more bearish observations out of the way first
False breakouts
We have recently seen a number of false breakouts across the major indices. These are not bullish developments.
Have a look at the chart of SPY (the S&P500 ETF) below. Notice how the 286.5 level (the January high) acted as resistance up until it was broken in late August. then it acted as support when the market re-tested this level in September and again paused there in October. This level will now act as resistance again and may take quite a bit of work to clear.
Same thing in mid-caps
A similar development has occurred in IWM (the Russell 200 mid-cap ETF). These false breakouts are NOT bullish!
The QQQ (NASDAQ ETF) just posted a double-top, which isn’t bullish either.
Now for my bullish observations
I continue to think that the weight of evidence points to a short-term bottom in the markets (at the very least) and a continuation of the bull market in the coming weeks and months. Let me explain why.
We are hitting some big support levels
The orange line in the chart of SPY above is the 200 day moving average (200 DMA).The 200DMA acts as a sort of line-in-the-sand between a long-term uptrend or down-trend. Stocks tend to perform better when they are above their 200DMA.
The SPY ETF has again come back to test its 200 day Moving average. This has acted as a meaningful level of support in the past. On Last Thursday’s low, SPY also probed previous support levels that coincide with the 61.8% retracement level of the rally from the February low.
It looks to me as though the market has done enough work to the downside and can now start consolidating/moving up again.
NB – these levels need to hold. If we see sharp moves lower next week I will likely reassess my whole thesis.
The selloff looks extreme
According to Bespoke, the S&P500 closed the end of the week 3.77 standard deviations below its 50 day moving average. As you can see from the chart below, this is amongst the most “stretched” below its 50DMA the S&P500 has ever been.
The S&P 500 has closed this far below its 50DMA only 11 other times over the past 90 years. In each case, the market rebounded sharply. So decades of history indicate we’re at a short-term bottom at the very least.
Sentiment looks dire
The Daily Sentiment Index (DSI) for both the S&P 500 and the NASDAQ dropped to 10 last week. Readings of < 15% are considered extremely bearish and suggest a short-term rally is likely.
The AAII survey of individual investors showed bullish sentiment had its largest one week drop since mid-November 2017, falling 15.05 percentage points. Bullish sentiment is now down to 30.6% from 45.66% last week. Keep in mind, the AAII survey didn’t even include the last two days. Bull markets just don’t end with this type of pessimism.
We are not seeing a flight to “safe havens”
In a real market panic, we typically see a flight to “safe haven” assets like US Treasuries, the Swiss Franc and the Japanese Yen. Last week bonds finished lower, Swiss Franc was unchanged and Yen was only marginally stronger. This suggests to me that what were are seeing in the stock market is a garden variety selloff rather than the start of something more sinister.
The Advance/Decline line hasn’t collapsed
The A/D line is a measure of market breadth that I have discussed on my last few videos. It has held up well and remains in an uptrend.
Typically the A/D line will break down before a major market top and “diverge” with price action. That is not what we are seeing here.
The US economy is performing strongly
I’ll be the first one to tell you that the economy does not equal the stock market, however bear markets do not typically occur outside of recessions. The US economy continues to perform strongly and critically, both Real Retail Sales Growth and Industrial Production continue to point in the right direction.
Please read my article the Simple Bear Market Predictor for a primer on how to interpret these.
Conclusions
I remain of the view that the path of least resistance remains higher and that new highs will be seen before this market cycle ends. For longer-term investors who are under-invested in stocks and looking to “buy the dip”, this looks like a good opportunity to me. Stop talking about buying-the-dip and start doing it!
For traders, keep your position size smaller than usual and look to trade both sides of the market until the trend becomes clearer. As noted above, I will likely reassess my bullish view if we see further weakness in the S&P 500 in the short-term. Until next time, good trading.