Everybody loved a bull market. Sentiment improves and even lackluster stocks find a bid.
Unfortunately, a never-ending bull market is a fairy tale. However, there are multiple kinds of bull markets. Some markets develop a bullish trend and can maintain that trend for many months. The key is that they do not go vertical and do not go weeks without profit taking. A prime example would be the bull market from July 2011 to July 2015. The S&P rallied from 1,075 to 2,135 or a whopping 1,060 points.
The rally was sustainable because there were regular bouts of minor profit taking and the rate of climb was not unreasonable. The S&P rose 5-7 points a day for 5-7 days and then rested for 3-5 days. This allowed existing investors to capture profits and offered new investors an opportunity to buy the dozen or more dips.
S&P Rally 2011-2015
In 2015/2016 that four year rally paused. We went sideways with declines of several hundred points more than once. Investors who had grown accustomed to the nice calm cycles over the prior four years were chewed up in the sideways volatility that followed.
Another kind of bull market is the one we are experiencing now. This is a special event market. Everyone waited with baited breath for the Brexit vote and the volatility appeared but lasted only two days. The rally was sharp but lasted only slightly more than two weeks.
The U.S. political campaign began to heat up in July and volatility dried up for four months. The markets began to factor in the worst outcome and the S&P declined to 4-month lows. Trump won and with the exception of four days in late November, the market has been vertical. This is not sustainable. If you compare the post election bounce below to the five years represented in the chart above you will not see an equivalent move of 175 points in five weeks. Markets that move that far, that fast tend to correct with equal speed.
However, if you look at the chart below there was another 150-point surge in 2016 after the Brexit vote. That surge took months to digest and consolidate. Markets do not behave well after periods of bullish excess.
In the current market, there are no indications of a pending collapse. That in itself is almost scary. The biggest declines are the ones that nobody expects. The MACD and RSI are at their highs and still accelerating. Markets can decline before the indicators flash a warning so we cannot depend on those at this point.
In this market, we need to look for external events that could cause traders to take profits. We already know that nearly every long position at this point has trailing stops. Every trader/investor that is currently long is amazed at his good luck and they are afraid to take profits because the market could go higher. Markets do tend to have these streaks from time to time and nobody wants to exit only to see the S&P rally another 100 points. While that is not impossible, it is highly improbable.
So what are the events that could end the rally? The Fed announcement next week could be hawkish and predict 4-6 rate hiked in 2017. That is also highly unlikely and the market has already discounted that potential. The market expects a December hike and then probably a hike in March with a relatively dovish Fed willing to let the economy run "hot" as Yellen said in a recent speech. So, the Fed announcement is not likely to be a problem.
Dow 20,000 is another potential hurdle. It is almost a given that the Dow will reach that level before Christmas. Very large round numbers at the end of a long rally tend to be electrically charged. I can remember many times over the last 25-30 years when a round number became a "sell the news" event. I cannot imagine a bigger, rounder number than 20,000 and it would come after a very overextended rally. I would say the risk of a selling event is high.
Offsetting that is the race to year-end by thousands of fund managers. They are in a very tough competition to beat their peers for total return and it is a hotly contested race. Many, probably the vast majority, were late to the party and now they are throwing every penny they have at the market in hopes of securing their bonuses and keeping their jobs. That could power window dressing right up to the end of December.
The perfect storm would be some "pre-selling" before the Dow actually got to 20,000 and the market could chop around in the 17,000-19,000 range until Christmas. A late December surge of window dressing after the holiday could push the Dow to 20K by the end of December and all hell would break loose on January 2nd as everyone tries to unload those positions at the same time.
January can be brutal. It does not always happen but when markets have been strongly bullish in Q4, January tends to see selling. Investors can take profits and not have to pay taxes for another year.
Given the post election rally, the move into a new tax year could be dangerous. Remember January 2016? The Dow gave back 1,850 points in just over two weeks.
Lastly, there will be a presidential inauguration on January 20th. More than one million people will attend the swearing in and a million more could line the parade route. There is an effort underway to get two million people from the opposing party to show up and protest. This could get really ugly.
There is always the potential for a terrorist attack. Whenever you get a million people in one place in this day and age, there is extreme risk. Traders with profits from the current rally will definitely want to take those gains off the table before the event.
The point to this commentary this week is to encourage investors to be aware of the coming events and also be aware that the current rally is not going to continue forever. The post election honeymoon period is coming to a close. Count on it.
There is an old saying in the markets. When the VIX is high it is time to buy. When the VIX is low it is time to go. The VIX closed under 12 on Friday and at historically low levels. While a volatility event may not happen for days or even weeks, we know without a doubt it will happen. Be prepared.
Enter passively and exit aggressively!
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