Expecting Weakness: Why the Market's Sugar High Is About to End

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 |  Includes: DIA, QQQ, SPY
by: Sean Hannon

With children changing into Halloween costumes and preparing to trick-or-treat, their chief concern is how much candy they can gather as quickly as possible. As parents prepare for the inevitable crash that accompanies every sugar-high, we hope the swings from giddiness to melodrama are brief and painless.

Investors are making similar preparations. With last week’s statistically insignificant, yet positive, close, the stock market continues pushing higher. Since August 23, the S&P 500 has rallied 11%. During this move, the index has closed higher eight of nine weeks and has yet to suffer a decline greater than 2%. Just as children will shovel candy into their mouths and enjoy instant satisfaction, investors who have bought every dip have done very well.

Those taking an unemotional view of the market logically question how long this pattern can continue. After all, with the markets overbought and in need of a pause, a quick decline would balance sentiment and provide a foundation for further rallies. As discussed in EPIC Insights, I believe the decline will arrive soon.

During this rally, two themes have bolstered stock prices—the Republicans winning large Congressional majorities that allow for a more business friendly political environment and the Federal Reserve’s (Fed) willingness to embark upon an aggressive quantitative easing (QE) program that will bolster asset prices. Now those tenants will be tested.

The upcoming week of 11/1 to 11/5 is packed with important data points, but most investors have narrowed their vision to Tuesday’s election and Wednesday’s interest rate decision from the Fed. The expectations are well known, but the market’s reaction is not. Hoping to add some clarity, three possible scenarios are:

1.Republican victory and a large QE program – The likely and expected outcome, I struggle to see how this would boost stock prices. Only new information will push prices higher and these moves are so well telegraphed that they would surprise no one. Instead, we should witness either selling on the news as investors take profits or markets reacting to the news as a nonevent. Either way, markets should either decline slightly or remain unchanged.

2.Democratic victory and no QE program – With virtually no chance of occurrence, this combination of events would shock investors and lead to a large collapse in stock prices.

3.Only one of the expected outcomes being met – A middle ground, this outcome would surprise investor and trigger a sell-off.

Looking at these three scenarios, I am reminded of legendary University of Texas football coach Darrell Royal’s feelings about throwing the football—“three things can happen when you pass and two of ‘em are bad.” With two of the three scenarios I describe leading to losses and the positive outcome also carrying a high likelihood of lower stock prices, the market’s sugar-high is about to end.