Equity Bears Are Right In The Wrong Market

| About: SPDR S&P (SPY)

Summary

If equities blow off, fundamentals could be ignored temporarily.

Rationalizing an irrational market can be expensive.

Long term positional traders have left the building.

Fundamentals are black and white, but what if the market is grey?

There are hundreds of potential drivers in each market, but only a handful really matter at any one time. You may be right about the bearish fundamentals for equities, but they may be ignored for the next year. Being right in the wrong market can be dangerous to your account.

The irrational market

There is a never ending stream of data for the market to digest. Price is a function of that data, or at least it seems that way. Price also tells us what data is relevant now and what it really cares about. Knowing what is driving a market is essential. It not only tells you what to monitor, it says what you can put to one side and label, 'relevant later'.

There is no better example of price ignoring fundamentals than the behavior during a bubble. When the Nasdaq traded at more than 100x forward EPS in 1999, most well informed investors had been cautious already for some time. But price kept rising; as long as going long made you money, no-one seemed to care much. This recklessness eventually caught up with the market, but not before destroying bears first.

Applying fundamental reasoning to a market driven on speculation and greed is like hammering a square peg into a circular hole. That is not to say fundamentals are irrelevant. They will always win in the long term. Markets cannot stay irrational forever, but as the old saying goes, they can 'stay irrational longer than you can stay solvent'.

Today's market

When I am talking about 'the market' in this article I am referring specifically to equities and the SPDR S&P 500 Trust ETF (SPY). The same concepts can be applied to many instruments, but not necessarily at the same time.

So how can we characterize today's market? To put it simply, there has been a 2 year consolidation in price accompanied by mixed fundamentals. The majority of U.S. macro is strong, but earnings and debt are worrisome, and the rest of the world is stumbling from one crisis to the next.

Fundamentals have mattered in this market, which is why price has generally gone nowhere. However there has to be a break one way or the other pretty soon - it can't go nowhere forever. It remains to be see which way the break will happen, but it is common for price to go too far in one direction before reversing. This is the last irrational move at the end of a trend. In this case, the move is likely to be up.

I think it's safe to say the bull market from the 2009 lows is mature. Looking at the size and duration of other bull market rallies gives some context:

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We can also look at the trend in terms of phases, or waves. The trend is still clearly up, but there is momentum divergence and the trend is visibly weakening after the huge run of 2012 - 2015.

Looking at the structure of the trend, and given the probability it is in the latter stages, we could say the SPY has just completed a large consolidation for wave 4 and has started a wave 5 rally (the last part of the trend sequence). See here for a quick guide to what this means.

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Here is how alphaking.com describe this stage of the trend:

'Once the selling pressure of the Wave 4 correction subsides then a blow-off speculative Wave 5 impulse move begins. This is the territory of the novice, and the investor who trades on emotion. Unlike the solid advance of Wave 3 - the reality wave - Wave 5 advances are carried on a wave of speculative greed with the desire to get-rich-quick spurring on the momentum players, who often feel they cannot lose with this stock since it is seemingly acting so well. They scoff at the cautious words of the veteran trader who warns of excessive valuations. "It's different this time, old timer," is their mantra.'

I don't think it matters if you agree with Elliott Wave principals or not. The description fits the current phase of the market quite well.

Please note the above chart uses a logarithmic scale. Linear targets for wave 5 are much more conservative at $235-$240.

Long term fundamental investors

If the current phase of the market is driven by short term speculation and greed, then it is fair to assume 'smart money' will know this and choose to sit it out.

I believe this is actually the case:

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The above chart shows the amount of volume traded at each price as a histogram on the left. The lower box shows a heavy volume traded during the early phase of the rally. The upper box towards the highs again has above average volume.

Who is doing the selling at the highs and who is buying? I can't say for certain, but I will make an educated guess that the long term positional traders buying near the lows are now distributing near the highs. They know the rally is mature and are taking the opportunity to lighten up.

When the bull market does come to an end, the smart money will be well positioned. Selling into strength for the last 2 years will allow them to navigate the next bear market.

Short term speculators may have their day, but fundamentals cannot be ignored for too long. When the market starts its decline, long term investors will not support it and 'buy the dip'. A dip for them is a lot larger than most expect.

Conclusions

There may many fundamental reasons to be bearish equities. I'd say the majority of articles I read on Seeking Alpha are bearish and I can't disagree with the facts presented. However, the aim for every investor is to make money, not be right. If being right in the wrong market loses you money, then it is perhaps time to shift focus. If the current market is driven by greed and short term speculation, then it is a dangerous time to be rational.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.