S&P 500: Expect A Slow Grind To An Early 2017 Top

| About: SPDR S&P (SPY)

Summary

Not every market top is accompanied by euphoria.

Current conditions and sentiment favor a slow, complacent grind higher.

Examples of what price action may look like.

It's hard to imagine this market ever topping. But it will. And even though the majority of traders and investors will be looking for a top in the next 6-12 months, the market will fool most of them and reverse when they least expect it.

I quite often hear there's too many bears for a reversal, and that markets top on euphoria. That's true up to a point. Most seasoned investors are skeptical of the current phase of the rally. Some go with it regardless, some fight it and short. There's very little euphoria, and I don't think there will be when we top.

Euphoria takes participation. Average Joe will be profiting from the rally and shouting about his winnings. Currently we have bullish sentiment readings, but my contra-indicators show retail traders are either short or side-lined:

I have an account with IG index, the UK's largest broker, and their readings show a similar story:

source: www.ig.com/uk/marketanalysis/ig-indices/...

I've tracked IG readings for years and the only time their clients have been right is when a market is turning. i.e. there are 70-80% short through a large rally, and when the rally does eventually reverse, there may be 60-70% still short. They have the correct positioning, not by skill or timing, but because they held on. And guess what? Because nearly all shorts are at a loss when the market does eventually decline, they will close much too soon, either at breakeven, or a small loss. Even worse, a week or two into the declines, the majority will be long!

I also see a lack of euphoria on Twitter, and Seeking Alpha. It's understandable and something I covered in my article, 'Equity Bears Are Right In the Wrong Market'. I think we are in the last phase of the bull market from the 2009 lows. It is driven less by fundamentals and more by short term speculation and positioning (specifically squeezing out shorts and drawing in 'bag holders' at the highs). There's very little for rational investors to get euphoric about.

As much as this market may go up, I don't think we will see much of a buying frenzy. It takes a special kind of bear to change his bias and buy all time highs. Bears will eventually capitulate, but don't expect the shoeshine boy to be giving out stock tips.

The grind

Since the break-out to new all time highs in the S&P500 (SPY), the VIX has been trending down and currently sits around 13.

Click to enlarge

source: stockcharts

With price already stretched, and VIX so low, it's hard for the rally to maintain its current trajectory. It can consolidate and go higher, but I think the conditions now favor a slower grind higher. This will frustrate longs and shorts alike and could end up looking like the long protracted 'rounded top' seen in 2015.

The chart below shows a rough guide as to what a repeat of 2015 might look like, with current price on the 60 minute chart in black, and the 2015 guide in red. Hardly euphoric.

Click to enlarge

We would need to see a sharp drop below the break-out price of 2130 for any similarity to be maintained. This is just one of many possibilities, and actually one I favor less than the path below.

Click to enlarge

This shows a daily chart of the current rally from the February 2016 lows (pink) superimposed onto the initial rally from the 2009 lows. This taps into fractal and Elliott Wave theory where wave 5 (current) often equals wave 1 (the initial recovery), both in size and structure. It projects a choppy move to around 2400 by March 2017.

Of course there is no guarantee of either of the two above scenarios, but the wave 5 = wave 1 is the first place I look for a guide, and so far, it has worked quite well. Both scenarios also fit the thesis where there the rally grinds up over time; both projected tops are in Q1 2017. Are current shorts prepared to hold out that long? I doubt it.

It is hard, even impossible to imagine the many twists and turns of a rally in advance. But past rallies offer clues. If the current rally keeps any similarity either of the two examples above, we may have a useful 'map' into an early 2017 top.

Conclusions

Euphoria and the last bear turning bullish is often a good reversal signal at tops. It may not happen this time. I am looking for a slower, complacent grind higher. The eventual reversal will take the majority by surprise, but I have done my homework and I know what I am looking for. I certainly won't be euphoric at SPX 2400.

Disclosure: I am/we are long BAC, AMZN, GS.

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.