We are finding ourselves at a critical junction in stocks. The recent rally lifting SPY off the February lows has extended further than anticipated. The bulls continue to drive demand, and shorts are covering on each break higher.
In my observation, stocks entered a bear market last summer based on the fundamental and economic factors I follow. This has been reflected in the charts which were showing typical long-term topping patterns. Market internals, sentiment and economic signs also pointed at a turn-down. Notably, inter-oceanic shipping and transportation were warning of an economic slowdown. Oil prices were causing grave concerns regarding the financial repercussions on the lower-rated issues in the credit sector.
Is the current rally indicative of a change in all the concerns that were valid just a few months ago? Oil just lifted above $40 per barrel; it could be on its way to $50 per barrel, which is an area that starts to alleviate a lot of financial pressure. The US dollar has stopped strengthening, which is improving the debt repayment prospects of emerging countries that repay their debt denominated in dollars. The transportation and industrial indices are showing strength as well. A weaker dollar improves the outlook on commodity prices.
Whether these macro changes in direction for the main components of the economy will stick remains to be seen. Admittedly, there are still many headwinds that face continued stock market upside. The negative interest rate policies (NIRP) of Europe and Japan showcase the dire situation of the central bankers that essentially have their backs against the wall in terms of how to provide further stimulus. It is also an admission of how poorly performing the overseas economies actually are.
The hazards to the financial system are not to be underestimated; many overseas banks are close to needing supportive measures, and NIRP causes a difficult operating environment for financial institutions including insurance companies. In addition, NIRP is not showing to be effective at creating stimulus and can therefore be termed a net negative (no pun intended) strategy. I think future historians will point that out.
Bull markets can climb a wall of worry, but this bull is aging, and the overall picture tells me we are in a bubble of "oversupply". An oversupply leads to lower valuations, i.e. deflation.
There is too much:
- Debt, private, corporate and governmental.
- Commodity supply, oil, natural gas, steel, etc.
- Financial stimulus; the incremental stimulus since 2009 is stupendous in size and scope.
A prognosis for future direction in the overall domestic stock market is muddy at best at this juncture. A hedged portfolio or a neutral approach or just cash until the dust settles is not such a bad strategy.
A quick look at the SPY chart reveals where the price has been and provides a visual reference for decision making. It also reflects the psychology of the market participants in a graphical format. In bull markets, participants have little fear, daily advances are smooth and extend over months and years. In bear-like markets, there are many more gaps, which are the result of fear and apprehension of possible downside moves. Since last summer, I have observed a difference in the representation of this behavior. The psychology of market participants has changed. Instead of using a specific percentage correction, generally 20%, I prefer to use participant behavior to characterize a bear market. As far as I am concerned, we are in a bear market. But I could be proven wrong.
As a market timer, I use many models to attempt finding higher probability inflection points. There are too many data points to get a clear picture for timing purposes, but when I lean towards a direction in terms of bull or bear and I look for a moment in time to take action, I revert to the simplest tool I have, and that is the chart. For me, there is an inflection point staring us in the face; it is illustrated below:
On this weekly chart, we can see that 181 on SPY is a key support area. the recent "double bottom" is not actually a double bottom. This is a support area that has already been tested three times; four if we count the near miss in August 2015. A failure of this area is a major but fairly late warning to investors. The critical inflection point near 208.50 is a high probability price point at which new sellers could enter the market. The opposite is true also. If SPY continues up through this level, it would open up the possibility for a further move up as shown in the monthly chart. Both multi-year scenarios are drawn out.
Nobody knows the answer to the market direction question, but it is at least good to acknowledge the possibilities. Then, there is the Fed. How many times will the Fed raise rates in 2016/2017? Currently, it sees the need to be cautious, and that is constructive for the markets.
I just can't see or maybe don't want to see the upside scenario and may need to adjust the tint on my glasses, but in writing to you, I have to be impartial and look at both sides.
Could a glimmer of positive resolution in the oil sector, plus the overseas stimulus factor, drive stocks past their highs of summer 2015? That is a possible scenario, what could disrupt it? When is the stimulus/debt/deflation bubble going to burst? Are corporate earnings going to pick back up?
As a long-term investor, the moment might be ripe to add a portfolio hedge in the form of longer-dated puts. An alternative is calls on the SPXS, they are pretty cheap going out to 2018, and would benefit from a volatility surge as well. This is much like buying insurance on other assets.
An option for traders is to play this short or medium term one to six months out with their favorite shorting tool. Put options, inverse triple ETFs, puts on a relatively weak stock in weak industries are some examples.
Disclosure: I am/we are long USO, SPXS.
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.