The Top Before The 'Big' Top - Weekly Blog # 567

by: Mike Lipper, CFA
Summary

Market analysts have developed many techniques to identify extreme movements, hoping to spot the appropriate time to reverse course and increase the chance of avoiding large losses or improve the chance of capturing large gains.

One of the charts that has a good record of predicting future movements is called a Head & Shoulders pattern.

For the past couple of weeks, the three major stock indices have produced the same rounding top chart pattern seen during past tops. The critical task is whether to take action based on these patterns or ignore them.

The one certainty about markets is their rise to tops and fall to bottoms. With this knowledge, market analysts have developed many techniques to identify extreme movements, hoping to spot the appropriate time to reverse course and increase the chance of avoiding large losses or improve the chance of capturing large gains. Market analysts have probably used price charts since the beginning of organized markets in the ancient world. One of the charts that has a good record of predicting future movements is called a Head & Shoulders pattern. (No statistical or other measure is 100% successful over time. Being correct roughly 2/3rds of the time produces satisfactory results, and the Head & Shoulders pattern generally does that.)

A price chart is produced for stocks each trading day in The Wall Street Journal, covering each of the three major stock indices: Dow Jones Industrial Average, Standard & Poor's 500, and the Nasdaq Composite. The three generally move in the same direction, but at different speeds. For the past couple of weeks, the three have produced the same rounding top chart pattern seen during past tops. The critical task is whether to take action based on these patterns or ignore them. I wonder if this is a sign of an important reversal, as the reversal pattern shows three distinct top formations.

Since the current market is down a bit from the former 2018 highs, a head is in place. Combine this with the relatively brief rounding tops mentioned and this pattern is predicting the end of the ten-year bull market that we have enjoyed for so long. A normal reversal is to approximately give up between 1/3rd to 1/2 of the prior gain. (If I knew for sure, each of you would be invited on my personal Boeing 747 on the way to a voyage on my battleship sized-yacht. But I don't know.)

There is a second possibility - that the pattern of the last couple weeks is a possible first shoulder to a new high above the 2018 level, with a more distant final shoulder before a major decline. The current absence of "irrational exuberance" for stocks gives me some hope for the second possibility.

Cautionary Signs for Short-Term Investors

In general, commodity prices have been falling for more than a year since they completed their own bull market, while governments and central banks have attempted to drive up growth and the rate of inflation. The continuing abnormal flows into fixed income and credit funds by both individual and institutional investors, at a time when the long-term outlook calls for rising interest rates, suggests that the new buyers are either naive or believe that they have superior trading skills in an increasingly illiquid market. Finally, there is the performance of mutual fund averages through last Thursday night, showing those with year-to-date gains in excess of 15%:

China Region Funds 17.75%
Energy MLP Funds 16.22%
Energy Funds 15.98%
Small-Cap Growth Funds 15.23%
Mid-Cap Growth Funds 15.05%

I suggest that those funds currently showing year-to-date gains of +15% are speculative and should be traded out quickly in a decline. However, if investors believe they have these trading skills, the fund categories may be appropriate for short-term focused portfolios.

Thoughts for Long-Term Investors

While short-term investors dominate trading, long-term investors own the bulk of equities around the world. For the US taxable investor, the last ten years have fattened their prior gains. This raises a question for those seeking to leave a legacy based on a stepped-up basis without paying capital gains tax - is it better to take the valuation now and pay capital gains tax or the alternative valuation as of the date of death? Even with a major market decline, beneficiaries will inherit more than they would have previously. Institutional investors concerned with the use of capital for multiple generations could stay invested, as some of the present holdings may serve them very well.

Mohamed A. El-Erian, chief economic advisor at Allianz, and formerly with PIMCO, Harvard Management and the IMF, has published a piece criticizing economists, particularly those within governments, for their reliance on mathematical models without using behavioral science and game theory. Markets often seem to be better equipped than economists in predicting future trends.

There appears to be some help on the way - the Bank of England is publishing a fan chart of possible future directions in their studies. The Congressional Budget Office (CBO) already shows a fan chart where 2/3rds of the possible outlooks lie. The CBO study predicts that the US government deficit will rise by about 50% as a percent of GDP in 2019. This could be a low estimate, as both political parties are big spenders. I suspect the next Democrat administration will easily outspend the current occupant in the White House. (This is one of the reasons to bet that inflation will rise.)

History Suggests A Brighter Future

After long periods of stagnation, beyond the world of numbers, forces have saved various societies from their foolish management. The Dark Ages in Europe effectively ended with the discovery and importation of Latin American gold. After years of war spending in 19th century Europe, the harnessing of steam power brought greater prosperity, as did the use of electricity. There is a chance that our world will be both disrupted and advanced through the spread of 5G networks, which will practically reach every person, vehicle, and activity. Within this century, the rising education, productivity, and savings coming from South East Asia could be another spur. Finally, the evolution of African resources and its people would produce major benefits to the world economy.

Bottom Line

We are likely to experience reversals and volatility, but also pulsating progress. While a few may have the appropriate insights and trading skills to trade various markets successfully, most won't be able to do it. Therefore, the best position is to stay in the game at various levels with sound and occasionally good investment managers.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.