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Aligning Our Expectations: More Caution Lights for the Market?

When we looked at the market in early April, a number of indications were favorable, confirming the bullish perspective from March.  The breadth had not deteriorated as we had seen at the prior market peak.  Since then, we've had challenging news coming out of the Middle East with increased conflict with Iran.  Most pointedly, we've had increased talk of trade wars, with the breakdown of talks with China.  How has that impacted the stock market and what could that mean going forward?

Breadth has decidedly deteriorated.  Although we are not far off the all-time highs in the SPX Index, new monthly and three-month lows across all stocks have outnumbered new highs for six consecutive sessions.  Indeed, in the past 14 sessions, only one day has seen more new three-month highs than lows.  On Thursday, for example we registered 103 new three-month highs across all indexes and 979 new lows.  (Data from Barchart.com).  That is a rather broad correction.  For the past two trading sessions, we've seen fewer than 40% of SPX stocks trading above their 3, 5, 10, and 20-day moving averages.  (Data from Indexindicators.com).

Now here's the interesting thing.  I went back to 2014 and looked for all occasions in which fewer than 40% of stocks were trading above their short- and medium-term moving averages (as above) and yet over 50% were above their 100- and 200-day averages.  That represents a meaningful correction in a longer-term upward trend.  There were 44 occasions in which that occurred.  Twenty sessions later, SPY was up 35 times, down 9 for an average gain of 1.19%.

What's now not to love?

The problem is that two of the downside occurrences were quite nasty and they were the occurrences in February and October of last year, where SPY dropped well over 5% in a week's time.  Since the setup on Thursday, the market bounce has been tepid at best.

This is where I love to have quantitative analyses and where I love integrating those into my discretionary decision-making.  While the odds of a market bounce are good when we correct in an upward market, we also have to be aware of the exceptions to the pattern.  We have made market highs in early 2018, late 2018, and recently in 2019.  Many sectors (such as financials and small caps) have lagged in this recent rise.  Many international equity indexes (look at EEM for example) have lagged badly.  I want to be open to the possibility that these three tops are part of a larger late-cycle topping process exacerbated by international geopolitics and trade concerns.  If that is the case, a very significant decline could ensue.  I have positioned my portfolios accordingly.

The goal is to stay open-minded and continually update market behavior to see if historical tendencies are playing out or if we're seeing yet another exception.  It is helpful to trade with expectations.  It is also helpful to align those expectations with the objective reality of current market behavior.

Further Reading:

Achieving the Benefits of Diversification in Our Lives

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