Is The Market On The Naughty List?

 

Two weeks ago, I warned that the “G-20 rally” had exhausted a bulk of the“oversold” condition which had existed at that time. I also recommended remaining cautious until the underlying technical backdrop had improved. While that turned out to be very good advice, the market is now reversed from where it was then. Markets are back to deeply oversold conditions and are sitting on important support. As shown in the chart below, these conditions have been previously present when markets have bounced.

On Tuesday, we discussed the potential for a “Santa Claus” rally as we head into the end of the year. In case you missed it, here was the important takeaway of that discussion:

“The following graph shows, in orange, aggregate cumulative returns by day count for the 28 Decembers we analyzed plotted alongside daily aggregated average returns by day.” 

“IF ‘Santa’ is going to visit ‘Broad & Wall’ this year, it will most likely occur between the 10th through the 17th trading days of the month. Such would equate to Friday, December 14th through Wednesday, December 26th.”

While the current oversold condition is supportive of a rally over the next couple of weeks, that does not mean this is a “stocking” you should stuff everything into. Given the macro-backdrop, any rally may be short-lived going into 2019 unless some of the pressure from weaker economic data, Brexit, Washington politics, “trade wars”, balance sheet reductions, and softer-earnings growth is relieved.

So far, such relief has yet to be the case as economic data both globally and domestically continues to weaken. As noted on Friday, this weakness is occurring at a time where the Federal Reserve continues to extract liquidity from the market. To wit:

“While the Fed’s rate hikes do indeed raise borrowing costs and slow economic growth, it is the extraction of liquidity from the markets which is most important. As shown in the chart below, the Fed is now reducing their flows by $50 billion each month. This is in direct contrast to the billions they were injecting previously which corresponds with the markets decade-long bull market despite weak revenue growth due to a sluggish economic expansion.”

“But it is no longer just the Fed. On Thursday, the European Central Bank made two important announcements.

  1. They will stop adding to its stock of government and corporate bonds at the end of December, and;
  2. They are seeing signs of weaker inflation and economic growth.

In other words, as world markets are beginning to struggle as the driver of the decade-long bull market is being removed.”

Last week, as we noted at RIA PRO, we put on a small S&P 500 (IVV) trading position for a potential oversold rally. As I noted on Friday, that trade has left much to be desired as the market simply has not been able to muster a sustainable bounce. On Friday, the market closed right at critical support levels.

Given the Fed meets next week, we are going to give our trade just the smallest margin of movement currently for three reasons:

  1. The market is deeply oversold which will contribute to a bounce on any bit of good news.
  2. The index closed lower than where it opened for 4-consecutive days. Such selling is often met with a one or two day bounce.
  3. Lastly, as noted previously, distributions for mutual funds are now mostly complete and they have to rebalance portfolios before the end of the reporting year. With next week having the highest historical probability for a rally, a more “dovish” than expected Fed could spark a bit of buying frenzy

While we are expecting an oversold rally, remember after having reduced exposure in portfolios previously, and carrying a much heavier weighting in cash, we are giving the market time to figure out what it wants to do. Given the consolidation range over the last couple of months, it is too risky to be either overly short, or aggressively long, currently. Cash remains the best hedge currently.

But let me repeat the most important point:

“The expected rally IS NOT the next version of the ‘bull market.’ Nor does a rally mean the ‘bear market’ is over. It will be a counter-trend rally to sell into.”

But it is not just the S&P 500 where this is occurring. As shown, every market is now trending negatively.

As I have noted previously, the weakness in the market continues to be a process that has gripped markets over the last several months as the Federal Reserve has steadily increased their extraction of liquidity. As shown in the chart above, the market has continued to build multiple tops as the 50-dma deepens its divergence from the 200-dma. Currently, downside stop losses are holding, but there isn’t much wiggle room here currently before further actions need to be taken.

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Disclosure: The information contained in this article should not be construed as financial or investment advice on any subject matter. Real Investment Advice is expressly disclaims all liability ...

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