EC A Rally For The History Books

Last week I noted that:

  1. You should be bearish right now if you are a short-medium term contrarian trader.
  2. You should be bullish right now if you are a short-medium term trend follower.
  3. If you are a long term buy and hold investor, your portfolio’s long term future returns will be poor. Passive investing will likely underperform active management in an era of high valuations.

As stocks rally into year-end, it’s important to remember that you don’t always need to trade. Going short a rally is dangerous since a rally can always overshoot expectations. Instead, contrarian traders can simply hold cash until the next fat pitch comes along. There are 1-2 good opportunities each year in a volatile environment like the one we’ve been in from 2017-present. Just wait for those 1-2 good opportunities each year. With central banks around the world unwilling to let systematic excess be washed out, such volatility will likely continue for the next 5 years. The more extreme movements markets generate, the more fat pitches there will be.

Let’s look at these risks.

The Bearish Side

Once-in-a-decade mean reversion

One of the most important medium term indicators I look at is “the S&P’s % change from its 2 year low”.

This bearish indicator generates a signal once-in-a-decade. Investors need to be extremely vigilant when it triggers a bearish signal. This indicator currently stands at 66%, an extreme reading which almost always led to stock market losses over the next 2-3 months:

A more dangerous point is when the S&P rallies 75% from a 2 year low. That is a 5% gain from where the S&P stands today (3915). This is how some of the sharpest, non-recession market crashes began:

The following charts illustrate the 3 most recent cases. When traders look at the history books and wonder what caused the 1987 crash, the words “mean reversion” come to mind.

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Moon Kil Woong 4 weeks ago Contributor's comment

If anything it shows how larger companies have been able to grow as the rest of the economy gets ravaged. This trend will likely continue.

Dick Kaplan 4 weeks ago Member's comment

Yes, it will continue unfortunately. I was a bit befuddled to hear that many companies with large cash reserves were doing well during the pandemic, were able to get millions in aid.

Kurt Benson 4 weeks ago Member's comment

Good to see you back here Troy, it's been a while.

William K. 4 weeks ago Member's comment

Interesting and educational, I think.

It seems that history does repeat itself, but not exactly. It also appears that the same effects appear to be coming from similar causes, without the exact correlation being clear.

But that somehow general trends appear to give fair predictions of future actions, but not clearly.

Adam Reynolds 4 weeks ago Member's comment

Good advice.