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.

All the historical cases saw the S&P rally further in the short term. But more importantly, the S&P eventually fell enough to erase those gains. This isn’t to say that “today is just like 2010, 1998, 1987”. The future is never just like the past. But traders should be very careful if the S&P rallies another 5-10%. Know where the market’s risk:reward profile stands.

Speculative signs

Speculative signs are popping up everywhere, from tech stocks to IPOs to Bitcoin to leveraged stocks to record-call buying.

Tech stocks are relentlessly grinding higher. The Nasdaq rallied by more than 0.5% on 97 days over the past 9 months. Such non-stop rallies only happened in the 2nd half of 1999. Back then, stocks rallied for another half year before the bubble popped:

To better put this speculative environment into context, look at the performance of Bitcoin vs. recent IPOs vs. the Nasdaq Composite vs. the S&P 500. The more speculative an asset is, the better it has performed in 2020:

As I noted on Wednesday, traders are chasing the riskiest of assets these days. An index of the most shorted and most leveraged stocks has outperformed the S&P 500 by a record 129% over the past 9 months (March 2020 bottom – present). The previous record of 83% was on December 3, 2009. To put that into context, U.S. stocks performed poorly in the first half of 2010.

Other signs of excess optimism

As I noted on Tuesday, the average Wall Street strategist expects the S&P 500 to gain 10% next year. While expectations of such gains are common in years when stocks crashed (strategists expect stocks to bounce back next year), they are uncommon when stocks did well this year. In other words, Wall Street strategists are chasing the rally right now and predicting that it will continue.

Their track record is poor:

1. December 2006: the bull market ended in 2007
2. December 2007: massive bear market in 2008
3. December 2014: stocks tanked in August 2015
4. December 2015: stocks tanked immediately in January 2016
5. December 2017: stocks experienced heavy volatility in 2018, with a crash in Q4 2018
6. Now

Insiders

Continuing from last week’s Market Report, corporate insiders are still not buying their own stocks. They have little reason to buy right now – corporate insiders usually buy low and sell high.

There were 177 other historical days on which the S&P 500’s insider buy/sell ratio was this low. The S&P 500’s forward returns over the next few months were consistently worse than random:

Being objective on the bullish side

One must examine BOTH bullish and bearish factors in order to properly analyze the market. The market is never 100% bullish or 100% bearish – anyone who tells you otherwise is misguiding you.

Breadth, momentum, breakouts everywhere (bullish)

Breadth and momentum are bullish factors for this “everything rally”. More than 80% of stocks around the world are above their 200 dma for the first time in almost a decade!

When this happened for the first time in more than 200 days, global equities usually charged higher over the next year:

U.S. Dollar recovery

The U.S. Dollar continues to slide lower as emerging market stocks surge higher. This has pushed the USD Short Term Sentiment’s 1 month average back down to one of its lowest readings ever:

Contrary to popular belief, sentiment shouldn’t always be used as a contrarian indicator. Extreme sentiment in markets with strong momentum characteristics (e.g. commodities & currencies) is often a sign of trend continuation. When the U.S. Dollar’s sentiment was this low in the past, the U.S. Dollar Index usually fell further in the next few months.

The USD’s next support is at 88-89. If the USD falls to this support before bouncing, the current inverse correlation between the USD and the S&P is a short term bullish factor for the S&P.

Conclusion

Speculative signs are popping up all over the world. Once again, this is not something to be worried about if you are a trend follower. If that’s your trading strategy, remain long but keep a close eye on your protective stops. If you aren’t a trend follower, now is the time to be cautious. Stocks can certainly rally another 5-10% (year-end rally!). But ask yourself this: do you need to trade when it’s dangerous to be long (too many signs of excess) and ALSO dangerous to be short (a rally can overshoot expectations)? If your answer is “no”, then don’t trade. Wait on the sidelines with your dry powder until the next big opportunity comes along.