Our long term S&P 500 model states that the U.S. stock market is not in a bear market. We define “bear markets” as declines that exceed 33.33% and last more than 1 year.

Our medium term S&P 500 model has been predicting a significant S&P 500 correction since the end of March 2015. We define a significant correction as either a big correction or a long consolidation.

Neither a big correction nor a long consolidation has been completed as of October 9, 2015. Hence, we are waiting for a significant correction to be completed before we buy stocks.

If the S&P 500 completes a long consolidation, we’ll buy back our UPRO (3x leveraged S&P ETF) at approximately the same price that we sold it at. If the S&P 500 completes a big correction, we’ll buy back our UPRO at a 40%+ discount.

We’ll cover the following topics in this post:

1. Shorts are getting squeezed.
2. The S&P 500 will reverse down from its 200 simple moving average (sma).
3. These bear market charts are wrong.

 

Shorts are getting squeezed

The S&P has been rallying furiously since October began. It rallied 140 points in 8 days. There is only one explanation for this level of strength in the market: bearish traders are getting short squeezed.

Short interest has been very high since the August 24 crash. Many traders believe that the S&P will retest its August 24 lows. (We believe that too, but our belief means nothing. We follow our models 100%.) With such a large amount of short positions, it’s very easy for bullish investors to create a massive short squeeze like the one we’ve seen over the past 2 weeks.

The following chart from Sentimentrader illustrates NYSE short interest. As you can see, short interest is very high historically speaking. It is now higher than it was during the big corrections of 2011 and 2010.

 

 

The S&P 500 Should Reverse Down from its 200 SMA

The good traders that we talk to are all waiting for the S&P to reach the 2060-2040 range before they start selling. Perhaps their short term outlook is correct. 2060 is where the 200 sma lies, and 2040 is previous support that has now become resistance.

 

 

One of two scenarios are playing out right now.

1. We are in the midst of a long consolidation and August 24 was the low of this consolidation, or…
2. We are in the midst of a big correction and the S&P will make new lows (i.e. to the 1800-1700 range).

We don’t know which of these 2 scenarios will play out. But regardless of which scenario plays out, the S&P should temporarily reverse down from its 200 sma.

History shows us that the S&P always backs down from its 200 sma in both scenarios – “the bottom is in” scenario and the “new low” scenario. The S&P always retraces at least 61.8% of the prior rally. If the S&P 500 retraces 61.8% from 1821 to 1960, it’ll fall to 1910-1900 level.

This means that if we’re going to buy stocks, we should at least wait until the S&P retraces to this level.

The following chart illustrates what happened in 2011. The S&P crashed in August, made a new low in October, rallied to the 200 sma, and then retraced 61.8%.

 

 

The following chart illustrates what happened in 2010. The S&P bottomed in July 2010, bounced to its 200 sma, and then retraced more than 61.8%.

 

 

The following chart illustrates what happened in the long consolidation of 1994. The S&P bottomed in March 1994, bounced to its 200 sma, retraced 61.8%, and did not make a new low.

 

 

The following chart illustrates what happened in 1990. The S&P bottomed in October 1990, bounced to its 200 sma, retraced 61.8% and did not make a new low.

 

 

So it doesn’t matter if the S&P will make a new low or not. Either way, it should back down from its 200 sma.

Some traders think that the S&P will fall to 1650 if it breaks 1800. They’re using the classic head-and-shoulders pattern. They argue that a break of the “neckline” will precipitate a crash to 1650. We do not use chart patterns at Investing Track.

It’s important to not read too much into the market’s short term direction. No one really knows where the market will go in the short term. (It’s just a game of probability.) The following chart sums up Jim Cramer’s opinion on the market’s short term direction.

 

 

These Charts are not Valid Bear Market Arguments

Bear market arguments are still flying off the shelves despite the recent rally in stocks.

Our model has predicted each of the 6 bear markets since 1920. Bear markets usually began around 3-6 months after our model emitted a sell signal. Our worst bear market call was in 1999 when we called a bear market early by 9 months (the bear market began in 2000). Thus, we have a very high level of confidence in our long term S&P 500 model.

Despite our high level of confidence, our model may be wrong this time. We believe that this bull market still has 3-5 years left to it, but perhaps the bear market began without our model emitting a sell signal. The odds of our model making this mistake are slim, but perhaps our model is missing something.

Regardless, we’re sticking to our guns. But even if a bear market has begun, we’d like to know the reasons. And the following bear market arguments are just wrong.

A Line in a Chart Does Not Determine Whether It’s a Bull Market or a Bear Market

There’s a popular chart that’s making its way around trading desks. In essence it looks like this, courtesy of NorthmanTrader.

 

 

The chart illustrates the S&P 500’s 5 monthly exponential moving average (ema) crossing below its 20 monthly sma. This chart essentially means that the current bull market is running out of steam.

It’s true that bear markets began the last 2 times this situation occurred. This is what what bearish investors are basing their doomsday scenario on. “A bear market has began because the bull market is running out of steam”. Here’s why this belief is misguided.

It is perfectly normal for a bull market to “run out of steam”, consolidate or correct, and then rally furiously. Going back in history shows us that the 5 monthly ema crossing below the 20 monthly ema can be bullish!

The following chart illustrates how the 5 monthly ema crossed below the 20 monthly ema in 1994. After a massive 1 year consolidation, the S&P’s bull market roared back to life and expanded by multiples in the ensuing years. Bearish investors were skinned alive.

 

 

Charts such as these are particularly popular among trader circles. Traders have a problem because they think that bear markets begin merely because of a technical pattern. In their lingo, “only price matters”. “A bear market has begun because the price is falling”.

False. Price action AND fundamentals matter. Bear markets begin because:

1. The market is in a bubble and that bubble is now popping.
2. The U.S. economy was dealt a devastating blow.

There’s another chart similar to the first one that’s going around trading desks. In essence, it looks like this, courtesy of Mella.

 

 

Like the first chart, the S&P facing resistance at the 20 monthly moving average doesn’t mean anything. Yes, it’s true that bear markets began the last two times this happened. However, bear markets did not ensue when this happened in the 1960s, 1980s and 1990s. The S&P 500 often faces resistance at the 20 monthly moving average during big corrections.

 

A “Death Cross” Is Not Bearish

The S&P 500 made a “death cross” (50 sma crosses under the 200 sma) more than a month ago. It’s interesting how many traders yell “bear market!” merely because 2 lines have crossed.

 

 

Brett Arends from MarketWatch conducted a study that goes back to 1900. The study shows what happens to the S&P 500 when a death cross occurs.

A death cross did not predict even a correction on more than 27 instances. In fact, the odds favor bullish investors when a death cross occurs. Stocks go up more often than they go down when a death cross occurs.

Bear markets calls because of a “death cross” are often plain wrong. A death cross occur in December 1914. Then the Dow Jones promptly soared 80%.

This technical indicator, like most others, is just hocus-pocus, based on the selective use of data and some bad logic.

We couldn’t agree more.

The U.S. Stock Market is Not Forever Range-Bound

The current correction began when various U.S. stock market indices were at old highs. These charts are from CNBC.

 

 

 

 

Some investors are concerned that the current correction began when the stock market was at old highs. Cornerstone Macro’s Carter Worth states

Look where it’s struggling right in 2000, 2007 peak. That’s not random.

Although we disagree with Worth’s conclusion, he does make a valid point: “That’s not random.” History shows us that many big corrections began when the U.S. stock market was at old all time highs. That’s perfectly normal.

However, bear markets do not begin just because the stock market is at old all time highs (whether the market’s been adjusted for inflation or not). If bear markets begin just because the market is approaching its old high, the U.S. stock market would never ever go up in the long term. It would forever be bound within a range. History shows us that the U.S. stock market does go up over a 50 year time frame, even when adjusted for inflation.

Bear markets like 2007 that begin at the previous all time high (year 2000) are very rare. Even the 1973 bear market began when the market was much higher than where the last bull market ended in 1968 (using the S&P 500 data).

There’s another problem with inflation-adjusted all time highs. The CPI’s calculation method is constantly being changed. There is no “real” rate of inflation. In fact, current inflation calculation method makes actual inflation seem a lot lower than it really is.