Bulls Still Have Support For Upside Breakout

AVERAGE STOCK NEAR IMPORTANT AREA

The broad Value Line Geometric Index is a good way to monitor the progress of the average stock. Given the index made a stand near similar levels in 2011, 2016, and 2018 (green arrows), the upward-sloping blue line represents an area of possible support. The expression what once acted as major resistance may now act as major support applies to the horizontal blue line where the index was rejected in 1998, 2007, and 2015 (red arrows).

STOCKS VERSUS BONDS

If the stock market is about to push higher, we would expect growth-oriented investments to outperform defensive investments, such as bonds. The ratio of stocks-to-bonds is also near a key area from a very long-term perspective. The ratio was rejected on a rally attempt in 2001 and was unable to clear the same area in 2007. The ratio stalled near the same blue horizontal line in 2017 before breaking out. Therefore, it is possible the blue horizontal line that acted as resistance for eighteen years may now act as support. We also have reason to believe stocks could make a stand soon relative to bonds based on the prior areas of support in 2009, 2012, and 2016 (green arrows).

DEMOGRAPHICS COULD DRIVE A MAJOR BREAKOUT

The chart on the left below shows the stock market is trying to move away from levels that have been relevant for twenty-one years. The stock-bond ratio is trying to move away from levels that have been relevant for eighteen years (right side).

Bank of America recently issued a report that points to the increasing possibility the role of bonds in a diversified portfolio may change significantly in the years ahead. From MarketWatch:

In a research note published by Bank of America Securities titled “The End of 60/40,” portfolio strategists Derek Harris and Jared Woodard argue that “there are good reasons to reconsider the role of bonds in your portfolio,” and to allocate a greater share toward equities.

DIFFICULT TO IGNORE DEMOGRAPHIC FACTS

The conclusions drawn in “The End of 60/40” align with a bullish breakout in the stock-bond ratio. What could drive such a significant shift? History says one major driver will most likely be demographics. This week’s CCM stock market video takes a detailed look at the factors that create major economic and financial market trends, concepts that may prove to be incredibly helpful to investors over the next five to fifteen years.

BULLS HAVE SOME WORK TO DO

The S&P 500 closed at 3025 on July 26. Given the market was trading at 3005 during Monday’s session, the bulls still have hurdles to clear. The ratio of consumer staples to the S&P 500 reversed near similar levels in 2016 and 2018 (red arrows); the S&P 500’s performance (bottom) tells us to remain open to a break to the upside for stocks in the coming days and weeks.

This post is written for clients of Ciovacco Capital Management and describes our approach in generic terms. It is provided to assist clients with basic concepts, rather than specific strategies or levels. The same terms of use disclaimers used in our weekly videos apply to all Short Takes posts and tweets on the CCM Twitter Feed, including the text and images above.

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THIS IS WHAT A MAJOR TREND REVERSAL LOOKS LIKE

The three periods shown below produced an average peak-to-trough loss of over 50%. Thus, it is prudent to understand some of the common characteristics found in all three cases. We can then look for similar characteristics in the present day. Imagine if you were a few years away from retirement when the 1973-1974 bear market hit. The S&P 500 dropped 48.2% causing many sleepless nights.

The chart above shows the S&P 500’s 200-day moving average during the earlier stages of the 1973-1974 bear market that came to an end on October 3, 1974. The chart seems fairly simple, but contains a ton of valuable information about a major shift in investor expectations regarding future economic and market outcomes.

While the combination of fundamental factors, including valuations, interest rates, inflation, economic issues, and geopolitical events are significantly different in all three major bear markets, there are also important and consistent lessons for investors. On the left side of the 1999-2001 chart below, the net aggregate opinion of all market participants regarding all subjects on all timeframes was bullish. Consequently, the bias was for the market to move higher based on positive expectations about future economic and market outcomes. In the early stages of the bear market, more and more market participants begin to respect the problems of the day, resulting in a major and sustained shift in the net aggregate opinion of all market participants regarding all subjects on all timeframes. Consequently, the odds shift to favoring a series of lower lows rather than a series of higher highs.

These examples provide a fact-based response to a common objection to historical studies:

“But today is significantly different from the periods shown in numerous ways.”

“Today is different” is always true. No two periods in human history have the exact same combination of fundamental, geopolitical, economic, psychological, and technical factors. The three painful bearish periods shown here (1973-1974, 2000-2002, and 2007-2009) are all unique in significant ways, but the process of a major shift in the net aggregate opinion of all market participants looks very similar in all three cases. Stated more simply, the whys differ in each case, but the major trend reversals are very similar.

The early stages of the financial crisis bear market occurred in a significantly different fundamental environment relative to the oil embargo 1970s and dot-com-hyped early 2000s, but the process of a major shift in market sentiment is similar in many important ways. There is nothing magical about the 200-day moving average; this is an exercise in pattern recognition. Chart patterns reflect patterns of human thought. People think and behave in similar ways near a major market peak because human greed and fear are constants. The same is true for all patterns in the stock market (bullish, neutral, and bearish).

HOW DOES THE SAME CHART LOOK TODAY?

If we look at the question above, it can be rephrased in this manner:

“Are we seeing a similar bearish shift in the net aggregate opinion of all market participants regarding all relevant subjects on all timeframes?”

The answer is no. The present day chart also represents a discernible pattern in human behavior. From a traditional charting perspective, the 2019 chart below appears to be a continuation pattern. The trend on the left side of the chart below is bullish. We are all familiar with the expression the market needs to consolidate its gains, which is exactly what took place in the center of the chart below. Given what we know today, we have a bullish trend, a period of consolidation, and what appears to be a resumption of the bullish trend.

Does the chart above look anything like the 1973-1974, 1999-2001, or 2007-2008 major-bear-market-reversal charts above? The answer is no, which means, as of this writing, the net aggregate opinion favors higher highs in the coming months relative to lower lows. The previous sentence contains a probabilistic statement based on the facts we have in hand today. If the facts change in a material manner, we must reassess the probabilities.

PATTERNS REFLECT COMMON HUMAN BEHAVIOR

The 200-day is useful here because we have a discernible pattern, just as there were discernible patterns in the three major bear market cases. In a continuation-pattern scenario, the net aggregate opinion over time is adversely impacted by a set of concerning issues (think Fed policy errors and the trade war in 2018). These issues cause the net aggregate opinion to shift in a similar manner to what transpired near the major S&P 500 peaks in 1973, 2000, and 2007. The difference in the continuation-pattern case is the concerning issues are addressed in some manner (Fed shifted in early January 2019 and trade has been trending in the right direction).

Thus, in the continuation-pattern cases, the net aggregate opinion shifts back to a bullish bias allowing the prior bullish trend to continue, which is exactly what happened in the 1994-1995 case shown below. The combination of factors is unique in each case, but the net outcome is the same. After consolidating and breaking out, the S&P 500 resumed its bullish trend and gained 54.56% over the next two years from the date shown on the chart below.

A similar shift in fundamental perceptions and human expectations occurred in the 2011-2012 continuation-pattern case. Once again, the combination of fundamental issues were different in the 1994-1995 and 2011-2012 cases, but the net interpretation and subsequent behavior by market participants was very similar. The results were similar as well; from the date shown in the chart below, the S&P 500 gained 39.97% over the next two years.

INSTITUTIONS AND FUNDAMENTALS

It would bolster the bullish thesis above if (a) present day fundamentals supported ongoing expansion over an imminent recession, and (b) if institutions were still open to bullish economic and market outcomes. This week’s CCM stock market video looks at fundamentals and technicals which support the “avoid a recession” case and the “institutions have not given up on this market” case. After viewing the facts presented in the video, you can draw your own conclusions.

EXECUTIVE SUMMARY

Keeping in mind chart patterns enable us to monitor shifts in the net aggregate opinion of all market participants regarding all subjects on all timeframes, does the pattern in 2019 look more like the major-topping patterns or more like the continuation patterns?

Since there is no question 2019 looks more like 1993-1995 and 2011-2012, it might be helpful to know what happened next in the two continuation-pattern cases. As the table shows below, the S&P 500 did continue the bullish trend and posted very impressive gains over the next five years.

ANALYSIS SPEAKS TO ODDS

Logic can be used to minimize the odds of repeating common investing missteps. The weight of the evidence says we should remain open to better than expected stock market outcomes while respecting the odds are based on the information we have in hand today. When the next major bear market arrives, the concepts outlined above will still be helpful; the message will simply shift from “sit tight with growth-oriented investments” to “take action to reduce risk to our hard-earned principal”. We will continue to take it day by day, while remaining open to all outcomes from wildly bullish to wildly bearish.

This week’s stock market video will most likely expand on the concepts covered above. Recent studies involving the market action near the 200-day and Fibonacci retracements align with the continuation-pattern thesis above.

WHAT ABOUT SMALL SAMPLE SIZES?

We cannot control sample sizes. There have only been three 40%-plus declines in the S&P 500 since 1950 (1973-74, 2000-2002, and 2007-2009), which represents a very small sample size. Are we supposed to totally ignore these major declines because of the small sample size? According to Reuters, the S&P 500 was officially launched on March 4, 1957, meaning any S&P 500 study deals with a very limited historical data set. It is what it is.

When we study rare events, we acknowledge the sample size and try to learn anything that can add value in the present day. There are countless economic and market studies that are based on small sample sizes. Typically, the small sample size argument is only raised when the results run counter to someone’s personal opinion. When results agree with someone’s personal view, the small sample size is suddenly not a problem. If you believe a study or data set is irrelevant, there is an easy solution - ignore it.

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