November Market Update
In the last blog post, we talked about watching for a close below 3584 on the S&P 500 on strong volume for those who believe we were already in the third leg lower in a long-term bear market. What often is the largest leg lower and also what is often a market crash.
Fortunately, the market did not close below 3584 on strong volume. The volume was lighter ahead of a key CPI inflation report.
After the key CPI number that was worse than expected, the market gapped lower but then rebounded strongly to close well above the 3584 level on very strong volume that day. The strong volume close below 3584 did not happen fortunately.
Good news for now at least. Like we said in a prior article, its a bullish sign when the market or a stock goes higher on bad news.
As we were saying then, its looking more like a 2nd leg lower in a long-term bear market which historically only goes down about 5% to 15% below the prior low. After that, you normally see a rally that lasts 6 weeks to several months. At least this is the cadence of the long-term US bear markets over the past few decades.
A week and a half after the CPI number, the S&P 500 formed a higher swing low and higher high in late October. This is a trend change confirmation back to the upside but only on an intermediate-term time-frame at best. We also saw a bullish-follow through day.
What Stocks are Working
Around that time we had a focus on long swing trading setups in our alert service and our own trading in mid to late October. Our top long trading opportunities at the time got off to a good start before pulling back late this week. They easily reached that 5% to 15% profit range where we like to take some profits and lock in a profit by raising the stop on our remaining position using the rules in our free primer.
The money is being made mostly in the large cap and defensive areas of the market right now. BJ and PPC were 2 of our favorites in good technical patterns and are off to a real nice start. We focus on stocks with rising estimates that are beating those estimates consistently and/or top growth stocks and these 2 fit the bill while being in more defensive industries.
Large caps and defensive stocks leading is a common tendency as you head into a growth slowdown or recession. The Dow Jones 30 index actually got above the 200 day moving average while the Nasdaq and small cap Russell 2000 index are still way below these levels.
The Fed in November and December
In prior blog posts and the alert service we have been talking about how there is a repeating pattern in this market environment. First, the market starts to gain traction and a new uptrend begins. Then inflation numbers come in stronger than expected and/or the Fed makes statements and becomes more hawkish than before which slams the market down for the next few days or more.
The inflation fight is on and the Fed has become serious about it throughout the year. As we have been discussing this year, what is the true terminal rate for the Fed funds rate when they continue to raise these expectations stepwise over and over again?
We would argue that no one knows. Maybe its 4.5%. Maybe 5.5%. Maybe a lot more but the pattern of increasing terminal rate expectations continues.
However, at some point, this pattern will change. Unfortunately, it may occur around the time we head into a more significant downturn.
In past cycles, the Fed had a chance to back off as inflation was not as much of a problem. This time inflation is higher and continues to be elevated.
The Fed started to raise interest rates in late 2004, about 3 years before the market peak in 2007 before the financial crisis. This time, the Fed started more than a year late due to pandemic and geopolitical concerns.
Inflation is now a bigger problem to contend with which requires faster and larger rate hikes. Meanwhile, the debt/GDP ratio is well north of 100% which becomes a conundrum for investors.
So is the Economy About to Crash?
The Atlanta GDP now forecast was pretty accurate again for Q3 GDP which came in at 2.6%. Not great economic growth but actually above the long-term expected trend after 2 negative quarters in Q1 and Q2.
The Atlanta GDP now is currently forecasting more than 3% growth in Q4. Softening in the labor market is starting to appear and this usually takes some time to deteriorate before a recession really starts. However, leading economic indicators continue to deteriorate and are pointing to a coming recession sometime over the next year or so.
Running to Catch Up
The question right now is how does a pandemic, delayed Fed reaction combined with excessive fiscal stimulus affect the timing of recessions? No one really knows for sure but we are about to find out. This will be a case study at some point to be sure.
But right now the price action in the market is behaving like the start of a second sustained rally in a long-term bear market. These sustained bear market rallies last several weeks to a few months historically before a crash.
Of course, the now silly looking bulls could still be right and this could be an exaggerated “mid cycle slowdown” with a strong rally ahead. A gutsy call given the rapid rate hikes and inflation that continues to come in worse than expected with energy prices potentially soaring in the months ahead.
In either case, we can make some money in a sustained market rally even if it just lasts a few more weeks. When swing trading, we can also trade a declining market as well. Swing trading puts and shorting tends to very profitable in the final phases of a bear market as discussed in a prior article.
What are the Key Levels to Watch?
Looking at past long-term bear markets, the second sustained bear market rally retraces no more than 50% to 61.8% of the prior leg lower in the long-term bear.
Here is a chart of the 2000-2002 bear market:
We can see how the S&P 500 retraced almost exactly 61.8%, a key fibonacci number, before the ugly third leg lower in a long-term bear market. The 2nd sustained rally in the dot com bear market took about 8 months before the market really fell apart.
The financial crisis bear market saw a 50% retracement of the 2nd leg lower in the long-term bear market.
This was one of the more ugly crashes in market history for the S&P 500. A more than 40% drawdown from the August highs in just a few months.
So, yes, we do have to be on our toes as interest rates move sharply higher and leading economic indicators continue to deteriorate.
The latest S&P 500 chart can be seen in the latest edition of the Weekly Alert being published Monday evening.
How can We Use This Information?
Well, we can say that a more than 2/3 retracement of the 2nd leg lower from the August highs to the October lows would be unprecedented in prior long-term bear markets. The S&P 500 has already retraced 50% of the 2nd leg lower but there is a good chance we will see a rally again in the weeks ahead with bumps along the way.
Unemployment is still low, GDP growth is expected to be positive in Q4 currently and other economic numbers are hanging in there so far. Normally, a crash occurs a bit later in the cycle when these numbers really deteriorate.
Plus we have likely political changes coming. The market likes a split government as impactful tax and regulatory policies become less likely. Market returns during these periods are generally better historically speaking versus times when one party has the presidency, house and senate.
So if the S&P 500 gets above 4,050 for a couple weeks, this would be a bullish sign. This would also likely correspond with a rising 50 day moving average and a 200 day moving starting to flatten out and maybe even bending higher after a long period where it has been sloping lower.
A more ideal period for long swing trading with longer hold times is a market trending higher above a rising 50 day moving average where the 50 day is above a rising 200 day moving average.
This is a good time to be on our toes to be sure when swing trading. The price action of the major indices is behaving like we are starting the second sustained bear market rally in a long-term bear market with a potential nasty third leg lower coming in the weeks or months ahead.
We can swing trade in either direction, continue to manage risk tightly with smaller position sizing, and get ready for a decisive turn in either direction. Money in short term treasuries yielding 4.5%+ while we wait for the best opportunities is not too bad.
Once we get clear signs that we are entering another leg lower, we can trade the best short/put option opportunities. This seems a bit early though given the latest economic data.
The major indices are still near long-term confirmed trendlines going back to 2009. So this continues to be a big test for the market longer-term as well.
A third leg lower and real crash tends to occur towards the end of a long-term bear market. So if we do see a severe recession in 2023, this could offer some great long opportunities for the following 3-5 years even if we do get a dramatic market crash in the weeks or months ahead.
It could become pretty attractive once the dust settles and we see a 15% to 40% move below the October lows if we see the economy and job market starting to fall apart. Either way, we will be trading in the direction of the current trend.
Fortunately, crashes late in bear markets tend to happen quickly with a strong rebound shortly after as can be seen on the charts above.
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