Ladies and Gentleman: It Is Time For Caution

Last time we wrote on the markets we continued to advocate a cautiously bullish market stance. We have felt that the technical turn that the market had taken since October (a turn upward in the moving averages, breadth thrusts, and liquidity flows) coupled with the seasonal strength one typically sees this time of year, justified a bullish position.  Overall, the broad market is up 26% year to date.

While this market turn did not start from a position of undervaluation (in fact it remained historically expensive by most time-tested metrics), it did start the current leg of this rally from a position of being “oversold”, both in momentum and sentiment.

So far, this attitude, cautious optimism as it was, has been profitable.  Quoting ourselves, we said we have had a good year in the last month.  The gains have indeed been impressive.  We thank the market for delivering such bounty.

However, we have expressed doubts that it will be sustainable. We mentioned that both momentum and sentiment were rising rapidly, in fact, too rapidly. We expressed concern by using the metaphor of a long-distance runner who starts too quickly, loses his pace, and winds up getting prematurely exhausted.

We expect this market strength will likely continue through the immediate period through the end of the year and into early January, “the Santa Claus rally”, but we have increasing concerns about how far it will continue into the new year.

As to when the market will peak and turn indicators down, we don’t know. Unfortunately, no one else knows either. The best that can be done is to be “situationally aware” and make a judgment about how much risk you are willing to take. That judgment thus must be left up to the reader and in some cases, the financial advisor the reader may be consulting with.

When you read any kind of advisory material, remember the author has no information about your personal financial situation. About all a general writer on markets can do, is describe conditions in the market. You are ultimately responsible for what you do with the information and whom you hire for advice.

And remember, if any writer really had the key to making a fortune on Wall Street, he would keep it to himself.

Besides, attempting to call market tops, is a good way to prove how fallible we humans can be. Usually, one does not find out the market has peaked until after it already has done so and you can see the actual turn downward in the indicators of price,  momentum, and sentiment.

So, to use another metaphor: the current situation is like driving in an ice storm and attempting to predict when an accident will happen. You can’t know, but you can describe the conditions in which one is driving and intuit that the situation is getting hazardous. Maybe it is better to find a place to sit the storm out rather than continue to drive. Do you have to be on the road at this time or are you required to drive further, despite the weather forecast? Are you running the risk of a fender bender or the risk of something worse?

With these caveats in mind, let’s review sentiment.  Remember, sentiment attempts to register both through surveys and in market action, what people are thinking.  It works best at extreme readings.  The underlying idea is that when opinion, bullish or bearish, well reasoned or hysterical, reaches extremes; the presumption is people have likely acted on their beliefs by committing money to their idea. In short, the market opinion is already reflected in the price structure of the market. Investors see much better times ahead, but ironically it may be already priced into the market as we write.

Right now, excitement is running high that the FED has indeed pulled off a soft landing, that recession has been avoided, inflation has been tamed, and that the FED will soon be lowering rates and opening up the money taps again. Along with this confidence that easy money is coming back, the market remains euphoric about the possibilities of AI. Many of the companies involved in this technology are among the “magnificent seven”, just seven high-tech stocks that now make up a whopping 35% of the capitalization of the S&P 500 companies.  

This is a concentration of influence on the index we have never seen before.

That the market is so dominated by such a few companies has raised concern among many but the market does not seem to care and just keeps plowing forward, despite valuations that are truly at nosebleed levels.  The average price-to-earnings multiple for these select market leaders is around 44 while the rest of the market is a robust 24.  Rarely has the spread ever been this wide. For the sake of proportion, the average PE for the market is around 16.

There are many sentiment indicators we could talk about, but too many indicators can be confusing to follow.  Because the CNN Fear and Greed gauge is available to any reader of The Prickly Pear for free (you can find it on the internet), and because it is comprised of six indicators, it is a handy tool to use.  Since we mentioned it before, we mention it again.

The last time we looked it was hovering in the mid-60s.  That is an elevated number to be sure, but not extreme.  We said to wait for more extreme readings.  Well, now they are extreme and have entered the danger zone.

Just back on October 5th, the index sat at 20, reflecting extreme fear.  That was a decent time to enter the market and we said so at the time. The market bottomed shortly thereafter and the S&P has rallied 16% in just three months. However, now the reading is 80!  In terms of recent history, it hit 82 on July 3rd, the stock market ran hot for about another two weeks, then stalled out and fell 11% to the October low.

So what is the bottom line here?  We have now entered the extreme greed zone, and abundant enthusiasm is likely getting worked into the price structure. And,  if recent history holds, the market could be facing some real difficulties in just a few weeks.

Now admittedly, there are many other indicators, but this one is pretty good and available to all readers. Make of it what you will.

In terms of momentum, we have a similar story to the one with sentiment.  We are at high levels.

Like sentiment indicators, when momentum indicators have been high for weeks, the market will tend to at least take a pause.  Unlike sentiment, momentum indicators are solely based on price action. Right now, they seem to be saying, “We are going too far, too fast.”

Finally, markets tend to stretch like a rubber band around an underlying moving average.

Here is a chart of the NASDAQ 100 (QQQ), which has been the real powerhouse of the market. You can see over the past ten years, that stretching around 20% above the 50-day moving average is pretty rare. It seems that when the rubber band stretches that far away from the moving average, the rubber band snaps and you get at least a contra-trend move of some significance. Statisticians call this regressing to the mean. We are now approaching another one of these conditions where a snapback would be normal. Of course, we could go up a few more percentage points, but it is unlikely to be huge from here.  

We could show you more indicators, some of which contradict what we are saying. That is what makes market predictions more of an art than a science. However, the preponderance of both sentiment and momentum indicators are now flashing an amber warning light.

We will share one other interesting fact as we close.  On December 19th, The Wall Street Journal reported that 58% of American households now own stocks, the highest ever recorded. While it is wonderful so many people are participating, it is likely current prices reflect their participation. It is a trite phrase, but the axiom “buy straw hats in January and snow shovels in July” comes to mind.

Thus, we have reached such extremes we would not be surprised to see the market get into trouble within the next few weeks. You can take that as a change from cautious optimism to outright concern. At this point, we don’t know if we will just see a correction from current excesses or whether we will see something more extensive like a bear market. Either way, that may mean that given your circumstances, some profits should be taken. In doing so, you may create a tax bill.

Over the years, we have found that it is not wise to let the tax tail wag the portfolio dog. Do what is best for the portfolio and pay whatever taxes are due. Market losses can easily be larger than your tax obligations.

Markets are now seriously overheated and investors are advised to preserve their hard-fought gains and not get greedy. The market readings presently are plenty greedy for all of us.

We don’t know any person or system that consistently calls tops and bottoms.  If such a system were found, everyone would adopt it and it would quickly lose its utility.  All we can say is buckle up, hazardous road conditions are likely just weeks ahead.

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Charts are courtesy of stockcharts.com and are drawn by the author.

Image Credit: Shutterstock