The markets have weathered the recent storm of selling and have sprung back fairly quickly this week. There may still be a squall or two ahead, but it appears the worst is over for now.
We still have not tested my target of 1,709, the 200 day moving average (DMA) on the S&P 500 Index, but we were close. We fell to 1,739 intraday on that average, which was just 1.7% shy of my target. That’s close but no cigar for me. Still, from the peak of the market to this week’s low, the S&P 500 declined 6%. That was a reasonable decline.
It was enough to reduce the overbought conditions of the market and to reduce the overwhelmingly bullish sentiment of investors that had kept me cautious for most of the first month of the year. The question that remains is whether the markets have a larger drop in store for us sometime in the future.
In the meantime, I suspect we are on our way back to the highs, around 1,850 on the S&P 500. Once the averages regain those levels, we may climb even higher. Exactly how we get there will be important.
If the rally is fast and furious, while investor sentiment becomes increasingly complacent, then once again that exuberance will set us up for another implosion. The next time around, however, the pullback could be in the double digit range. So what will I be looking for in gauging the future risk of a sharp downturn?
I want to see a broad-based rally; one with increasing volume with all sectors performing well. On the other hand, a rising market, where advancers have a hard time outnumbering declines, and where valuations remain stretched with fewer and fewer stocks participating will turn me cautious once again. Under those conditions, I would expect renewed weakness and a deteriorating technical picture of the markets.
However, those are future concerns, which could or could not develop in the months ahead. For right now, the pullback is essentially over. What lessons readers should take away from this experience are two-fold. Number one, the markets will have these kind of sell-offs 3 or 4 times a year. Although it is easier to spot a potential short-term decline, it is practically impossible to call a short-term bottom. That’s why I advised you to do nothing.
Number two, attempting to avoid these sell offs by trading out and then buying back into the market is extremely difficult, if not impossible, on a consistent basis. Let’s say you did not follow my advice, but instead sold out a few weeks ago when I first advised readers that a pull back was in the offing. So far, so good. Congratulations, you saved some money but when do you get back in?
My target for a potential bottom was the 200 DMA on the S&P 500 Index, which we never reached. Remember this forecasting stuff is an art, not a science. Instead, it was the Dow Jones Industrial Average that hit and broke its 200 DMA on Monday into Tuesday and then bounced. The rest of the indexes took heart and followed the Dow higher.
No harm done for those who took my advice and stayed fully invested. Your paper losses are rapidly dwindling as the markets gain traction. But for those short-term traders who are still waiting for the S&P to breach its 200 DMA, well, that’s my point.
Do you hope the markets’ bounce will fail and go lower from here, what if it doesn’t? Will you be forced to chase stocks higher? As I’ve said, getting back in is a lot more difficult than you may think. While you ponder your next move, the rest of us can be grateful that this correction is over.