August 22, 2017

Up, Up and Away? Not If History Has a Say.

The market rallied hard making it the 9 out of 11 tradings days with positive gains. SPY has made since 4.2% during that time, but over the past month SPY has made a staggering 8.7%. And as expected, now we are seeing sentiment change.

But, I am not completely sold on the rally yet.

Why? Well, other than the overbought to very overbought readings in most of the ETFs I follow and all of the reasons mentioned in my post yesterday, we are also entering into the weakest period of the month of January. Just look at the DIA chart below for percentage of times positive over the next five trading days.

courtesy of (click to enlarge)

If you look at the ETFs I follow in the High-Probability, Mean-Reversion Indicator you can see that almost every ETF I follow is in a short-term extreme. Extremes that have not been seen in quite some time. I can’t remember the last time I saw all four major market benchmarks in a very overbought state. The decline is coming and soon. The question is how long will it last? Will it be long enough to close the gap from 1/3 or will it be a another one hit wonder. We shall all see soon enough.

I also came across an interesting article written by James Kostohryz wrote on Seeking Alpha which mentions three handy tools for investors to identify the characteristics of a bear market rally so as not to be lured into one. Interesting reading indeed.

How to Recognize a Bear Market Rally

1. Fundamentals: The first challenge in determining if a rally is legitimate or not is to address the fundamentals of the bear market. Are they still in play? “Stocks will often rally on relatively insignificant news during a bear market rally – news that in no way negate causes of the original decline. However, in a bear market rally, fundamental deterioration continues beneath the surface despite rising stock prices.”

Given that troubles in Europe helped spark the market decline, we can say these fears still hold. In fact, the likelihood of an economic collapse in Europe seems more likely today than it did on October 4th. The same can be said of America’s political and budget-cutting issues.

2. Low Volume Advances: “Bear market rallies are characterized by extremely sharp advances on relatively low volume. Such advances are driven by price-indifferent purchases by short sellers, put buyers and call sellers that are aggressively executing stop-loss orders,” writes Kostohryz. “Furthermore, in bear market rallies the sharpness of the price increases indicate price indifference on the part of long investors.”

With regard to this element, market actions since October 4th have been sharp and on low volume.

3. Sentiment: Rallies are fueled by a reversal of pessimism and skepticism, explains Kostohryz. “Extremely bullish sentiment suggests a high probability that reasonably foreseeable positive factors are already almost entirely discounted in the price of stocks.”

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