Is the coast all clear for another massive move up in the stock market?
Written by: Benjamin Bimson CIMA® / BCJ Financial Group
This is one question that more than one person has asked this last week. This is always a tricky question. The way that we look at these things depends on what model we are using. If we look from top down economically (global economic picture and then apply it to the investments), combine with trends and trend directions, we would say there was a good reason to become more cautious about a month ago.
Things are improving to the point that we could go back to a fully invested portfolio. When we look at persistence of price movements and sheer demand for specific asset classes, we can clearly see that demand is supporting stock prices very well for now. The only thing is that due to the sheer number of headline risks, volatility has picked up.
First, I will start with some reasons that caution became important. The impact of very real geo-political risks by the end of March 2017 had increased because they indicated the potential for the Trump administration to be unable to pass meaningful healthcare and tax reform, potential conflicts with North Korea (and perhaps Russia), the prospect that the Fed was going to be raising interest rates and insecurity about the ability of Washington to goose the economy enough to keep the economic engine steaming forward. This all combined with a very expensive stock market (when viewed through the lens of price to earnings ratios), slowing manufacturing data, some potentially serious European elections and murky near term trends, caution is important.
There are a lot of ways we look at this data and use a weight-of-the-evidence approach to tell us when there is a high probability of making money in the stock market and when there is growing risk that taking market risk could end badly. One of our models indicated that caution was warranted. Here is one of the views that is probably one the easiest to understand.
I have highlighted some notable points that the market has gone into a consolidation phase (no clear direction for a short term that can develop into a longer term). The top portion of the chart shows the S&P 500. The boxes are around times that volume confirmed by trend and direction what was being observed in the price charts. The section on the bottom have boxes around the portion of time that enough of our other indicators confirmed the caution. Note that this type of analysis does not predict the likelihood of a market decline, it simply identifies times that there is a real potential for a change of direction in the major trend. It has many caution signs that do not result in major market declines. However, in order to miss the major market declines, it makes sense to take the small caution signs in order to avoid the big bad nasty stuff like 2008.
There are signs that indicate that the current cautious indicator is likely to be false. We simply cannot know for sure until there is confirmation that healthy market breadth has returned to the market. There are still very real risks that things could spiral out of control in Asia, and there has still not been any healthcare or tax reform passed in congress or signed into law (but it is looking better for the moment).
Other models that we run take a different view that relates global issues but looks for asset classes we allocate to that are outperforming on a relative basis as long as they are projected to keep “winning” for the next 30 days. This view actually had the entire portfolio in stocks during April and put up good numbers. It was mostly allocated to Technology and Foreign stocks. The time frame when this type of strategy under performs is when a period of consolidation is followed by a swift breakout to the downside. It can take a month or two to pick up on the trend change and allocate to defensive positions. The biggest challenge of this is that it tends to trade often which can be tax insensitive.
So where are we headed next? Well, if things continue to improve with Asian relations, if tax reform and healthcare reform make real progress in Congress, we will probably see further growth in the stock market and we could easily be in a position where our caution indicators show that taking market risk is appropriate. However, if we have any major shocks, we could slip into a market correction. A recession is highly unlikely at this point, but not impossible if enough trouble enters the market.
Knowing yourself and what you are likely to expect from your portfolio is the key here. It makes sense to have investment rules guiding you through the confusion of data being thrown out on every tweet, post, online article and television show. There is not a shortage of strong opinions! That is one of the marks of an aged market trend in a sideways market.
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