S&P 500: Recent Consolidation Allows Push Higher - Risks Remain
Over the past several weeks the markets have been trapped within a very tight consolidation process vacillating between positive and negative returns each day for 17 days in a row - a feat not seen since 1981. The first chart below shows that action over the last month with the S&P 500 index contained within a tight trading range. Also important is the very small correction in the overbought condition (top part of the chart) that occurred at the beginning of April.
The combination of this short term consolidation, and reduction in the overbought condition, gave the markets "fuel" for a move higher in the short term. The catalyst for that push higher came with the "early release" of the FOMC minutes which showed that there was no risk of an end to the current Quantitative Easing programs from the Fed anytime soon.
Notice, however, that prices on a very short term basis have surged to more than 3-standard deviations above the 21-day moving average. This is something that has not occurred since mid-September of 2012 just before a near 8% correction in the market. The next chart shows these two peaks along with similar short term corrections in the overbought status of the market and the subsequent spike higher that marked the end of the previous run.
However, from a longer term perspective, the overbought, over extended and excessively bullish status of the market remains little changed. For money management purposes we prefer to use weekly data as it reduces the day to day volatility of the market. On this basis the risk of a larger correction remain very high.
The first chart below shows the S&P 500 index overlaid against Bollinger bands set at 3-standard deviations of the 50-week moving average. [Geeks note: 3-standard deviations comprises roughly 99% of all possible outcomes in a normal distribution.] While the market is breaking out to new highs , which is bullish sign, it is also important to remember that this action is exactly what we saw at the peak of the last cyclical bull market in 2000 and 2008.
Could this time be different? Sure. In 2000, and 2008, the Federal Reserve was not injecting liquidity directly into the system. However, while such actions may extend current momentum in the market, it does not remove the event of a bigger correction at some point in the not so distant future.
It is not just the standard deviation in the price of the market that should be worrisome to you as an investor. The relative strength of the market, also using weekly data, is at historically high levels as shown in the chart below. Relative strength at these levels, if you refer to the chart above, have coincided with decent corrections in the market in the past.
Furthermore, one of my favorite market warning indicators is using monthly data on the S&P 500 when viewing very long term overbought/sold conditions. The chart below shows that overbought conditions at these levels (top chart) has historically coincided with major market peaks since the beginning of the current secular bear market in 2000.
Also, as noted, while the market has surpassed its 2007 market peak - it has not surpassed the rising trend of peaks since the market peak in 2000.
While we have certainly been cautioning of the rising risk in the market - we have also maintained our current allocation model at full weightings. This is because, as I have repeatedly stated, the Fed's artificial interventions would likely drive asset prices to new all-time highs.
However, as I stated then:
"...it is important as investors, that we do not simply dismiss the dangers that continue to build in the economy and the markets. To simply assume that there are no excesses being created in various asset classes is short sighted. Asset 'bubbles' are never recognized, or acknowledged, until after the fact. Currently the increases being witnessed are primarily due to the inflows of liquidity which is masking the deterioration of fundamental underpinnings. That is an unsustainable trend in the longer term, but, in the short term there is nothing inhibiting further increases as long as complacency remains high.
At some point, and it is only a function of time, reality and fantasy will collide. When this occurs the media will question how such a thing could of happened? Questions will be asked why no one saw it coming. Fingers will be pointed and blame will be laid. This will happen. When? Later this year? Next year? Timing is always the problem. This is why it is more important than ever that you remain aware of the risks and pay attention to exposure that you take on within your portfolio. There is no prize for beating the market from one year to the next, however, there are severe penalties when things don't go as planned."
What could be the catalyst that trips up the market? It could well be a resurgence in the Eurozone crisis, the U.S. being dragged into recession by a weak global economy, an attack from North Korea, or the upcoming debt ceiling/budget debate this summer. However, since the markets are already aware of these issues it will probably not be something so readily apparent but rather something that we haven't even considered as of yet. What I do know is that bull markets generally end slowly. Unfortunately, when bull markets do end - they end sharply sending investors fleeing for safety and screaming in fear.
The risks of such a correction remain very real. While the S&P 500 could well reach our secondary target of 1600 from current levels the risks of chasing such a small advance are greatly outweighed by the damage that would be caused within the confines of a normal market correction of 10-15%. However, with margin debt currently near record levels - my expectation is that the next major correction could be far worse than the historical norms.