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posted on 07 May 2017

Weak Record Close

Written by , Clarity Financial

Review and Update

Over the last few weeks, I have been discussing the ongoing consolidation process for the S&P 500 from the March highs. (For a review read: "Oversold Bounce Or Return Of The Bull," and "Return Of The Bull...For Now.") As the expected rally in stocks, and reversal in bonds, took shape as the S&P 500 was finally able to ratchet a record close at 2399.29. (Read: 10/2016 - "2400 Or Bust")

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"With the market on a short-term 'buy signal,' deference should be given to the probability of a further market advance heading into May. With earnings season in full swing, there is a very likely probability that stocks can sustain their bullish bias for now."

The market did do exactly that this past week, and while hitting a new high, as noted above, it was a "weak" breakout as volume contracted. My friend Dana Lyons made an interesting observation this past week:

You will notice that while such events did NOT rule out "new highs" first, such periods often preceded either mild or intermediate-term corrections.

Furthermore, despite the record close on Friday, it did little to change the intermediate term backdrop of the markets. The "warning signal" I discussed three weeks ago, still remains which is currently keeping a lid on stock prices for now. More importantly, we remain very close to triggering the secondary "sell signal," also from an extremely high level, which would also raise caution levels higher, cut such has not happened...yet.

Importantly, both signals are improving over the last week, and, as I wrote last week:

"If the markets can continue to rally next week, and push to new highs, then both of those signals will reverse. The problem is the reversal from high levels historically has only been short-lived before a more significant decline took place as shown in the chart below."

While much of the price action on Friday was due to continued "dovish Fed-speak" from a raft of speakers on Friday, it was also the high expectation of a successful French election this coming weekend. But, as Kevin Muir noted on Friday:

"Yet, since it was announced that Le Pen and Macron had advanced to the second round, the market has become convinced Macron will be the next leader of France. Yeah, I get it, the math definitely seems to indicate that Le Pen will not be able to defeat Macron.

The market is way too cavalier about this weekend's election. In modern history, there has never been a French election without one of the two main parties being in the second round. This is unprecedented. If someone tells you they know how the French electorate will behave, they are deluding themselves.

There is no doubt Le Pen is at least as a polarizing figure as Trump. It will once again be difficult for many citizens to admit they plan on voting for her. Therefore the polls might be underestimating her support."

Given that backdrop, any upset over the weekend could lead to a rather sharp reversal on Monday. So, remaining a bit cautious until after the election is likely wise. At current levels, the potential "reward" from an upward move next week is far outweighed by the downside risk.

Therefore, a "reactionary" approach to portfolio management is a better choice in the current environment. In other words, let the market determine our next course of action rather than trying to "guess" at what may happen. Throughout history, investors have rarely "guessed" well.

Despite the push higher this past week, it should be noted that since the beginning of March internal measures have remained weak. With the markets very extended above their 200-dma, a correction is likely over the next month or so. This is particularly the case as volatility has dropped to its lowest levels in recent history.

Furthermore, both the ratio and number of stocks above their respective 50 and 200 day moving averages has also remained weak.

Lastly, the market remains very 3-standard deviations above its 3-year moving average. While the long-term signal currently remains on a "buy," it will not require much weakness sometime this summer to trigger a long-term "sell."

For now, the market remains in a bullish trend which keeps portfolios allocated on the long-side. Outside of small tweaks and close monitoring, nothing has occurred, yet, which would warrant more drastic movements within the allocation model. However, we have reached a point in the market cycle where the "risk" of remaining heavily invested in the market far outweighs the potential "reward."

As has been the case over the last couple of weeks, caution, nothing more, is advised for now.

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