Written by Lance Roberts, Clarity Financial
“Could you add a few more lines to the chart!”
That was one of the funniest comments I got last week.
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I get it.
Over the last couple of months, I have been tracking the correction of the market based on three (3) potential outcomes mapped out in late March. However, for new readers seeing just the latest version, without the previous context, I get the confusion. (I laid out the progression last week if you want to review.)
First, let’s start with where we left off last week, updated through Friday’s close.
Let’s start out with the “good news.”
- The market maintained support at the 200-dma again which furthers strengthens that support level.
- The advance on Thursday and Friday kept the short-term “buy signal” positive through the end of the week, although just barely.
- The 50-dma, which has broken below the 100-dma, has flattened out.
The “not so good news” remains:
- The market remains confined to a broader consolidation pattern.
- The sell-off early last week did not get the market back to short-term oversold
- There is a massive cluster of resistance just above where the market closed on Friday.
Let me review our expectations from last week.
“In last weekend’s missive, as the rally approached the 100-dma, we recommended that investors use the rally to take action and rebalance risk in portfolios. We also discussed the benefits of holding extra cash.
This week, we are continuing to carry an overweight position in cash. However, we are monitoring the possible actions heading into next week:
- With the market on a short-term “buy” signal, there remains a potential for another rally attempt next week. If the market can clear the downtrend, then we will be looking for an opportunity to redeploy cash.
- However, the failure at resistance applies more downward pressures to prices in the short-term which keeps risk elevated. Pathway 2 is becoming much more viable if market action doesn’t improve soon.
- Over the next couple of weeks, it is critically important for the market to regain its footing and not break the 200-day moving average which will likely accelerate the correction process.
Over the last week, the market fulfilled all three points as the initial decline and retest of the 200-dma set up a rally that left the market below resistance and effectively unchanged (-0.01%) for the week. This is despite “great earnings” and a relaxation of geopolitical. issues.
That’s not great news.
However, what has changed is that our previous three pathways are now no longer valid.
When I first went through this exercise of laying out possible pathways, I stated:
“Considering all the various factors, I begin to layout the ‘possible’ paths the market could take from here. I quickly ran into the problem of there being ‘too many’ potential paths the market could take to make a legible chart for discussion purposes. However, the bulk of the paths took some form of the three I have listed below.”
In laying out new pathways, the same problem remains. However, once again, I have chosen three possible paths which include a majority of the potential outcomes, or more commonly known as “a guess.”
- Pathway #1 is the most bullish of potential outcomes. With earnings continuing next week, and short-term conditions mildly oversold, the market is able to push through resistance and rally back towards old highs. (Probability = 20%)
- Pathway #2 is the most bearish with the market failing at the cluster of overhead resistance once again but this time violating the 200-dma. This decline begins a process of a deeper correction as we head into the summer months. (Probability = 30%)
- Pathway #3a and #3b suggest a further rally to the 100-dma, a pullback to the previous downtrend and then either an advance that breaks above the 100-dma and begins a more bullish rise, OR a failure and another test of the 200-dma. (Probability =50%)
I am currently giving the pathways #3a and #3b the most weight only because we are in the midst of earnings season which could continue to provide some short-term support. However, as we will discuss momentarily, as we head into the summer months, things become much more unstable.
Let me restate that these potential pathways are only “guesses” at what the market could do next.
- Those in the bullish camp are expectorating the market to move straight up.
- The bears are expecting it to move straight down.
Neither ever happens.
As a portfolio manager, I don’t have the luxury of being either “bullish” or “bearish” which can lead to substantial career risk when things inevitably go wrong.
However, since I have to make some guesses at potential outcomes in order to allocate portfolios and manage risk accordingly, this process of mapping and writing out potential pathways forces me to weigh options. Without such a process, investing would be akin to “driving with your eyes closed” which tends to have rather unhappy endings.
With portfolios still weighted towards equity, but overweight in cash and shorter-duration fixed income, we can afford to sit still into next week and allow the market to choose its path.
