Written by Lance Roberts, Clarity Financial
Over the last couple of weeks, we have been discussing the market’s advance from the lows and why retesting old highs was quite probable. To wit:
“The markets are close to registering a ‘golden cross.’ This is some of that technical ‘voodoo’ where the 50-day moving average (dma) crosses above the longer-term 200-dma. This ‘cross’ provides substantial support for stocks at that level and limits downside risk to some degree in the short-term.”
As I penned on Monday for our RIA PRO subscribers (Try it FREE for 30-days and get access to daily trading ideas on the markets, sectors, portfolio positions and long-short idea list):
“As we discussed last week, the rally above, and retest of support at 280 sets up a test of all-time highs. I expect that will occur early next week. SPY is extremely overbought, so a test and failure at the highs will not be surprising.
- Short-Term Positioning: Bullish
- Last Week: Previously increased sizing to full weight.
- This Week: Hold
- Stop-loss moved up to $280″
More importantly, on Friday, the markets broke above short-term resistance and the psychological barrier of 2900. This will likely get the bulls all excited over the weekend to make an attempt for all-time highs.
While the bullish bias is definitely behind investors currently, there are concerns relative to the current risk/reward backdrop.
As shown in the chart above, the market is not only back to more extreme overbought levels, it is also close to registering a short-term sell signal. With prices now compressed into a very tight range, the risk of a downside break has risen. Drew Zimmerman from Polar Futures Group also made some very astute observations on Friday.
“Is it the middle of April or the middle of August? The weekly trading volume of shares on the US indices and the number of futures contracts that traded this week was the lowest since last summer and among the lowest weekly levels of the past several years. This low volume has reduced price volatility with the VIX index trading back to down to levels not seen since the beginning of October last year before the equity price decline started. Even the volatility in the G7 currencies is the lowest it has been since the middle of 2014!
So, it’s quiet out there….what does that mean? Equity markets are only a couple of percentage points from all-time highs, things must be good! The central banks have done their job, they have all gone back to accommodative policy stances, and China easing more aggressively. We have gone from worries of a global slowdown to not worrying at all because the central banks have our back, and in that environment taking more risk pays. The central banks must know what is best right?
However, when we see broad markets get this quiet, it usually means we are about to get a rude surprise. When things coil up, it is common to see some explosive moves. Given the very low level of volatility, it may be an opportune time to buy some protection.”
We agree with the last statement. This is supported by the extreme level of the current “buy” signal as shown in the shaded orange bar graph in the chart below. These rare extreme extensions occur at extremes of sell-offs and rallies.
As stated, we definitely agree and as such are maintaining our current equity exposure, with an overweight positioning in cash and fixed income. While this allocation structure is currently providing some performance drag, it is also greatly reducing overall portfolio volatility which we think we will be well rewarded for over the next four to six months.
This is generally where someone with a reading disability sends me an email:
“But you are always bearish”
“The market has not been this oversold at any point in the last 20-years, on a monthly basis, as shown in the chart below.
The other bit of good cheer for the bulls is that unlike the previous two starts to more protracted bear markets, the long-term monthly uptrend has not been broken, yet. As noted above, the market is sitting on that uptrend support line which began in 2009.
At this point, the risk/reward for traders is clearly sided to the bulls…for now.”
So, for the reading impaired:
We are carrying reduced equity long positions, we are overweight cash, and fixed income because the deeply oversold condition which previously existed has been entirely reversed. This has occurred at a time where the earnings and economic backdrop are deteriorating, not improving.
Simply, the risk/reward setup is no longer as favorable as it was in December.
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