How Long Will the Party Last?

S&P 500 at Record Highs Ignores Global Outlook

The S&P 500 has reached new record highs following a disastrous start to the year. While the January/February sell-off was clearly extreme and exaggerated, can the same be said of the current advance in the S&P 500 and other global stock indexes? It’s a question being asked by many market watchers, which suggests to me that a lot of investors have missed this move and are stuck watching on the sidelines. I’ll count myself among them—having bought the post-Brexit dip, I got out in the first week of July.

On its own, that suggests a classic set-up for a fifth wave higher. With many investors sidelined and not willing to buy into the current rally, persistent and sustained gains finally lure them back into the market, generating a flurry of late-to-the-party buying. After that, all the buyers are in and the bottom is more likely to fall out.

It also suggests that investors who have missed recent gains will materialize on any pullbacks, hoping to get back in for future gains, potentially keeping the market more supported than is warranted. Taken together, it presents a choppy and difficult trading environment.

On the fundamental side, market gains seem more misplaced than justified, in my view. To be sure, US data has been quite solid in recent weeks and the end of the month is expected to see a healthy 2Q US GDP report (forecast at +2.6%; prior +1.1%), buoyed by strong personal consumption (forecast +4.1%; prior +1.5%). Data out of Europe and Japan, however, have turned sharply lower in recent months, while the best that can be said of China is that the outlook remains stable at lower levels. The IMF (International Monetary Fund) acknowledged this deterioration by downgrading its outlook for global growth just this week.

TINA-There Is No Alternative

It may simply be that investors are desperate for returns, and with rates near zero or negative in major economies, stocks are the only option. However, we had the same environment back in January/February and again following Brexit, when global stocks experienced sharp downturns. So the TINA theory doesn’t exclude abrupt reversals, and, in fact, probably encourages them. Complacency can generate its own volatility.

From the technical side, momentum studies show the S&P 500 is overbought and potentially topping (chart above), and we have drifted through the primary trend line off the Brexit lows (red line). And yet price is holding its ground, for now at least. In the chart below, we have another indication that the current price advance is reaching historically unsustainable levels.

Futures on the VIX Index (S&P 500 Volatility Index) are at the widest spread to spot VIX contracts in many months (oval in lower panel of chart), and are approaching 2 standard deviations of the 5-year range (upper green line). When the VIX futures/VIX spot spread reaches such extreme levels, downside corrections frequently follow.

What Can Investors Do?

To be forewarned is to be forearmed. Depending on individual positioning and risk appetite, investors have several ways to navigate these waters:

Take (partial) Profit: Investors who have been long stocks are likely in the money and might want to consider taking some money off the table. Full or partial profit taking on current strength would be entirely justified—you can’t go broke taking profit. You might consider rotating into fixed income for capital preservation and possibly gaining if yields fall on a stock market decline. (For Fibonacci followers, 1291 in the S&P 500 is where wave 3 will equal wave 1.)

Raise Stop losses: If you don’t want to try to outguess the market, you could simply raise stop loss orders nearer to current market levels, to within 2-3%, for example, or a close below the Ichimoku Tenkan line (purple line) at 1257. If the market does indeed turn down, you’ll have protection in place that can safeguard some of your gains and you won’t have to worry about deciding whether or not to sell while the market is falling.

Use Inverse ETFs: Inverse ETFs rise in value when the underlying index, such as the S&P 500, declines. Inverse ETFs can be used to hedge existing long stock positions, or profit on a speculative view to short the market. Remember, however, inverse ETFs re-set daily, meaning they should be used on an intraday or very short-term basis. If you buy an inverse ETF today, and the market declines in two weeks’ time, the ETF may actually be lower in value relative to the index price due to the time lag. Some available inverse ETFs are: DOG (short DJIA); PSQ (short NASDAQ 100); RWM (short Russell 2000); SH (short S&P 500); and EUM (short emerging markets).

Identify Limit Order Price Levels: If you’re looking to buy dips, now is the time to do your homework and prepare. If the market does turn down, you’ll have a well-thought plan to put into action while the rest of the market may be panicking, and you won’t suffer from hesitation and potentially miss a buying opportunity. If you like stocks at current levels, then you’d have to love them at a 5-10% discount, right?

I don’t know what the catalyst might be that derails the current rally, but it pays to anticipate and be prepared. We’ve been through several shocks already this year and there’s no reason not to expect further surprises. It could be as simple as continued US resilience putting a Fed rate hike back in play as early as September, which could cut the summer rally short. There’s an old saying that it’s best to arrive at a party late and leave at its peak.