Stock Market SPX Levitation Rally Act 2

By: Zeal_LLC

In less than 8 weeks, the flagship S&P 500 stock index (SPX) has relentlessly powered 12.6% higher.  This big run has been very unbalanced too, utterly dominated by long up-day streaks.  And for the most part, the occasional down days have been trivial.  The SPX simply continues to melt up day after day, its surreal levitation act making traders nervous.

With most technical and sentiment indicators pegged at very overbought states, consensus naturally expects a sharp correction.  One would certainly be nice, as it would neutralize today’s stupendous complacency and erase much short-term risk from the marketplace.  But interestingly, there is another thesis that traders ought to consider.

Perhaps this SPX levitation act is actually righteous.  I know this sounds crazy, and in most market environments it would be.  But at today’s peculiar place in the greater bull-bear cycles, levitating is actually what the stock markets do.  And if the odds favor the SPX continuing in this surreal course, the optimal trading strategies are wildly different from consensus.

Knowing where we are in the bull-bear cycles is like having a strategic roadmap for the stock markets.  There are two kinds of bulls and bears, secular and cyclical.  The secular variety last about 17 years each, and within them smaller multi-year cyclical bulls and bears flow and ebb.  We are currently in a secular bear that started in March 2000, and a cyclical bull within it that launched a year ago in March 2009.

It turns out that starting around 6 months into cyclical bulls within secular bears, the kind of SPX levitation act we are seeing today is typical.  The stock markets initially rocket higher out of their secular-bear lows, but then they start relentlessly grinding higher without any major corrections.  Pullbacks are seen periodically, but these are pretty small relative to the massive moves higher.

This phenomenon is quite clear in past cyclical bulls within secular bears.  When you overlay today’s markets on those examples, they match up remarkably well.  Today I’m considering two such past episodes.  The first is the last cyclical bull within today’s secular bear that erupted in March 2003.  The second is a cyclical bull in the mid-1970s that launched at the same point in that previous secular bear where today’s cyclical bull was born in today’s secular bear.

Since the cyclical bull that emerged in early 2003 was inside the same secular bear we are drifting in today, it had a very similar trading range.  In fact, these cyclical bulls share a common SPX scale.  The stock markets’ behavior in each is remarkably similar.  Today’s SPX cyclical bull in blue is superimposed over the 2003-to-2004 SPX action in red.  This chart is quite startling if you haven’t studied it before.

Both of these cyclical bulls started rocketing higher out of deeply-oversold March lows.  Both had June interim highs followed by summer pullbacks.  Then both had autumn rallies punctuated with minor pullbacks.  And after these wickedly-fast early-cyclical-bull gains, both failed to see a single full-blown correction.  The many similarities here despite the 6-year gulf of time are extraordinary.

For our purposes today, check out the pullbacks.  In our current cyclical bull, we have really only seen 4 after that initial vertical surge out of the lows.  They weighed in at 7.1% over 19 trading days ending in July, 4.3% over 8 days ending in October, 5.6% over 9 days also ending in October, and 8.1% over 14 days ending in February.  This averages out to 6.3% over 13 trading days, which is really pretty mild as far as corrections go.

So what makes a correction?  Like much in the markets, the definitions are varied.  Many traders believe a correction has to hit 10%+, before then it is simply a pullback.  Others believe corrections drag a price back down to its 200-day moving average, something that has never come close to happening in today’s cyclical bull since its 200dma turned higher.  By both of these definitions, we certainly haven’t seen any corrections yet.

Despite this, since early August traders have been zealously looking for correction-magnitude retreat events.  I counted myself among this group as well late last year, before I had done the initial research and found out these levitation acts are normal at this stage in cyclical bulls.  Anyone who has relied on conventional technical or sentimental analysis, and has been sitting out waiting for a correction, has forfeited some awesome gains.

And interestingly, this behavior tends to persist in the second year of cyclical bulls.  Note above in the red SPX series in 2004, the equivalent of 2010 in today’s cyclical bull, that minor pullbacks continued to be the order of the day going forward.  Back then the SPX saw a 5.7% retreat over 29 trading days ending in March, 5.8% over 29 days ending in May, and 7.1% over 35 days ending in August.  This averages out to 6.2% over 31 trading days, which is nowhere near correction-magnitude.

Thus across both young cyclical bulls, we saw average pullbacks in the 6% range.  The worst ones ran 7% to 8% or so.  Based on this precedent, perhaps the odds for any full-blown corrections in the rest of this year are much lower than most traders assume.  If the rest of 2010 tracks like the rest of 2004, the same stage in these respective cyclical bulls, we will merely see relatively mild pullbacks from time to time.

Another interesting thing about the 2004 scenario is the SPX entered a high consolidation after enjoying such awesome early-cyclical-bull gains.  Between March 2003 and February 2004, the SPX shot 44.6% higher.  Meanwhile today’s bull soared 70.0% between March 2009 and January 2010.  While the latter’s gain is much larger, most of this was due to the SPX starting off a lower base.  The terminal plunge in February and March 2009 was a lot more severe than its counterpart 6 years earlier.

Provocatively in both these cases, the SPX initially stalled out near 1150 in the January timeframe.  After that in 2004, it generally ground sideways to lower.  While today’s path has instead taken it to new highs, they aren’t materially above January’s (just 3.4% higher this week).  So there is a good chance we may very well see another high consolidation for the next 7 months or so centered around 1150.  Summer tends to be a weaker time for stocks, so our high consolidation may have another downward bias.

And interestingly, this high consolidation in year two of a mid-secular-bear cyclical bull holds true in the last secular bear too.  It ran nearly 17 years, from February 1966 to August 1982.  In rough terms, 2009 is the equivalent of 1975 and 2010 of 1976 in that earlier secular bear.  This chart also highlights the giant sideways trading ranges that make up secular bears.  Most investors assume secular bears go lower, but the truth is they grind sideways on balance for 17 years.

Note that after emerging out of late 1974’s stock-panic-like event, the SPX rocketed higher in 1975.  We saw this same phenomenon in 2009, the first year of a mid-secular-bear cyclical bull at the same point in the bull-bear cycles as this example above.  But in 1976 this fast rally flattened out and consolidated high.  For most of 1976, the SPX generally meandered within today’s equivalent of 1075 to 1175.

And the largest retreat you can see in 1976 ran from September to November, 8.4% over 35 trading days.  While on the large side for a pullback, it was still certainly no correction.  And interestingly these numbers jibe well with the pullbacks observed in 2004 and 2010.  So there is plenty of precedent from this particular stage in bull-bear cycles suggesting that traders shouldn’t expect major corrections despite the big rallies.

Why is this the case?  How can the SPX levitate near highs after such large, fast, and unbalanced rallies?  I suspect there are many reasons, but several primary ones leap out in my mind.  They are technical and sentimental, with the latter psychological components likely playing the greatest role in driving these surreal SPX levitations.

Note in the chart above that secular bears have giant sideways trading ranges.  In our bear today, this runs between roughly 750 and 1500 on the SPX.  Since 2000, the SPX has rarely fallen below 750 or climbed above 1500, and none of these outlying extremes persisted for too long.  In the context of this giant secular trading range, today’s 1150ish SPX remains relatively low.  It is merely in the middle of its secular range.

So while it is true the SPX has rocketed 75.8% higher in just over a year, an amount which admittedly seems absurd on the surface, the SPX’s absolute levels today are not extreme considered in their longer context.  After plunging 56.8% in its last cyclical bear that ended in March 2009, the SPX had a lot of ground to make up.  And despite its gigantic early-cyclical-bull rally since, it remains far under its October 2007 levels of 1565 at the top of its last cyclical bull.

Since the SPX isn’t super-high by any means when considered in broader context, this explains why it can consolidate at what looks like high short-term levels technically.  The absolute SPX levels are still relatively low even within the context of our secular bear.  Most of the huge rally we saw in the past year was merely an offsetting bounce after a mind-blowingly brutal stock-panic plunge that drove the stock markets to ridiculously-oversold levels.

But even more important than secular technical context is the psychology of early cyclical bulls.  As you know, most investors missed out on the great majority of this past year’s humongous rally.  Instead of being hardcore contrarians and very bullish on the stock markets in March 2009 like we were, they bought into the whole mainstream end-of-the-world sentiment thing.  Despite one of the biggest stock-market rallies of the modern times since, trillions of dollars sat out languishing in zero-yielding cash.

It is really pretty sad.  When everyone is bearish is the best time to be bullish, and contrarians and students of the markets realized this.  But mainstream financial thought didn’t, and investors lost trillions in gains because of this short-sightedness.  As the post-panic rally grew larger and larger, the psychological pressure on those investors who missed out on most of it grew ever more intense.  There was and is tremendous pressure to get out of cash and get invested.

Thus every time there is a pullback in the SPX, legions of investors and speculators are waiting on the sidelines eager to deploy on any sign of weakness.  Their collective buying pressure is immense, and this buy-the-dips dynamic is probably why we only see relatively mild pullbacks at this stage in a mid-secular-bear cyclical bull.  Catch-up buying short circuits every pullback before it can snowball into a correction.  I don’t expect this to abate until the vast majority of the mountains of cash on the sidelines get deployed.

And while the psychological pressure of missing out and rushing to catch up is intense for individuals, it is an order of magnitude worse for professional money managers.  If you are running a fund and find your performance lagging your peers’ because you weren’t fully invested in this cyclical bull, your investors start pulling capital out of your fund.  Underperformance in a strong market kills funds.  You can’t sit in cash if your peers aren’t, thus you have to aggressively buy every minor retreat to attempt to get fully deployed.

So there are great technical and sentimental reasons why these SPX levitation acts are plausible at this particular stage in the bull-bear cycles.  Stock prices aren’t high in the grand secular scheme and investors who weren’t contrarian enough to ride most of the early-cyclical-bull rally are desperately buying whenever possible to attempt to catch up.  This dynamic will likely persist throughout the rest of 2010.

Thus as traders, we have to realize that we probably won’t get that major correction that looks so desperately overdue by many technical and sentimental measures.  This makes short-side bets look a lot less attractive despite the short-term overboughtness pervading the stock markets.  It also means that traders waiting for a major correction to deploy are likely to continue to be disappointed.  A high consolidation with minor pullbacks doesn’t create any deeply-oversold buying opportunities.

At Zeal we are actively playing this SPX-levitation environment in multiple ways.  First, we continue to look for relatively-oversold commodities-stock sectors and individual stocks.  The best example today is the gold and silver stocks, which we have been deploying in aggressively in recent months.  After having recently weathered a giant 27.6% correction ending in early February, they are cheap relative to gold itself.  We just published a comprehensive new report detailing our dozen favorite advanced-stage junior golds.  Buy your copy today and get deployed!

Undervalued individual stocks have the best potential to thrive in this ongoing high consolidation.  We are also avoiding the temptation to short stocks and indexes that look overbought.  It is hard to make money on the short side without serious corrections.  If you want to grow your knowledge of the markets and greatly increase your odds for trading success, subscribe today to our acclaimed monthly newsletter.  Our subscribers know about these trends and how to trade them long before the mainstream.

The bottom line is today’s surreal SPX levitation act is probably sustainable.  Yes the markets look overbought and a sharp correction would do wonders to rebalance sentiment.  But at this stage in the bull-bear cycles, all that is likely is high consolidations interrupted by periodic mild pullbacks.  This is primarily driven by psychology, the need for investors late to the rally to chase the gains they missed.

While it flies in the face of conventional analysis not to consider today’s stock markets ripe for a plunge, as traders we must adapt to prevailing conditions.  And emerging out of deeply-oversold lows in a young mid-secular-bear cyclical bull, the odds don’t favor major corrections.  In fact they don’t exist in history at this stage in bull-bear cycles.  So prudent traders have to hold their noses and go with the high consolidation.

By Adam Hamilton, CPA

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