Last week, the spread between bullish and bearish sentiment widened substantially, pushing market conditions to what I’ve often described as an “overvalued, overbought, overbullish” syndrome.
While our general outlook has remained rather neutral in recent weeks, this shift pushes our immediate outlook back to hard-negative. However, I should emphasize that this outlook is not particularly robust at present. Indeed, we could soon find ourselves back to a neutral outlook in the event of a moderate further improvement in market internals. As I’ve emphasized regularly since mid-2014, when we adapted our methods to address the key challenges we encountered in the half-cycle since 2009 (see the Box in The Next Big Short for a detailed narrative), the advancing half-cycle since 2009 has been different from market cycles across history, in that aggressive central bank easing has persistently deferred the typical consequences of overvalued, overbought, overbullish conditions. In the face of QE, one had to wait until market internals deteriorated explicitly (indicating a shift toward risk-aversion among investors) before adopting a hard-negative outlook.
While the recent market advance appears driven by little but trend-following and short-covering, moderate further improvement in market internals could return us to a fairly neutral near-term outlook. Beyond encouraging a neutral stance with a small “tail-risk” hedge about the 1980-2015 area on the Standard & Poor's 500 (the area where nearly all our trend-sensitive measures would pile onto the negative side) we won’t fight risk-seeking behavior in the event it re-emerges in the form of uniform market internals. Still, even if the major indices were to register fresh highs, my impression would remain that the market is in the process of tracing out the arc of an extended top formation.
It’s largely forgotten that, during the 2000 top formation, the S&P 500 lost 12% from July-October 1999, recovered to fresh highs, retreated by nearly 10% from December 1999 to February 2000, recovered to fresh highs, experienced another 10% correction into May, recovered to a new high in total return (though not in price) on Sept. 1, 2000, retreated 17% by December, and by January 2001 had recovered within 10% from its all-time high and was unchanged from its level of June 1999.
Likewise, during the 2007 top formation, the S&P 500 corrected nearly 10% from July to August, recovered to a fresh high in October, corrected over 10% into November, recovered nearly all of it by December, followed with a 16% loss, and by May 2008 had recovered within 9% of its all-time high and was unchanged from its level of October 2006.
In 1954, John Kenneth Galbraith offered a similar narrative of the top-formation leading up to the 1929 crash: “The temporary breaks in the market which preceded the crash were a serious trial for those who had declined fantasy. Early in 1928, in June, in December, and in February and March of 1929 it seemed that the end had come. On various of these occasions the Times happily reported the return to reality. And then the market took flight again. Only a durable sense of doom could survive such discouragement. The time was coming when the optimists would reap a rich harvest of discredit. But it has long since been forgotten that for many months those who resisted reassurance were similarly, if less permanently, discredited.”
