3 Reasons To Expect Another Melt-Up And Not A Crash

My Comments: this is in keeping with my theme this week, what you might do with your un-invested money. As usual, I have no idea if the following will work in your favor or not. And it reflects a technical approach to investing as opposed to a fundamental approach.

There are several charts and tables in support of the arguments made. If you’re inclined to dig into the weeds, then the following URL will take you to the original. I’ve chosen to only share the words and not the charts. Good luck.

by Unknown \ 17 MAY 2020 \ https://tinyurl.com/y7eh6o2q

Summary

  • S&P 500 (SPX) continues to gyrate between 50-day and 200-day moving average, but technicals are shifting in bulls’ favor.
  • Investor sentiment based on the AAII survey turned extremely bearish in spite of the recovery rally in SPX, which historically is a contrarian buy signal.
  • The volatility index (VIX) has dropped under the 20-week moving average, a bullish sign which also points to further gains in SPX.
  • Lack of follow-through to the downside despite weak fundamentals and seasonality could set the stage for another technical-driven melt-up.

Another week and another whipsaw in the U.S. stock market, as the S&P 500 (SP500) closed down -2%, but escaped mostly unscathed from yet another barrage of horrific economic data and rising geopolitical tensions between U.S. and China. As we wrote in past few weeks, the tug-of-war between bulls and bears remains in progress until either the 50-day or 200-day moving average gets decisively breached. With SPX virtually unchanged over the past month, it is safe to say neither side has the upper-hand so far.

That said, a failed bearish reversal pattern may have given the bulls the edge going forward. Recall from two weeks ago, we asserted that the “shooting star” candlestick pattern in the S&P 500 weekly chart would lead to a significant pullback in the following three months with a 70% chance:

However, bears have been unable to deliver a knock-out punch with the SPX having advanced 1% over the past two weeks. Moreover, based on the above historical analysis, the lack of follow-through on the bearish pattern is a bullish signal, as the S&P 500 proceeded to rally further 2 out of 3 times. Even in the case of late-2002, note that SPX was already at the tail end of its bear market:

Considering that we had a 50-day lower Bollinger Band signal just two months ago, recent price action more closely resembles the post 1987-crash trajectory, during which the recovery rally in SPX would continue unabated beyond the 200-day moving average after a similar failed shooting star pattern:

In short, from a technical perspective, although SPX remains in no-man’s land, the longer it is able to hold above the 50-day moving average especially in the face of negative reversals and bearish sentiment, odds become increasingly in favor of another leg higher in broader stock market. In other words, “what can’t go down often goes up”.

The Case For “The Most Hated Rally Ever” To Continue

From disastrous economic data to negative earnings, escalating geopolitical risks to fears of COVID-19 second waves, there are dozens if not hundreds of fundamental reasons why the stock market ought to crash. Indeed, it is Wall Street’s consensus that lower prices are to be expected in S&P 500 this summer:

Goldman Sachs: As Kostin puts it, “many market participants – ourselves included – have expressed incredulity at the fact that the S&P 500 trades just 17% below its all-time high amid the largest economic shock in nearly a century. We opined in January that the earnings power and valuations of the top five stocks suggested they could avoid the fate of the top stocks in 2000. However, the further market concentration rises, the harder it will be for the S&P 500 index to keep rising without more broad-based participation.” – Source: Zero Hedge

Bank of America turned “tactically bearish” on stocks after the rally in the S&P 500 index, citing the four key reasons: 1) Real risk of a second wave of infections in South Korea and in the US cases still rising outside of New York. 2) Investors are flying blind with more than 30% of S&P 500 companies withdrawing earnings guidance. 3) The ratio of positive vs. negative sentiment on corporate earnings calls is the worst since 2012. 4) The disconnect between the economy and equity markets. – Source: FXStreet

Billionaires with the brightest minds including Warren Buffett and David Tepper are not buying into this raging bull run neither. To wit from the founder of Appaloosa Management on CNBC:

“The market is pretty high and the Fed has put a lot of money in here. There’s been different misallocation of capital in the markets. Certainly you are seeing pockets of that now in the stock market. The market is by anybody’s standard pretty full.” The S&P 500′s forward price-earnings ratio based on estimates for the next 12 months has ballooned to above 20, a level not seen since 2002. – Source: CNBC

Individual investors concur as well, as the 10-week moving average of the AAII bearish sentiment rose to the highest since early 2009 at 48%:

All in all, most expect this much hated bear market rally in stocks to end sooner than later. Yet, history suggests that such immensely negative sentiment can be interpreted as a contrarian bullish indicator. Specifically, there were two other periods during which AAII bearish sentiment’s 10-week moving average exceeded 45% while S&P 500 rallied more than 5%: late-1990 and mid-2009, both of which marked the beginning of a new bull market averaging 10+% gain in the ensuing three months:

While one could argue this time is different, we prefer to keep an open mind and respect the price action instead.

Free-Falling VIX – Another Positive Sentiment Indicator

Further supporting the bullish theory is the continued collapse in the CBOE volatility index (VIX), which finally dropped below the crucial 20-week moving average after 11 weeks:

As the chart illustrates, there were only handful of times since 2008 during which the VIX stayed above the 20-week moving average for more than 10 straight weeks. We notice that in each of those occasions, the subsequent decline underneath the moving average proved to be the turning point, as VIX would complete a round-trip back to the lows within months. In that scenario, the continued free-fall in VIX most certainly would be accompanied with a melt-up in S&P 500.

Election Year Seasonality About To Turn Positive Again

In a typical U.S. election year, the stock market tends to exhibit weakness between April and May according to SeasonalCharts.com. While a substantial pullback has not materialized, the recovery rally has largely stalled with higher highs being rejected during that period.

Going forward, seasonality will soon become a positive tailwind into the rest of the year as shown above, and as such, could contribute to a breakout higher in S&P 500 along with the technical and sentiment factors discussed previously.

To summarize, although we have been bearish and looking for a re-test of the lows during the course of this rally, recent developments in technicals and sentiment have compelled us to adjust our tactical outlook. In other words, we are now expecting the unexpected: another leg higher and breakout above the 200-day moving average in the S&P 500 driven by short covering and normalization of overly bearish sentiment. At the same time, we will remain flexible and re-assess if VIX is able to close back above the 20-week moving average.

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