Technically, the rally off the Christmas Eve 2018 low has been record-breaking on several measures.
History shows fairly rosy returns after setups like this; but with quite a few interim thorns along the way.
Sentiment has begun to shift as the “smart money” starts to take some risk off the table.
At a recent client event I was asked about our ongoing view that volatility would remain elevated—specifically, whether the rally off the December 2018 low in U.S. stocks was an indication that our view might be wrong. As a reminder, heightened volatility does not only mean downside moves—it tends to mean sometimes-unpredictable and rapid shifts in direction.
What a difference an Eve makes
We never recommend short-term market timing and the action in the stock market over the past month or so is testament to the difficulty of market timing—especially if you’re making all-or-nothing decisions with your money. From the September 20, 2018 peak in the S&P 500, stocks suffered a near-bear market (-19.8%) through the close on Christmas Eve. On cue, Santa Claus made his appearance later that night and from that low, stocks rebounded slightly more than 10% through last Friday’s close.
Christmas Eve 2018 was punctuated by some panic selling and led to a massive shift in investor sentiment as per many of the more popular indicators thereof. The panic seen during several trading days in the fourth quarter led to 52-week new lows on the New York Stock Exchange (NYSE) soaring to such high levels that it got into the zone that Ned Davis Research (NDR) says is “so bad, it’s good.” In that rare zone, the market has historically done quite well.
In fact, as of January 9, 2019 the 10-day change in the S&P 500 advance/decline (A/D) line posted its largest-ever gain. According to Bespoke Investment Group (BIG), on Christmas Eve, it clocked in at -2,440, which was the most negative reading since August 2011. Ten days later, the 10-day A/D totally reversed to a reading of +1,938, which was the most positive reading since July 2016. It was the largest 10-day change (+4,378) in the indicator on record (see chart below)—and it wasn’t even really close. The next-closest reading to the upside was on 12/5/08 when it had a 10-day change of +3,755.
A/D’s Record Surge
Source: Charles Schwab, Bespoke Investment Group, as of January 10, 2019.
Zweig (Volume) Breadth Thrust
The reversal was so extreme that on two separate trading days since Christmas, volume in rising stocks was more than nine times the volume in declining stocks. This is a volume-modified trigger known as a Zweig Breadth Thrust. (As a reminder, before joining Schwab, I worked for the late/great Marty Zweig from 1986 to 1999.)
Since that indicator’s creation, many technicians—including SentimenTrader (ST)—have more recently discovered the better fit of “volume” over “number of issues” when looking at the ratio of up-to-down issues on any given day.
When looking at the declines and attempted recoveries since stocks started their slide in late-summer 2018, what’s transpired in the few weeks since Christmas is markedly different than the ones that failed prior to that, according to ST.
In order for ST’s modified volume-based breadth thrust indicator to trigger, the 10-day exponential moving average of the up volume ratio needs to become oversold by diving below 40%; then increase enough to exceed 61.5% within two weeks. As you can see in the chart below, the thrust was triggered a week ago.
Zweig (Volume) Breadth Thrust Triggers
Source: Charles Schwab, SentimenTrader, as of January 11, 2019.
All of the prior signals are shown in the table below (those occurring amid a 52-week low for the S&P 500). There were a few notable failures in the mid-1970s as well as 2007-2008, but otherwise the median returns were fairly impressive.
Source: Charles Schwab, SentimenTrader, as of January 11, 2019.
But the technical news is not all rosy—some of the historical data shows some thorns. In the span from the close on Christmas Eve through last Friday’s close, the S&P 500 retraced more than 42% of its prior decline—more than the 38.2% Fibonacci retracement commonly cited by market technicians as an initial hurdle for recoveries.
BIG looked at how common it was for the S&P 500 to fall 15% or more within the span of three months or less, only to rally 10% or more off the low in 10 trading days or less. Since WWII there have been 12 prior occurrences, highlighted in the table below. Although average/median returns were healthy looking ahead, notice that half the occurrences saw lower lows in subsequent periods.
Source: Charles Schwab, Bespoke Investment Group, as of January 11, 2019.
Sentiment a thorn in bulls’ side?
Another rose that may have grown a few thorns is investor sentiment. From the extremes of pessimism reached into the Christmas Eve carnage, some notable reversals have kicked in alongside the subsequent rally. Many weekly-based sentiment indicators haven’t yet picked up the latter stages of the rally in their readings; however there is one set of indicators I track that is daily.
ST’s “Smart Money” and “Dumb Money” Confidence indicators are behavioral (not attitudinal) in nature and track what these two cohorts are doing in real-time and on a daily basis. Historically, investors were well-served to generally move in the same direction as the “smart money” and do the opposite of the “dumb money.”
As you can see in the chart below—which should not come as a surprise given how ferocious the rally was off the December low—the “smart money” has been taking some risk off the table, while the “dumb money” has been chasing the rally. This should serve as a slight warning, albeit not yet at an extreme.
Smart Money/Dumb Money Confidence Converging
Source: Charles Schwab, SentimenTrader, as of January 11, 2019.
Concluding on a more fundamental note
Leaving aside the stock market’s technical and sentiment underpinnings, the fundamental picture remains mixed. Good news has come in the form of a retreat in the U.S. dollar, easing credit market strains (and looser financial conditions), a more dovish Federal Reserve and reports of some favorable developments in trade negotiations between the United States and China.
However, there is little indication that the aforementioned reversals mark the beginning of new trends; at the same time, we will soon be embarking on earnings season—in the midst of a slowdown in economic growth. Although earnings are expected to have been fairly strong last quarter, they were likely well off their growth pace of the prior quarters in 2018; while estimates for 2019 earnings have been under increasingly downward pressure. Key during earnings season will be less about prior quarter commentary, and more about forward outlooks.
We continue to recommend that investors remain at or near their long-term strategic allocation to U.S. stocks, with a continued bias toward high-quality large-cap stocks. I have recently warmed up to higher-quality smaller-cap stocks as well, but don’t necessarily believe the Russell 2000 will sustainably outperform the S&P 500 given the elevated percentage within the former of non-earners and/or “zombie” companies.
Important Disclosures:
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
