This One Number Makes Me Think the Rally Is Over

This week I heard from a reader with a question I bet is on every investor’s lips.

Q: Michael, Excellent written article … However, I am curious on your “take” as we move into fall and December – What about the notorious “Christmas rally”? ~ James B.

A: James, the S&P 500 has rallied a remarkable 13% in the last five weeks, recapturing all of its summer losses. The Dow Jones Industrial Average jumped by 8.5%, while the S&P 500 soared by 8%, and the Nasdaq Composite Index outdid them both with a 9.38% performance. Even more noteworthy is that the three major indices have done this in the face of unrelentingly poor economic data. (More on that in a minute.)

So it’s no surprise you’re wondering, as we sit here in the first week of November, whether Santa Claus came early or whether the market will keep “melting up” through the end of the year. And I bet you’re not the only one.

Here’s the number I’m looking at…

Just FOUR Stocks Caused 20% of This Rally

As I told you last week, nobody expected the type of rally we saw in October.

But here’s what people are missing.

Twenty percent of the gain in the S&P 500 in October was accounted for by a near $300 billion rise in the value of just four stocksAmazon.com Inc. (NasdaqGS:AMZN), Apple Inc. (NasdaqGS:AAPL), Microsoft Corp. (NasdaqGS:MSFT), and Facebook Inc. (NasdaqGS:FB).

In fact, the only bright spot has been the strong earnings reported by a select number of large-cap tech giants like these. The rest of the earnings landscape has been lousy.

While other stocks did gain ground, including beaten-up energy and industrial names, much of the market remains in a stealth bear market with year-to-date losses of 20% or more. And while the market had a great month in October, many of the big-name hedge funds had catastrophically poor months and are nursing double-digit losses for the year.

Unless you own the limited number of stocks that are rising, you are not participating in this rally.

The reason why the rally is so narrow is that its underpinnings are extremely weak. Basically, the market moved up as economic data deteriorated through the month. Third-quarter U.S. GDP came in at an anemic 1.5%. The manufacturing PMI number came in at 50.1, a number that points toward recession. The last two times this number hit 50, the Fed initiated QE in 2011 and 2012. The news from abroad isn’t any better. China’s economy is getting worse, not better, while Japan remains stuck in terminal decline and Europe is struggling while it waits for another round of QE from the ECB. Corporate earnings are weak because the economies in which corporations are operating are weak domestically and globally.

But investors, being a herd-driven and Pavlovian bunch, decided to stick to the old playbook of “bad news is good news” in October. The worse the news got, the more they believed that central banks would come to their rescue again. The only problem with this scenario is that central banks have not come to their rescue; these confederacies of dunces with economists PhDs have merely propped up weak economies by drowning them in more debt that can never be repaid. The longer they keep interest rates at zero and print more debt, the longer it will take for economic recovery to occur.

So what does this mean for stock market investors?

There’s a Lesson in This Chart

SMI-1105

Click to Enlarge

Check out this chart. Since 1980, the S&P 500 has experienced average intra-year drops of -14.2% but has produced positive average returns in 27 of those 35 years. This year, the S&P 500 was down as much as -12% before staging its recent rally. In 2013, it was down as much as -6% before closing the year up 30%.

The point is that, without exception, the market drops at some point during the year but tends to end up with a positive return. That is why investing in the stock market is a marathon and not a sprint. But when the market becomes dangerously overvalued, it is still prudent to reduce exposure. And I believe we are again at one of those points after the recent rally.

So What’s Next for Stocks?

I honestly have no idea whether stocks will keep on rallying. Nobody does. But my best judgment is that they will not.  Having already hit my year-end target of 1875-1900 in September, I believe the S&P 500 is entering a bear market and we are now experiencing a classic bear market rally.

Could stocks keep defying gravity and rally into year end? Definitely. Some strategists like Tom Lee are calling for the S&P 500 to reach 2350 by December 31, a rise of another 12%. But Mr. Lee is always telling people stocks are going up and even a broken clock is right twice a day.

I think it’s more likely that most of the rally is in the books. There are too many economic headwinds to support much higher stock prices, especially if the Fed finally carries through with its threat to raise rates for the first time in nearly a decade in December. Stocks are now back at the same overvalued level from which they corrected in August. Long-term investors can stay the course, but traders should be grateful for the early Christmas rally and take their gains and go home.

Or make some of the moves I’m going to be showing you here…

P.S. Thanks to James B. for writing in. Send your own questions to me at customerservice@suremoneyinvestor.com. I really enjoy your ideas, conversation, and friendship.

24 Responses to “This One Number Makes Me Think the Rally Is Over”

  1. When the Chinese stock market tanked, many of the 600 million Chinese middle class got burned. What are the probabilities that they are putting their money into American stocks now and by doing so are driving American equities up to support a bull market?

  2. I am new to your site Michael. So far you seem to have a reasonable handle on the market and the economy. I don’t take much outside investment advice but I do subscribe to several research companies only to keep track of what I may be missing on my own. I now find it ironic that the four current subscriptions appear to be diabolically apposed, calling for Inflation, Deflation, Stagflation or none of the above. Buy Gold, no buy Silver, stay away from both, Yellen will raise, no she can’t. China is broke, no it’s not. The Dollar is just the best looking NAG in the glue factory. I was not around in the 20’s,30s’ or the 40s’ but I am older than most dirt and I can assure you most of us who are paying attention have never and I mean never witnessed such economic arrogance, incompetence, greed and Global confusion. Your take?

  3. I agree in general with Mr. Lewitt but there such an euphoria on the leaders mentioned in the article that I fear this market will never go down, ever, for the moment. What could very well happen is that this AMZNing euphoria moves on to the rest of the market. Today even NRP beat…

  4. Your articles have become the only ones I read. Thank you for bringing clarity to a noisy environment of business news.
    I keep hearing that the melt-up is now beginning with mom and pop money finally coming from the sidelines into the market. What is your opinion about that theory?

  5. Michael, Thank you for answering my “X-mas rally” question with some interesting statistics. Appears the next 6 – 7 months (May) will be problematic w/ U. S. indices now above 200 moving day avg’s and relatively low Vix’s. My take … market has “peaked” and will vary somewhere plus (or minus) 5-10% off their high’s due to volatility over the next several months. And “without a MAJOR catalyst” to the upside, market will move into a “severe” bear market. Please provide strategies on how to “profit” during these times since volatility will become an “issue” when entering and exiting. Thanks. James (J. V.) Bentley

  6. These are all good questions and comments. I note that Michael is proposing to have some reasonably good idea as to what we average folk should probably do with our very hard earned funds….but when does he actually ‘reply’, as in ‘push that reply button so we, his readers, can see his responses? How long do we usually have to wait?

  7. Hi Michael your comment here is appreciated. I’m a big advocate of being able to read the charts. I especially like Investor’s Business Daily and William O’Neil. There’s also the Elliot Wave. Much of these patterns are based on fractials and they repeat themselves. The Elliot Waves come in threes. If you pull back to the max on the major indices you can literally see the waves. The Dot-com bust started in March o 2000 and ended in October of 2002. The RE bust started in October of 2007 and ended in March of 2009. From IBD there’s a topping pattern called; The Head and Shoulders, usually used for shorting. The examples I have took 8 months to take effect. If you look at the Nasdaq it topped in July. 8 months out from that is March of 2016. This may all be a coincidence, but it is a very clear pattern that is playing out so far and puts this bust 15 years to the week from the first one. I project all Hell will break loose in March. What do you think?

  8. and what if the Rapture of the Church were to hit by the 11th of Nov ?? what would stocks do then ?? i think maybe it would
    be wise to consider what the market would do if Jesus Christ returned…………just saying …………….

  9. Mike – your insights into the market swings are a breadth of fresh air in a confusing world of expert opinions. The artificial currencies now circulating the globe are the “hot air” that is keeping all these stock prices at totally unrealistic levels. Soon the hot air balloon must settle, and from the looks of things, it will not be a soft landing. So . . . to repeat other comments above, what is your best guess timetable, and what steps should we be taking to get back into the game having sat on the sidelines during the market deflation? Keep up the great work.

  10. To profit from a decline, one can purchase shares of various “inverse” ETFs which rise in value when the market drops. Examples are FAZ and TZA, which are related to financial stocks and small-cap stocks, respectively.

    One could also profit from a rise in the VIX (aka the investor fear gauge) with ETFs such as TVIX and UVXY.

    S&P has likely peaked at 2137.1 for a good long time. The wave structure could be developing as a contracting triangle which should ultimately break out forcefully to the downside when it reaches an apex. My guess for when would be December, if interest rates rise.

  11. Ayn – Thanks for your very concise and pointed advice for those not aware of those vehicles. Also for your call on the “peak for a good long time”.

    I for one cannot fathom how a .25% interest rate hike can cause so much turmoil in the market. On Friday financial stocks jumped almost 3% on the conviction that a rate change is coming in December. The computer algorithms have taken over market trading and the result is moves that make no common sense whatsoever. A time to be very cautious and expect the unexpected. Though common sense tells me a drop is imminent, the bears have been calling for a major correction since 2009 missing out on 6 years of vertical gains.

  12. Bob, I appreciate your response. I think the peak was reached in May mainly because the S&P was, at 2137.13, then level with the year 2000 peak in inflation-adjusted terms. In other words, after filtering out the distortion in the index caused by the decrease in the Dollar’s purchasing power over the years, the index has not really surpassed the 2000 peak.

    This fact is supportive of an Elliott Wave pattern termed a “flat” correction (having started in 2000) which expects a 3-wave decline, then a 3-wave rise back to about the same level, and then finally a 5-wave decline of equal or greater extent to end it. The three segments are labeled “A, B, C” on a chart. 2000-2009 was A, and 2009 to 2015 was likely B. Wave B, in my opinion, is ending as a contracting triangle which will continue to bounce in a narrowing range until it breaks out powerfully into wave C downward. The Elliott Wave pattern is a reflection of market sentiment which tends to follow certain repeating fractal patterns as mentioned by the author. I don’t believe an interest rate hike will cause the overall decline per say, as I think the pattern is already in play, although it may affect the timing and volatility of the pattern. I have charts on tradingview.com under aynczubas if you would like to see them.

  13. Your point is understandable, but I should also say that automated trading should ultimately reflect the intentions of its programmers, the traders, albeit less emotionally and more pragmatically carrying out orders to buy and sell from moment to moment. I think if you examine the market from an E.W. perspective, the moves can be made sense of.

  14. There are two opposing forces acting on the American economy. Oil prices are giving our economy a HUGE economic boost, effectively TWO TRILLION dollars each year shared by all the world’s economies. The problem America is facing is 10,000 people retiring every day for the next 15 years. These high wage earners will be replaced by lower wage entry level employees.
    This is why it is difficult to calculate the outcome of an event that hasn’t occurred since the WWII generation retired which started about the time Jimmy Carter took office.

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