The Train has Left the Station

It’s been quite a week for the bulls and an almost straight up move from the nasty open last Friday on the weaker than expected employment data. Earlier this week, I posted a study that concluded a huge Q4 rally was underway. And that was on the heels of a series I have published on post crash behavior that was also strongly bullish.

The train has left the station.

Where are all the mouthpieces who were calling for a bear market? Where are all the people who kept arguing with me that my bullish forecast was nonsense? The naysayers have become eerily silent!

The move we are seeing from the lows has been nothing short of dynamic, as it usually is when the bottom is in. Relentless buying. Maybe a down day or two as a quick pause, but nothing more. Volume is high. Stock market internals are powerful. New sector leadership is trying to emerge.

The three key sectors, semis, transports and banks are behaving nicely. Consumer discretionary, left for dead over and over and over for six years, continues to lead. After several failed attempts, energy and materials have trapped the bears and are surging higher. Even high yield bonds, which have long concerned me, are showing signs of life.

Come on in. The water is nice!

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Down August AND September Equals HUGE Q4 Rally

Although I have been struggling to find enough stocks behaving constructively in the 9 major sectors to lead the next rally, I still do not see a meaningfully bearish scenario at this point for Q4. Besides the post crash trend, which can be viewed HERE, HERE and HERE, almost every sentiment indicator is showing excessive pessimism, which translates into positive returns going forward this quarter.

After the month of August closed down, I shared two separate studies that indicated that September would be down as well. Although September closed with a bullish bang, the month still closed down more than 7%, which leads to another study. When August is down and September is down, October typically continues lower early on and forms a bottom from which a significant rally emerges. Hence, October sometimes being referred to as a bear killer for bottoms seen in 2014, 2011, 2002, 1999, 1998, 1997, 1990, 1989, 1987 and on.

Down Augusts followed by down Septembers are not a common occurrence. Over the past 35 years, there have been only 6 occurrences.  I think you will be surprised at the outcomes below.

6 out of 6 times, the S&P 500 rallied sharply in the fourth quarter, averaging a very impressive gain of 10.86%!

My view continues to be that after this bottoming pattern is complete, all-time highs are in store for the major stock market indices. I also believe that Dow 20,000 is a reasonable target before Q4 of 2016.

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More on the Post Crash Pattern… Both Paths are Bullish

The only thing missing from a “perfect” pattern is for the S&P 500 to breach the August lows for up to a few days. I hesitate to use the word “perfect” because it rarely plays out exactly as I expect, but it certainly did so in 2011. Additionally, in both 1987 and 1989 which I partially dismissed, the final lows did not breach the crash lows before the big rally began.

As you can see from the chart above, I have two colored scenarios to the right of where the current price action ends. The light blue is the more immediately short-term bullish scenario and has the final bottom as being in and the rally beginning last week. The orange line is less short-term bullish as it has one more decline into the final low over the coming few weeks before blasting off to the upside.

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Post-Crash Behavior Still Following My Scenario

Immediately after the August 24 mini crash, I opined that the bottoming process could begin as early as that very week, which it did. I also wrote extensively and did a fair amount of media discussions on the topic. So far, the major indices are nicely following that scenario which had stocks rallying off the crash low into a September peak and then revisiting that low by the middle of October.

Remember the comparisons I offered from 1987, 1989, 1994, 1997, 1998, 2010 and 2011? You can read the full article HERE. ($marts20150902.pdf) I was also excited to share my findings on CNBC’s Fast Money.

At this point, I am totally eliminating 1994, 1997 and 2010 as the correlation (how closely the patterns resemble the current one) has broken down. I am also partially eliminating 1987 and 1989 as the rally from the crash bottom to the ensuing peak was a mere two and five days long as you can see below.

We are now left with 1998 and 2011 as the most likely comparable periods to today. Not surprising, they are very similar as I review the price action, number of days in the rally period and days separating the mini crash low from the final low.

Below is 1998 where we see the late August crash, followed by a 17 day rally and 28 days between the lows before stocks embarked on a powerful rally to fresh all-time highs.

2011 is next and similar. 17 days of rally with 40 days between lows.

Finally, 2015 is below. First, you can see how the rally period allowed me to partially or mostly eliminate 1987 and 1989 although 1987 still looks similar to 1998, 2011 and 2015 if you look at the days between lows.

While the higher highs in the rally from the August mini crash looks more like 1998 than 2011, 1998 also rallied further than what we saw last month. I would offer that a synthesis of 1998 and 2011 is probably the best fit.

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Are We There Yet?

This feels like a family car trip with one of the kids constantly asking, “are we there yet?”

Much of what I have to say remains the same. Stocks have almost perfectly followed my post mini-crash scenario since August 24 and they are now in the zone for a possible successful retest of those lows between now and say, October 15. With the major indices opening sharply higher today, talk will once again focus on IF we have seen the bottom and this is day one of the rally.

Last Friday, we faced a similar set up, but I opined that the odds did not favor a low. Today, with the S&P 500 and S&P 400 retesting their closing lows from August and the Russell 2000 undercutting it, the odds now move to 50/50 that the final low has been seen. Even money is not an investing bet I would normally take as I typically like the odds to be in my favor. With that said, I think it’s better to pay a little higher prices than buy right here without an edge. In the end, I still think that another selling wave hits over the next few weeks.

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Was That It?

At their worst levels on Thursday, the major stock indices were bludgeoned and downright ugly. The Dow was down to 16,000 and could have been cracked open like a coconut today had the bulls not mounted a very strong late day charge. The rally was somewhat impressive and leaves open the question of whether we just saw the revisiting of the August lows I have spoken about on CNBC’s Fast Money and written about here. With stocks looking up more than 1% at the open, it will be interesting to hear what gets circulated in the media.

My take is that the odds do not favor yesterday’s low as being the final chance to get on board the train to new highs. It was a nice reversal, but I don’t think price went deep enough nor shook out enough weak handed holders during the day. In short, the decline was too orderly. I think more work needs to be done on the downside.

Looking at the calendar, it’s not a usual time to see a final stock market bottom, but that doesn’t mean we can’t see a low now. Additionally, we typically see a little more time go by from the crash low (Aug 24). More than likely, after selling off in almost straight line fashion since the Fed decision last week, the stock market needs to bounce short-term before heading lower to what I believe will be the ultimate bottom. As I continue to write, I am keenly interested in which sectors lead and lag during the rallies.

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Market Behaving as Expected. Bottom Shortly.

In my last update, I opined that the Fed should not raise rates and that whatever they did, the market would end whatever move it was having and reverse in the other direction. First, I am glad that Yellen & Co. did not raise rates. That time will come, but it wasn’t last week. Second, stocks rallied nicely into the Fed meeting and in the moments after the announcement. However, it was the perfect “buy the rumor, sell the news” as stocks reversed sharply shortly thereafter and closed near the lows for the day. I totally dismiss that the market was disappointed by the Fed’s lack of raising rates. That’s preposterous. Stocks rallied into the announcement in the classic ” buy the rumor” trend. Friday was an ugly day for the bulls and after the typical post-weekend, feeble bounce on Monday, the bears are out in full force today.

None of this action should come as a surprise as I wrote about post-crash behavior many times here and in Street$marts. From its intra-day low on August 24 to last week’s peak, the Dow jumped roughly 1500 points, retracing about 50% of what it lost since its last all-time high in May. Stocks are now in the throes of the secondary decline to revisit the levels seen in late August. I expect that visit to be successful within a few percent and eventually lead to all-time highs again.

The stock market doesn’t look pretty now and I don’t expect that to change until after the bottom is reached over the next two to four weeks. There will be all kinds of reasons not to buy when it’s time. “The market has lost confidence in the Fed.” “China is having a hard landing.” “Global economic growth is recessionary.” And on and on and on.

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Market Reaction to Fed Announcement

The big lingering question regarding the Fed meeting after the decision is how to properly position portfolios. If you thought it was tough to get an edge on the rate decision, the markets’ reaction is even more so, which is why I would absolutely not advocate making wholesale changes ahead of the announcement. It’s one thing to flip a coin on the decision, but it’s a whole other thing to get the markets’ reaction correct as well.

The four possible scenarios are below.

Rate hike and rally
Rate hike and decline
No hike and rally
No hike and decline

Before pondering that, I saw a few Tweets that suggested Yellen could raise rates with dovish comments or leave rates alone and offer hawkish comments. And if the Fed doesn’t raise rates now, we will be having this same discussion before the December meeting. It’s enough to make you head spin!

Regarding stock market reaction, the very short-term sentiment indicators still have sufficient enough pessimism to support further upside. If I had to lean, that’s the direction the odds favor right now, but I certainly would not bet the farm on it. Good thing for me since I don’t own a farm!

The Fed trend also has a 70% upward bias for the day, but some of that fuel was likely used this week.

Should stocks spike higher on the news and follow through, I will view that as a selling opportunity rather than a momentum buying opportunity, which should be the minority opinion.

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Will They or Won’t They

I truly cannot wait until September 17th at 2:01 PM. At that time, the Federal Open Market Committee, aka, the Fed, will make a decision about interest rates. I don’t know anyone who isn’t completely exhausted from all of the Fed talk over the past few months. It’s enough already. How many times do we need to see “Countdown to the Fed Decision”, “Special Report: The Fed”, “Breaking News…”, etc. Are there no other business stories worthy of being discussed in the media?

Here’s the deal. Unlike almost every other interest rate cycle change, the odds of a rate hike on Thursday are really about 50-50. The Fed has laid the groundwork for the markets to expect a rate at some point since Ben Bernanke’s famous Taper Tantrum speech more than two years ago. However, something keeps getting in the way.

Should the Fed raise short-term interest rates?

The market has already done so on the 10 year treasury note to the tune of 37%. Yes, you read that correctly. The 10 year yield has risen from 1.675% in February to 2.30% as I type this. And that’s not counting the move from 1.40% back in July 2012.

Since 2008, my thesis has been and continues to be that the Fed should not raise interest rates until the other side of the next recession. This is your “typical” post-financial crisis recovery that’s very uneven. It teases and tantalizes on the upside and frustrates and terrorizes on the downside. Another recession, albeit mild, is coming over the next few years. That’s okay. We’ll get through it. On the other side of it, our economy should get back to trend or average GDP growth, not seen since pre-2008. This could also coincide with Europe getting its fiscal act together after another sovereign debt crisis.

Anyway, I don’t believe the Fed should raise rates and I will guess that they don’t raise rates today. Inflation is nowhere to be found. Rumor has it that the Social Security Administration is using 0% for the 2016 COLA increase to social security benefits. Yes, I know all about the conspiracies to limit COLA increases to help the budget, but just look around you. Transitory things like energy and grains have collapsed. Wage growth is woefully pathetic. Money velocity has been in the perfect downtrend since 1998.

While the dollar has been very stable for the past six months, that comes on the heels of a 20% rally (huge in the currency market) over the prior 9 months, which can be considered a quasi-rate hike. The very dovish IMF and ECB are begging and pleading on hands and knees for Janet Yellen to leave interest rates alone. Think of all that emerging market debt denominated in dollars that has been hammered by dollar strength and will likely get much worse. Think about the currency imbalances with the dollar appreciating so mightily. A rate hike here will not be good for our struggling trading partners in Canada and Mexico.

Why raise interest rates?

I have heard some pundits use the word “credibility”. The Fed needs to hike rates to either preserve or establish credibility. I am sorry, but that’s idiotic and doesn’t need any further rebuttal. Some believe that an unemployment rate of 5.1% represents “full” or “maximum” employment and that a rate hike is necessary to cool the jobs market. Another reason I totally dismiss as unfounded. How about the labor participation rate at 62.80%, a 38 year low?!?!

Finally, there are those who believe our economy is growing strongly enough to warrant a rate higher than 0%. To me, that argument at least has merit and I can’t easily rebut it. The recovery remains uneven, but GDP is growing. I wrote a strongly worded piece after Q1 GDP printed so poorly that I totally dismiss it as yet another bad seasonal adjustment and that I thought Q2 and Q3 would print between 2% and 3%. I was wrong. It’s even better. However, with that, let’s not forget that wage growth remains awful and inflation is non-existent.

Interestingly, while Fed members have given speeches all over the place all year, Chair Janet Yellen has been uncharacteristically silent of late. You would think that if the Fed was about to raise rates, Yellen would be stumping with at least some trial balloons or hints. The rate hike argument has persisted for two years and without it, there hasn’t been any negative consequences. Why not continue to wait…

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Follow Up to Post Crash Behavior

Last week, I wrote a piece here and in Street$marts entitled, Post Crash Behavior Leading to Dow 20,000. If you haven’t read it, I think it’s a worthwhile read (of course I do since I wrote it!) whether you agree with the content or not. Subsequently, I was really excited to join CNBC’s Fast Money to discuss my research. A few things I want to add.

I used the word “crash” very liberally in my study. After “bubble”, crash is probably the most overused word in investing. True, historic stock market crashes typically only occur once in an investing lifetime. They are such emotional affairs and require years of setting up. It’s that perfect storm. We saw one in 1929 as well as 1987. The rest are really just large declines that accelerated like a crash. You can call them crashettes or mini crashes.

As Mark Twain said a “few” years ago, history rhymes, it doesn’t repeat. No two market environments or rallies or corrections are exactly alike. The market does its best to confound the masses most of the time. I remember in 1998 that the NASDAQ 100 actually went from its August mini crash when Russia defaulted on her debt, straight back to all-time highs in September, only to see another mini crash in October when Long-Term Capital blew up. The masses were generally hopping on board the tech train until the tech wreck hit a few weeks later.

If you look closely at my study, 2011 looks very similar to 1998 and 1987 for the most part, but not exactly. 1989, 1994, 1997 and 2010 are not highly alike although 1989 and 1997 are the most alike of the group. 2015’s price decline is similar to 2010.

In the end, it’s much healthier for the stock market to thrash around for 4-6 weeks and test the mettle of both bull and bear. That kind of constructive repair from all the damage done during the decline would set the market up for a potentially powerful fourth quarter rally. I would be very concerned if stocks just took off higher from here without looking back.

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