Markets have been fascinating this year. From my perspective, it has been a big battle of opposing forces.
Macro economic analysis and fundamental analysis create a framework of what markets should do but obviously they don’t always cooperate. Technical analysis and systematic strategies attempt to analyze how one should be positioned based on what markets are doing, irregardless of the macro environment or valuation. I incorporate both approaches into our portfolio management because they tend to compliment each other well.
The sweet spot is when both views line up. This creates the conditions where one can take positions in their portfolio with a lot of conviction but that just hasn’t been the case so far this year.
Looking at the current markets, the macro environment (what should be) has said to be cautious for most of this year and to remain so into year end at least, but the technical backdrop that I’m actually seeing (what is) has remained relatively strong. Our adaptive allocation strategies have largely remained fully invested all year and I’m still not seeing the typical signs of weakness that typically presage credit and stock market weakness. But if things begin to deteriorate in the technical picture, which would then align with the macro backdrop, then I will quickly look to protect.
A simple indicator to track is the cumulative advance/decline line which measures a running summation of the net number of securities that are up each day minus the number that are down. It’s showing no signs of weakness which suggests that liquidity is still plentiful in markets. You typically see weakness in the advance/decline data before it manifests in the market indices, as can be seen by the negative divergence between the A/D line and the S&P 500 last Sept/Oct in the chart below (around the middle of the chart). Conversely, the cumulative advance/decline line making new highs before the market is usually a bullish signal that we should soon see the broad stock market indices make a fresh high — as we saw in the spring of 2018. If the cumulative advance/decline line makes a new high in the next week or two, it would be a bullish signal for stocks.
And if you’re curious what the top in 2008 looked like, here it is. A negative divergence between the advance/decline data and market prices gave an early warning that the underlying internals were not strong and did not support new price highs.
2006 – 2010
Now, the A-D data isn’t an end all be all; it’s just one of many useful tools in the toolbox. A lack of weakness in the A-D line right now goes against the long-term chart of momentum that I’ve posted several times this year, which shows that the broad US market has largely been consolidating for most of the year and is dangerously close to breaking the uptrend. October opened below the trend line and we quickly saw a drop. The S&P 500 needs to close above 3010 this month for the trend to hold. However, international stock markets look like they might be starting to kick on so this has been raising the probability in my mind that this year has been a long consolidation before another synchronized global rally.
It might seem like I’m going back and forth with my view on the stock market this year, but this illustrates the battle of opposing forces. Markets should always be viewed with a probabilistic framework. The macro backdrop has suggested stocks should move lower and I’ve been seeing momentum wane all year so the higher probability outcome in my mind has been eventual stock market weakness. However, further strength in the international markets and continued strength in the A-D data starts to raise the probability of eventual strength. So unless I see a deterioration in the internals (i.e. credit spreads widening, deterioration in the advance/decline data, etc.), I can’t become overly bearish.
In summary, it appears to me like markets are coiling. I can see a scenario where the major indices are up 10% to 15% over the next year, but I can also see a scenario where they’re down 25%! That’s a really large gap between those outcomes so it would be a mistake to prematurely bet heavily on either. I’ve been expecting weakness, I’m ready for it, but it hasn’t materialized yet (and may not ever). Markets are a never ending game of balancing probabilities of all potential outcomes and it’s still too early to know which outcome will ultimately win.
And so, we wait.
-Nick