It’s Retest Day

I’ve been sitting here parsing through all kinds of economic data trying to make the case for a bear market, and I’ll be honest – it’s tough. There just aren’t many data points that portend a rolling over of the business cycle, or primary trend.

There are of course a few, such as the declines in housing starts and building permits (shown below), but other than that, most leading indicators remain in firm uptrends (the S&P 500 being the notable exception).

Housing Starts and Building Permits

Consider the following:

  • Consumer confidence remains strong and near the highest levels since 2000
  • Small Business Optimism remains at record levels
  • ISM Services PMI sits at 62.5%, signaling strong expansion
  • ISM Manufacturing PMI sits at 57.7%, signaling strong expansion
  • Job openings remain near record levels
  • Average weekly hours worked in the manufacturing sector remain near all-time highs
  • Manufacturers’ value of new orders for consumer goods is at an all-time high
  • Manufacturers’ New orders of nondefense capital goods excluding aircraft is just off an all-time high
  • Initial claims for unemployment remain near record lows
  • Yield curve remains positively sloped

These are all leading indicators, and they’re all pointing toward a U.S. economy firing on all cylinders. And yet, the stock market continues to behave like a wounded animal going through its death throes.

So what gives?

Before we try and answer that, I’d like to provide some context. Normally, a correction like this wouldn’t phase me because we know it’s a natural part of the ebb and flow of markets. But it’s the broader context in which this correction is developing that is concerning.

Rather than being a single-day or short-term event, stock market tops are a lengthy process in which the entire market rolls over. Sure, the S&P 500 may peak on one particular day, but different groups of stocks all peak at different times.

This results in “rounded” market tops, and we can see two examples of these in the charts below. The top chart shows the 2007 peak, and the lower chart shows the 2000 peak. In both cases, the actual day the S&P 500 peaked is shown in green.

2007 Market Top

2000 Market Top

There are a couple of key items I’d like to point out with regard to these charts. First, notice that in both cases, investors had around 9-12 months to exit the stock market while stocks were within 10% of their high water mark (blue shaded area). This implies that there is never a need to panic, and that we can take measured steps with regard to reducing our exposure when the time comes.

Second, in both these cases, the S&P’s long-term absolute momentum went negative. In simple terms, that just means the S&P began trading lower than where it had been many months earlier.

This transition to a negative absolute momentum is critical because in essence, what is suggests is that over a long period of time (more than enough to be considered representative of the primary trend), the market has done nothing but churn.

And that’s exactly where we’re at now. With the market currently retesting the October 29th low, absolute momentum has turned flat or negative over the preceding 8-10 months.

S&P 500 YTD Performance

This does not mean the bull market is over, but it’s a strong indication that we’re at a precarious place. We saw similar price action back in 2015 – 2016 and that didn’t result in either a recession or full-fledged bear market, but it did signal an earnings recession that had to pass before prices could resume their ascent.

In the same fashion, I’m wondering if perhaps some of the ongoing concerns have simply grown to the point where big institutional investors are deciding to step aside until the smoke clears. Maybe they’ve had enough of trade wars, the Fed, and global uncertainty. Or maybe there’s a concern the Mueller investigation will come out with something shocking, or the next two years of congressional gridlock will avert Trump’s pro-business policies.

Whatever it is, I think it’s important to point out that we are not on the precipice of a major economic collapse, as we were back in ’07. Even if I’m wrong, and the late-September peak was in fact THE peak, the likelihood of a big drawdown is low, as economic fundamentals remain firm.

That being the case, I feel like I owe it to you to discuss how I would approach the markets from both perspectives: an ongoing continuation of the bull, vs. the recent start of a bear.

In terms of the former, which I still believe to be correct, I would be using this latest retest as a buying opportunity. Today we’re seeing the classic signs of a retest (big gap down followed by the bulls trying to rally back above the key support level) and as of now, it looks like support may hold.

S&P 500 and NYSE A-D Line

You might think I’m crazy to suggest buying here, but in my mind, this represents a sale on what I still believe to be good quality merchandise (U.S. stocks). In the words of Baron Rothschild, “the time to buy is when there’s blood in the streets.”

And hey, if you happen to be too scared to buy regular stocks, you can pick up some Berkshire B shares. It was noted recently that Warren has been buying back shares of Berkshire for the first time in six years. According to Berkshire’s amended operational policy, this can only be done when Buffett and vice chairman Charlie Munger “believe that the repurchase price is below Berkshire’s intrinsic value, conservatively determined.”

On the other hand, if you think that we’re in the grips of a full-fledged bear market, then you’ll want to lighten up your exposure … but not yet. As you can see in the two charts we looked at showing market tops back in 2000 and 2007, the market always stages a few countertrend rallies back towards new highs after its ultimate peak.

In this case, with the market temporarily oversold, you would want to wait for one of those countertrend rallies before selling. As I said before, I don’t think the bull is over yet, but if you are convinced otherwise then that is your playbook.



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