A Brief Pause or the End for Equities?
All
financial assets move in long wave cycles from undervalued to overvalued and back again, but whilst the duration of these cycles varies across these asset groups, irrespective of whether it is
commodities, equities , bonds or real estate, they all move in a similar way. During the movement from undervalued to overvalues, prices rise in a long term 'bull market', punctuated by severe corrections or counter-trend moves along the way. Once the over valuation has reached an extreme, the market reverses, and enters a 'bear market' where prices once again start their long descent.
We can see this illustrated in the chart below.
During the 'bull market' phase, as prices rise and the fear of the preceding 'bear market' is forgotten, investors emotions slowly move from depression through hope, optimism and exitement to reach their final state of euphoria and greed.
However, whilst this journey might seem simple, due to these counter-trend moves the reality is very different. Whenever investors become too bullish, too confident and too convinced that a trend is in place, a correction will take place that will shake their beliefs and re-introduce a touch of fear into their lives, Is the bull market over? Will prices continue to fall? The bull market will shake some investors off its back and then continue onwards and upwards until investors once again get too bullish. This is why it is so important to monitor things like the Committment of Traders (COT) reports, as they can give great insight into the level of bullishness in a market give indications as to when a counter-trend move might begin.
We can see how these counter-trend moves have impacted the S&P 500 Index since the start of the current cyclical bull market in 2009.
These corrections are normally fast and furious, exactly the kind of conditions needed to inspire fear amongst investors, and during the month of August we have seen counter-trend moves in a number of markets, among them Equity markets, the US dollar and Gold. In the next chart of the S&P 500 Index I have extended the data to include the entire move since the 2009 lows and we can see how long it has been since a serious correction took hold, it was clearly long overdue.
Because of the severity of the latest correction, especially last weeks volatility, investors have once again begun to question whether the bull market is over. The answer is possibly, but I doubt it. Bull markets finish when the public get sucked in due to the constantly rising prices. This stampede of investors leads to spectacular price rises and a 'blow-off' phase, typified by 'this time is different' thinking and to coin a phrase from Alan Greenspan, 'irrational exuberance' (see chart below). Thus far we have not witnessed this, and allied to my belief that as the global economy unfolds money will flow into US Equities as a safe haven leads me to believe that equities will recover and go to new highs.
However, just because the market should rally to new highs doesn't mean it can't have a bigger correction now. If we look at the Point & Figure chart of the S&P Index below we can see that the rally from last weeks low at 1870 has paused at overhead resistance in the 1990 area.
The market is now at a critical juncture where either the panic will subside and prices will continue to grind higher, or the market will roll over again and test the lows. Should the sell-off resume, the 1870 low will provide the first point of support, followed by 1830 and 1740. It is also worth noting the bearish price objective of 1621, and although price counts tend to be more accurate when they occur in the direction of the major trend (which in the case of the S&P is up) we should not just disregard it.
Having waited so long for a correction to materialize, it is unlikely to be over so soon, and the probability is that there is more volatility ahead. Should we retest the lows and go lower, keep your eyes on the support levels and the 'talking heads' on TV.
When they start saying that the bull market is over, it's time to buy!
