November was one of the strongest months in market history. Various markets across the globe are pushing to new all-time highs. When conditions are bullish, we should expect bullish outcomes. In this month’s report, we look at an important investing lesson and identify the top two potential outcomes for markets in the coming months.
“If you change the way you look at things, the things you look at change.”
-Wayne Dyer
There are times when markets give investors very obvious lessons. The best investors listen when these time happen. The past month has been an excellent time to learn and improve on your investment process.
Prior to the election, the prevailing wisdom was that an uncertain or delayed election outcome would cause volatility in the markets. This makes complete sense. We live in a very polarized political climate. There have been countless riots this year. Many businesses boarded up their windows in anticipation of post-election violence. Tensions across the country were running very high.
Following the election, there was no clear winner. Vote counts were delayed. Accusations of fraud were everywhere. Legal challenges were obviously going to be made. This was the EXACT scenario that “should” cause markets to be extremely volatile.
What happened in the markets? The S&P 500 surged over 12% in 6 days. This happened before any election resolution and before any vaccine news. In fact, since the vaccine announcements, markets have gone sideways.
What is the lesson?
Stop trying to predict the markets.
Markets don’t always make sense to the casual observer. Heck, they don’t always make sense to the professional observer, ourselves included.
Predicting the future outcome of the markets, and gambling your hard-earned wealth on predicting extremely complex systems, is not a prudent use of your capital…both financial capital and mental capital.
It introduces too many negative consequences into your process. If you’re wrong, you become paralyzed. You thought markets should fall, but they rose dramatically. Or you thought markets should rise, and they fell dramatically.
So you’re left holding too much cash. Or you’re left holding stocks with big losses. Both have incredibly damaging effects on the psyche of the investor. You risk having one mistake carry over to your next decision. As they say in golf, don’t let one bad shot ruin your round.
We’ll dig deeper into this lesson next month by focusing on the effects that predictions have on the brain. But keep one lesson about predictions in mind…it’s not about getting it right all the time. It’s about probabilities. It’s about identifying the conditions that are present in markets, and whether those conditions provide good investment opportunities.
The best condition to identify and understand is price. This is what too many investors overlook. Which is strange because price is what matters most. Price is what makes an investment good or bad. Price is what affects your statement value. Price is what allows you to achieve your investment goals. Price is what pays. A good investment is one that goes up in price. So why focus on things that may or may not influence price?
We’re in a climate where price seems to be disconnected with reality. And that’s okay. It happens more often that we realize. It’s just SO obvious right now that it’s hard to ignore.
But price IS reality. A stock is worth what someone else will pay for it.
This is why we look at charts and discuss them in this publication. Charts are visual representations of the reality of the markets. We can disagree with them all we want, but that’s the reality.
So let’s focus on price and look at some charts.
New Highs are Bullish
A key part of the IronBridge investment process is the identification of trends. We don’t like to fight the market, and prefer investing with the wind at our backs. That means finding favorable trends and participating in them. And right now, there are favorable trends everywhere.
In the US, not only are large-cap stocks making new highs, but we’re seeing the more aggressive areas of the market make new highs as well. Mid-caps, small-caps and semiconductors made new all-time highs last week. Various international stock markets in Europe, Asia and South America are also making new highs.
The areas that were hit the hardest in the COVID crash, such as energy companies, banks, airlines and publicly traded restaurants are even participating in the move higher.
Let’s start by looking at the granddaddy of global markets, the S&P 500.
Following the COVID lows in late March, the S&P skyrocketed higher, almost unabated, through early September. But since the September high, markets have been choppy, with no real direction.
The first chart below shows this price action.
Following the September highs, there was no news at all that would cause the markets to pull back. But the S&P fell 10% in a few short weeks.
The choppiness continued with nearly three months of a sideways consolidation. This served to work off some of the excess bullishness that had built up from the March lows.
The surge around election day is an interesting one. As we mentioned above, markets rose 12% around the election. The high of that move actually came on the day that the Pfizer vaccine was announced. This came at the end of the move higher, not the beginning.
In fact, since the Pfizer news, we have had two other major developments in COVID, with the Moderna vaccine showing 94% efficacy, and the treatment that President Trump received while at Walter Reed hospital was also approved. Yet markets have gone sideways.
The markets seem to have anticipated the vaccine news. It has been public knowledge for quite some time that many vaccines were getting close to being available. If that is the case, then markets may also be looking past the obvious spike higher in cases we are currently witnessing across the country and the globe.
The markets also like a split government. There was no blue wave, and it seems that the US government under a President Biden may be a very centrist one. We wrote about this immediately after the election in our report “Gridlock is Good”, which you can read HERE.
Most importantly, the Fed is still very accommodative. They are scheduled to put another $3-4 Trillion into the financial markets in the coming months, and that should provide another tailwind to markets.
It’s not only the S&P that is breaking higher. Other notable indexes making new highs are shown in the next chart.
This chart shows the following indices moving clockwise from the top left: the S&P 500, the Dow Jones Industrial Average, the mid-cap S&P 400 Index and the small-cap Russell 2000 Index on the bottom left. The orange lines on the charts are the previous highs.
The first to make new highs was the S&P, which happened in September. This was primarily due to the heavy weighting of companies like Apple, Amazon and Microsoft in this index. Last week saw the remaining indices make new highs.
However, the most notable development is on the bottom two charts. These are weekly charts showing prices back to 2017.
Small-caps and mid-caps have both struggled to get above their price level from early 2018. These markets have gone sideways for almost three years.
When markets move sideways for long periods of time, there is usually substantial buying pressure when prices do finally break higher. This is precisely what we’ve seen happen in the past month. In fact, November was the strongest month EVER for small cap stocks…up nearly 20%. So much for volatility around the election.
No one predicted this kind of strength. It seems to have been quite the opposite. Most investment firms were predicting volatility, and rightfully so.
These are not signs of weakness. There is literally nothing more bullish than new highs. It is by definition the sign of an up-trend.
With the backdrop of strong price trends, a supportive Fed, and a potential light at the end of the COVID tunnel, what could go wrong?
Potential Outcomes
Again, price is what matters, not predictions. So while the backdrop appears very favorable, that does not mean that markets are without risk right now.
We view the current environment as having a binary outcome potential, where only two scenarios are likely.
We show these outcomes in the chart below.
While anything can happen, the first scenario seems most likely at this point.
Scenario #1: Melt Up
Despite the massive move higher since March, the conditions are present for what is called a melt-up. The tech bubble of the late 90’s is the best example of this environment. In this scenario, prices are not only dislocated from reality, the become more dislocated at an increasing rate.
A realistic target for this scenario is for the S&P 500 to get to the 4500 range. This would be close to a 30% return from here. There are scenarios where the market isn’t quite that strong, but there are also scenarios where the markets move even higher.
What could lead to this happening?
As we have said countless times over the past 6 months, the Fed is the most important factor in the markets right now. They are printing massive amounts of money that is making its way into the financial markets.
The primary risk to this scenario is that there is a change of policy at the Fed. This risk, however, may have been greatly diminished with the announcement today that President-Elect Biden will nominate former Fed-chair Janet Yellen as the Treasury Secretary.
This is a strong endorsement of the easy-money policies that the Fed has been implementing for years, and a clear signal that Biden wants to continue pumping liquidity into the system.
So it appears that the Fed won’t be an issue in the near term.
We then have to shift the focus to COVID. Cases are spiking, and Los Angeles just imposed another lock down. Will this happen on a more widespread basis?
Possibly, but the market is clearly signalling that it thinks the worst of the economic-related COVID issues could very well be behind us. What a wonderful thing to even consider.
This scenario is a fun environment if you own stocks. Melt-ups can provide amazing returns in short periods of time. It is a crushing environment if you’re sitting on too much cash, or even worse, if you’re trying to short the market.
While it appears to be a favorable backdrop for stocks, don’t ignore the downside risks either.
Scenario 2: Whipsaws
The other scenario that could play out would be a whipsaw market. Whipsaws occur when there is no real direction, and breakouts get reversed quickly. This results in a frustrating market that punishes a great number of people.
In this scenario, COVID is the likely culprit for market weakness. There could also be something completely different and unknown that causes it as well, but the logical reason would be continued economic hardships and deaths from this virus.
Markets need to reverse lower very soon in order for this scenario to play out.
This scenario would result in a few things happening:
- First, the break to new all-time highs wouldn’t last. Markets would reverse course and move down below the 3550-3600 range on the chart above. Everyone who thought the breakout would continue would be mistaken.
- Then, a quick move to the lower end of the range since September would occur. This could happen in a matter of weeks, if not faster.
- The market would then break the lower end of the range, and get to the 3100 level, plus or minus.
- The break lower would then be reversed, causing the markets to whipsaw around that low. This would cause everyone who thought we were headed to much lower markets to be mistaken, and prices would start to move substantially higher.
Ultimately this scenario puts the market at new all-time highs. We would just need one more bout of volatility to come to fruition first.
Of the two scenarios, our clients are currently positioned for scenario #1, and think this has the higher chance of happening. But we will not die on that hill, and are ready to make adjustments as necessary.
Bottom Line
Bottom line, the conditions are currently bullish. There has been a strong uptrend since the COVID lows, and these trends have been confirmed by multiple new highs.
In bullish environments, we should expect bullish outcomes.
If you have excess cash right now, you can put it to work. Just pay attention to your exits and have a defined risk management plan. As quickly as these environments rise, they can just as easily fall and erase all of their gains.
It appears that we have another window of opportunity in front of us. Take advantage of it. And if things change, don’t be afraid to adjust course.
Invest Wisely!