David Moenning

About the Author David Moenning

David Moenning is a the Chief Investment Officer at Heritage Capital, which focuses on active risk management of the U.S. stock market. Dave is also the proprietor of StateoftheMarkets.com, which provides free and subscription-based portfolio services. Dave began his investment career in 1980 and has been an independent money manager since 1987. Thus, Dave has been live on the firing line and investing for a living for more than 25 years.

Market Outlook: A Pullback To Test Support Would Be Logical

What a difference a week or so makes. Seven trading days ago, most everything I read had a negative bent to it. Everyone was just SO sure that the stock market would bump its head on the obvious resistance level at S&P 2020. Everyone was also sure that stocks would proceed to head directly south and take another trip through the range. And everyone in the bear camp was pretty darn sure that the market was going to break to new lows.

But if 28 years of experience has taught me anything it is that once everyone begins to sing the same song in this game, Ms. Market tends to go out of her way to make a fool of the crowd.

Sure enough, the day after the chorus had grown quite loud about the dire outlook for stocks, the market turned around. Sure enough, on October 15th, the S&P 500 erased the prior two days of “disappointing action.” And then sure enough, just when everybody thought 2020 was the ceiling, but bulls found a way to “break on through to the other side.”.

Super Mario to the Rescue!

Sure, “Super Mario” certainly had a hand in the bulls regaining their long lost mojo as traders on every inch of the planet now know what to do when a central bank starts openly talking about more QE. And then when you add in the rumblings out of China about more stimulative activity, well, it appears that the mood at the corner of Broad and Wall has definitely changed.

And frankly, there is a good reason for the mood swing seen in the market recently. You see, if the ECB is already talking about doing what it takes to get the Eurozone economy out of the dumps and the Chinese are preparing all kinds of plans to keep their economy growing at a reasonable rate (aka 7% per year), then the primary worry in the stock market – weakening global growth – can be easily refuted.

In other words, it is hard to worry about global growth going south when the primary players involved (U.S., Europe, and China) are focused on making sure that growth occurs, right?

S&P 500 – Daily

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So, the question facing investors as we enter the last week of the month – which just happens to coincide with the beginning of the strongest seasonal period for stocks – is, where do we go from here?

To be sure, stocks are currently overbought. Our short-term indicators (the stochastic in the lower clip of the chart above is a decent quick-and-dirty example of a short-term overbought/sold indicator) tell us that stocks have indeed moved a long way in a pretty short period of time. And to most traders, this means that it is time to “go the other way” for a day or three.

As such, it would be completely logical/normal to see a pullback of sorts in the coming days as the bulls could use a respite after such a spirited advance (I’ve drawn in a likely scenario for price on the chart above).

However, it is important to note that a strong overbought condition can also be a “thrust signal,” which is a good thing. In short, when the bulls are “in gear” the moves tend to have some “oomph” behind them. And while today’s algo-driven trading environment makes it harder to tell when a thrust is “real” (versus a period of time in which the algos are seen chasing their tails in one direction or the other), our momentum indicators are starting to show some signs of life.

What Do the Indicators Say?

Below is a table showing the current readings and the corresponding historical returns of those readings for some of our favorite indicators.

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The first section contains a series of classic market momentum indicators. A quick glance at the colors on the indicator readings really tells the story as there is a fair amount of green here. The bottom line is that momentum is pretty decent and we are starting to see some of the “thrust” indicators flash buy signals. (Oh, and it doesn’t hurt that my “desert island” indicator is back on a buy signal.)

The next section is a group of “early warning” indicators. While there is some red visible, the overall reading from this group of indicators is mostly neutral. As such, there isn’t a strong reason to get overly concerned about an intermediate-term “mean reversion” move in stocks at this time.

And finally, there are the “external factor” indicators/models. These are designed to give us a feel for the state of the big-picture drivers of stock prices. And as you can plainly see, there is a lot of green on that screen. In fact, the only negative is the “absolute valuation” component, which can be offset by the “relative valuation” reading. But even with the negative in the valuation area, the average historical return for the group remains pretty healthy.

The Bottom Line

The bottom line here is fairly straightforward. On a short-term basis, the bulls have gained control of the ball and appear to be large and in charge at the moment. However, stocks are now overbought and due for a pause. As such, a pullback to test support would be logical. But from a longer-term perspective, seasonality is favorable, the central banks of the world remain the bulls’ best friend, and the external indicators are largely positive.

Therefore, it looks like the corrective phase has come to an end and I would not at all be surprised to see the bulls continue make the bears’ lives miserable as we head into year-end.