The rally, driven by the highest level of short interest since 2008, has once again ignited “bullish optimism.” As shown in the chart below, the number of stocks on “bullish buy signals” has exploded in recent weeks.
While the “bulls” are quick to point out the current rebound much resembles that of 2011, I have made notes of the differences between 2011 and 2008. The reality is the current market set up is more closely aligned with the early stages of a bear market reversal.
However, with the markets extremely oversold following the August-September declines, the rebound in the markets was not unexpected. As I have repeatedly noted over the last couple of months, these strong reflexive rallies should be used to rebalance portfolios and reduce areas of excessive risk.
With the markets currently pushing extreme short-term overbought territory and encountering a significant amount of overhead resistance, it is likely that the current reflexive rally that began four weeks ago is near its conclusion.
During the summer rout, many investors were reminded of what the term “risk” truly meant. Reflexive rallies of the magnitude witnessed as of late is a “gift” that should be used by individuals to rebalance and realign portfolios with personal risk tolerances.
(In other words, if you didn’t like what happened during August and September, it was a warning you have too much risk in your portfolio. The next time, the market will likely not be so forgiving.)
As shown below, the current sell-off, and reflexive rally, has occurred with both major market “sell signals” registered. Since the turn of the century, the combination of these technical indicators has only occurred at the onset of more meaningful corrections.
[NOTE: This is a monthly chart. Therefore, only the month-end close of the market will matter in determining what likely happens next. A failure of the market to close above the short-term moving average may suggest more corrective action to come.]
It is too early to determine whether the “bull market” has resumed. While the markets have indeed entered into the “seasonally strong period,” there are many external risks still weighing on sentiment. These keeps my statement from last week valid:
“For longer-term investors, and particularly those with a relatively short window to retirement, the downside risk still far outweighs the potential upside in the market currently. When a more constructive backdrop emerges, portfolio risk can be increased to garner actual returns rather than using the ensuing rally to make up previous losses.”
The “Fed” Effect
In a more normal market, I would already be well convinced that the bullish trend had ended, particularly against the backdrop of an earnings recession and weak economic data. But this is by no means a normal market given the ongoing interventions by the Federal Reserve to support asset prices.
This is a point I noted earlier this month.
“It is worth noting that contractions/expansions in the Fed’s balance sheet has a very high correlation with subsequent market action as liquidity is pushed into the financial system.As shown in the chart below, the Federal Reserve has already once again began to quietly expand their balance sheet following the recent downturn. Not surprisingly, the market has responded in kind with the recent push higher. My suspicion is that if such minor interventions fail to stabilize the market, a more aggressive posture could be taken.”
