Summary
- Too the moon could happen on early treatments or vaccines for Coronavirus COVID-19, Fed largess and a “V” shape recovery.
- Various serious corrections could occur in the short (within 6 months) and intermediate (6 months to 2 years) term time frames.
- Valuations really do still matter, at least in theory.
- Good can turn to bad, and vice versa, and vice versa, really fast.
- Consider your risk tolerance and personal financial situation above everything else when deciding your asset allocation.
There is no magical system that can tell anybody what the stock market will do. However, there are signs that investors should heed when hit in the face.
In the short term, the market is a popularity contest. In the long term, the market is a weighing machine. – Investor From Omaha
Despite a market that has seen the Coronavirus COVID-19 crash and a face ripping rebound rally in the space of three months, it really is just fear and greed at the end of the day. In other words, the same ol’ same ol’.
Smart investors like you will control your emotions and think about what has real value in the intermediate and long terms. You will adjust your asset allocation based on what the stock market gives you in the short-term and turn it into better performance for the long-term.
Right now the stock market is giving two very clear signals: A short-term signal that most people are not aware of and an intermediate term signal people ignore regularly. Today we will talk about those signals in the context of different stock market outcomes over different time frames.
Too The Moon
Since March 24th, the stock market has been pricing in the most bullish scenario. Presumably, that is miracle treatments and vaccines for Coronavirus COVID-19, massive Federal Reserve and government spending, and a “V” shaped recovery for the economy.
Under this scenario, the stock market will continue its rise to new highs over the course of this year. Resistance levels will continue to be broken as small investors pile back into the stock market, traders pump the bull market and larger investors come off the sidelines.
Historically, this equation does not normally play out. It is rare that small investors lead a stock market rally. Usually, small investors are the last ones to get invested. This time, they seem to be the first.
Larger investors coming off the sidelines, particularly family offices, seems very unlikely to me as they generally have investment policies that they stick with. Family offices are generally unmoved by short-term rallies. Even before Coronavirus, they had been trickling out of the stock market for over a year according to Institutional Investor magazine and other sources.
Traders are notorious trend followers. They will ride any trend as long as it is profitable that day. If the tide starts to turn, if the rocket fuel starts to run out, it is typical for the traders to start to trickle out of a trade – in this case bullish – and position for a reversal. That trickle then turns into a stampede as the trend stalls and the narrative becomes louder. Eventually, the market turns and the rest pile into the new trend.
Even with the “too the moon” scenario, there will be retracements of the stock market gains. A significant set of support levels around 274-0 and 257-1 on the S&P 500 ETF (SPY). I’ve cleaned my work space up a bit on the chart below, but tried to leave enough to see the relationships in a small viewing space. The yellow lines represent areas that a bullish investor can buy near as part of a scaling in process.
https://www.tradingview.com/x/xQoVNOcz/
If you believe in the most bullish scenario, you will want to get expand equity holdings near the yellow support ranges. I am likely to sell some cash-secured puts when the S&P 500 gets into the lower $270s. I’ll be targeting stocks that I believe will grow in the “got here faster than we thought work from home economy.”
Coronavirus Crash II
This is the scenario that everyone seems to worry about – myself included. Economic data is brutal and the likelihood of a “V” shaped recovery seems remote as long as most, or even a sizable minority, of people are afraid of contracting COVID-19.
In this scenario, the stock market does more than a small correction. It retests the March 23rd lows, possibly setting new lows between about 208 and 187 on the SPY. There is also a “less bearish” scenario where the retest gets close to the lows, but doesn’t fall quite that far. See the overlapping supports at about 235.
The argument for this scenario is that there simply is not enough Hopium or Fed money to offset:
- the massive intermediate term economic damage being done.
- the emergence of zombie companies in the S&P 500.
- another round of layoffs as the Payroll Protection Program loan to grant period ends.
- a wave of bankruptcies later in the year into next year.
- commercial real estate problems caused by fewer tenants and lower rents.
If this scenario started to play out, I would consider adding more positions as the S&P 500 got into the 230s. At that point, I would be looking to measure downward momentum and start to look for the blow-off bottom day, ala March 23rd. I don’t know when that would come, but I would be getting my shopping list in order.
Under most circumstances, excluding the Armageddon scenario, I would be about 90% invested in the 210-190 range for the SPY. Of course, as members know, I would not be buying SPY, but rather from the ETFs and stocks we track on the Very Short Lists.
The Armageddon Scenario
I will not spend much time here because I do not think there is a high likelihood of what I would consider the “Armageddon scenario” where three things happened all at once:
- a wicked second wave of Coronavirus – possible, if not probable, but not enough to sink us much further than the 210-190 range on the SPY by itself.
- a drying up of Federal Reserve and U.S. Government relief efforts.
- trade conflicts leading to a massive disruptions of supply chains as politicians jockey to avoid responsibility for not handling the pandemic well.
Under that scenario, the S&P 500 could clearly test major support levels not seen in over a decade. If this happens, every single politician in the world should be sacked – no exceptions, not a single one.
https://www.tradingview.com/x/AoBXEvXT/
If the Armageddon scenario plays out, I guess I would sell every physical possession I had and buy stocks in blue chip growth companies.
A Short Term Sign
We have discussed alligator jaws (or maybe that’s a croc) many times. Certain relationships play out over and over. One of those is that when the CBOE Equity Put to Call ration blows out, there is a reaction by the stock market.
We never know exactly when or to what degree these stock market reactions will take, but we can make some risk management decisions based on the relationships. In this case, we can see that the put to call ratio is below .5 again. This has typically signaled a stock market correction of some magnitude is imminent.
If the Bullish stock market scenario is playing out, then the coming stock market correction won’t bite too deeply. If a worse scenario is playing out, then the stock market correction could be worse. If it is worse, it usually plays out in a few waves down.
An Intermediate Term Sign
A deeper warning that I have covered for nearly a year now is that the stock market remains overvalued – even for “V” shape recovery earnings which we will not get. In reality-land, corporate earnings are going to be ugly to rough through at least sometime next year. Here’s is are two graphics we have become familiar with:
As you can see, we are still in nosebleed territory. And, those charts reflect today, not tomorrow. If earnings continue to weaken, then those overvaluations become even more extreme.
Maybe valuations do not matter though. I talked about that here:
Stocks Are Still Overvalued – Does It Matter?
What I believe though is that ultimately, valuations do matter. But, maybe I am wrong. Maybe there is enough Hopium to drive stocks higher no matter what. Maybe it is different this time.
The Long Term Reality
Do not bet against America in the long-term!
You have heard versions of that from Warren Buffett over and over. Recently Fed Chairman Powell said the same thing. Pick a hugely successful person and the majority of them are optimistic about the future. So am I.
Ultimately, the United States has a combination of natural resources, geographic safety, entrepreneurial spirit, smart and skilled labor, diversity, military might, law and government to always have a strong economy emerge from the speed bumps.
Coronavirus COVID-19, as horrible as it is as a human tragedy that we are probably making worse with selfish behaviors of some, is no different than any other setback when it comes to the financial perspective. We will overcome it in time.
For that reason, you should never live in a bunker for long. Once the storm has passed, you will want to be fully invested again. It is very likely, that with the massive financial resources we are throwing at this tragedy and a build up of demand, on top of needs we already knew about, that we see another boom that lasts until the next speed bump.
Asset Allocation Now
I believe that whichever scenario plays out, we will see at least a pullback to the 274-251 range on the S&P 500. So, I am still very cash heavy. Around 50% in most accounts, though I also have long-dated covered calls written on most holdings.
Yesterday, as I mentioned in the chat room where you can find some real time hedging and swing trades, I bought a small tranche of S&P 500 puts priced near the money for August. If the SPY rallies over 300 in coming weeks to the resistance box you see near the top of the first chart, then I will buy more puts as a hedge.
I have a small order to buy the Invesco QQQ ETF (QQQ) at $170. I have a much larger GTC order to buy at QQQ $150. The rest of my asset allocation will be from the ETFs in the most recent members chart book and stocks mentioned in the recent 67 page “Investing After Coronavirus COVID-19” special report. The stocks I am most focused on are those that are likely to be added to the S&P 500 in June and coming quarters.
