Mid-week market update: What should investors do when faced with competing narratives and historical studies with opposite conclusions?
The major market indices made another all-time high today. Ryan Detrick pointed out that ATHs tend to be bullish. That’s because of the price momentum effect that is in force which propels stock prices to new highs.
On the other hand, SentimenTrader observed last week that the market has flashed another series of Hindenburg Omens. Subsequent to that tweet, Tom McClellan pointed out that there was another Hindenburg Omen on Monday. Historically, clusters of Hindenburg Omens have resolved with a bearish bias.
Should traders be bullish or bearish?
Here is some out-of-the-box thinking. I would argue that the stock market rally is actually the result of a fear. Yes, you read that correctly – Fear.
The bull and bear cases
There is little doubt that the market is overbought. The bulls will argue, however, that the market could be just starting a series of “good overbought” readings that accompany a slow grind upwards.
SentimenTrader also warned about the precarious and complacent state of the put/call ratio, which has always resolved with a market decline over the next two weeks. Some of the excess bullishness to retail buying of TSLA call options, which SentimenTrader referred to as a “speculative spigot”.
From a broader sentiment context, my suite of non-survey sentiment indicators do not reveal excessive bullishness other than the put/call ratio. In the past, short-term tops have been marked by these indicators flashing complacent readings, or near complacent readings. That does not seem to be the case today.
A fear trade
Instead, I would argue that the relentless bid in US equities is reflective of fear – yes, fear. Global investors have been piling into US stocks as a safe haven trade in the face of coronavirus risks. The rally has been misinterpreted by American investors as an unsustainable on fundamental, technical, and sentiment metrics.
Sure, the market is overbought today, and may see a brief 1-2 day pullback. That is why we are seeing the narrow leadership, the Hindenburg Omens which are reflective of a bifurcated market, and selected signs of sentiment excess, such as extreme lows in the put/call ratio.
It may seem obvious, but when the market doesn’t fall after a rally leg, it usually means it wants continue upwards with the rising trend. My inner trader remains bullishly positioned, but he recognizes that this is an environment characterized by high volatility. Traders should therefore properly adjust their position sizes in light of elevated risk levels.
Disclosure: Long SPXL