Climbing the Wall of Worry

The Purge is over

This week, the three-week losing streak that saw the S&P 500 drop over 8% ended as markets bounced from seemingly oversold positions.

The violent swings continued. Investor sentiment flipped as previous pullbacks created buying opportunities.

The S&P 500 rose nearly 3.7%, while the NASDAQ’s gained 4.1% to help it recover some of the 11% it lost in recent weeks.

Looking ahead, the August CPI print being released tomorrow will hugely impact market sentiment.

If inflation continues to moderate, those waiting on the sidelines will enter the field of play, pushing markets higher.

If inflation figures rise, those climbing the wall of worry will fall right back at base camp.

My money is on the former.

Block out the noise

Everything seems relentlessly bearish at the moment.

The recession obsession is everywhere.

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This chart from ‘Sentiment Trader’ pretty much sums it up.

At first glance, everything appears catastrophic—three times more hedging than the Global Financial Crisis is surely an obvious sell signal?

Institutions are running scared, so retail investors should be doing the same. Right?

Not quite.

Firstly, the market is more than three times larger than it was in 2008, and therefore the $8 billion in put options is less than 2008 in relative terms.

More importantly, these put positions are not necessarily a bearish sign. The $8 billion worth of call options purchased right before the market fell 20+% in June should tell you everything you need to know about how predictive this pattern is.

But of course, the data is shown to make sure it triggers investor fear.

The moral of the story: In a world where the most polarizing content wins, be mindful of the information you consume.

Nothing is ever as good or as bad as it seems.

Adjust Your Focus

Instead of the constant noise, try and focus in on a select number of sources and signals

One signal I like to track is the 200-day/40-week moving averages.

Calculating the average price of a stock or an index over a given number of days is a primary way of examining the long-term trends in the markets.

These averages serve as an uncanny support level when the price is above the moving average or resistance level when the price is below it.

I have provided an example of a 50-day moving-average line acting as both a support level and resistance level below.

Support and Resistance

At their most basic level, when stocks move above these averages, it is seen as a buy signal, and when stocks move below, it is seen as a sell signal.

The logic is the momentum that pushed the market out of its ‘average’ trend will continue to drive markets higher and vice versa.

While it may seem rudimentary to state that a stock that is going up will continue to go up, momentum has been a potent factor in quant-driven markets over recent years.

Aside from the directionality that these moving averages suggest once the trend line is broken, they also provide information on how the market will behave.

As Michael Batnick writes,

The risk/return profile for stocks changes dramatically depending on which side of the line you’re on. The annualized standard deviation for the S&P 500 is 12.6% when it’s above the 200-day and 24.5% when it’s below it.

Essentially, volatility doubles when stocks are trading below their 200-day moving average.

This means we end up with more gut-wrenching down days and more hellacious up days.

Market sentiment will flip on a dime, and erratic behaviour will be commonplace.

Sound familiar?

At present, there is no denying we are in a downtrend.

Two recent attempts to break above the Nasdaq’s 40-week moving average in March and August were met with resistance, and for now, the barrier remains.

NASDAQ Fails to Break Through Resistance Levels

Source: TradingView

The same can be said for the S&P 500. The 200-day moving average, at approximately 4,295, has been a barrier too great to cross over recent months. After closing on an almost four-month high on August 16, the S&P 500 stopped and reversed at its long-term moving average.

S&P 500 Fails to Break Through Resistance Level in April

Source:TradingView

INSIGHT

I acknowledge not every signal is clear cut, and the true clarity of moving averages is often most evident after the fact.

With that said, these indicators provide insight into the levels at which price is most likely to meet resistance or support, allowing you to focus on the price points of most significance in the market.

At present, these levels of resistance are roughly 4,295 for the S&P 500 and 13,260 for the NASDAQ. Any breakout above these numbers would be a positive indicator and represent a buy signal for investor.

With that said, both indexes still remain well below these ranges so shorter term averages will represent a more appropriate target for the near term.

As well as price level guidance, the situational awareness that comes from these indicators will help determine your next move.

Far too often we presume what has worked for us in the past will continue to work for us into the future.

Our success breads complacency as we become blind sided by our most recent wins.

These moving averages will help you pinpoint when the market environment and momentum has changed significantly, prompting a re-assessment of your approach.

Your last 10 ‘buy the dip’ strategy may have worked, but your next may not work out so favourably in this new, more volatile environment.

My advice, remain cautious for now.

In a period of both damage and opportunity, you need to do your research before diving in.

The gains won’t come as easily as they once did.

Outlook

There are obvious reasons to be fearful, you hear them every day, but this isn’t the beginning of the end.

Are we in a downtrend where rising interest rates and inflation pressures are forcing investors to reassess equity valuations?

Yes.

Is this repricing within the realm of standard market conditions as we reset our expectations following a decade of relentless Fed support?

Yes.

Is the apocalypse coming?

No.

Despite the headlines, It’s not all bad news.

• • Company earnings have held up well

• • Labour markets remain strong

• • Supply-side inflation pressures have eased,

• • Interest rates hikes are likely to slow following the FOMC meeting this month

• • This year’s pullback has stripped much of the excess out of markets

As I have discussed previously, we are unlikely to have the same rate of recovery we experienced when the Fed was funding asset price inflation.

Market uncertainty could result in horizontal trading for quite some time, but all is not lost.

Without a new macro shock, I don’t see markets falling significantly below the lows set in June.

Obviously, a Taiwan invasion or WW3 breaking out means all bets are off. But once again, in a world where anything is possible, focus your investment thesis on what is most probable and build in some margin for error to protect when things inevitably fail to play out exactly as you planned.

Short of a crystal ball, that’s the best you can do and the easiest way to black out the noise.