Extreme Nuance

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This week has taken the market to a new level of extreme. US stocks remain rampant breaking almost all records. Yet US yields are making 10 month highs some commodities are flying and the USD is at 10 month lows. A broken market for sure. And one that will be further challenged by the Davos summit on January 23-26 if Donald Trump brings his ‘America First’ focus along as he promises. With noises about NAFTA and alleged Chinese curtailment of US bond buying in retaliation for sanctions the situation and probably markets are likely to get rocky.

As we explained in our last newsletter, January has a habit not only of possibly shaping the year through the January Effect and Condition but also taking correlation break downs to extremes. Given the number of messages from very experienced traders (20+ years) saying they have never seen the like, we must be careful about attaching too much significance to some moves or drawing too many conclusions. Besides the breath-taking similarity of the Dollar, particularly EURUSD, to 2002 (the Pandora’s Box analogy), there are only two real historical precedents for this seemingly unique set of circumstances: 1929 and 1987. Yeah, right, ramp and crash years. But 2017, despite our start of the year projection, was only a ramp year . Being right in the wrong market now doesn’t make money. Being right in DAX and wrong in SPX confuses. But understanding why one can be right and wrong now helps one be right in future.

This week we send out INDEX 2018 for all the stock indices we cover (US – SPX, DJIA, NDX, SPX Sectors, RUT, WIL; German DAX, French CAC, EuroSTOXX, Japanese Nikkei, UK FTSE and Indian Nifty). After a huge amount of research, we have reached some very clear confident conclusions. By the reaction of some who have glimpsed some aspects, the results are exciting, accessible and, as one person put it, “immense”. Huge opportunity to make money both ways.

Introduction to INDEX 2018

The outlook for the equity markets in 2018 is challenging but exciting and ripe with opportunity. If 2017 can, in retrospect, be described as an aggressive one way street then 2018 should prove to be an equally aggressive two-way street. Volatility is here to stay.

During 2016 and at the start of 2017 we made number of very bold calls based on historical comparisons.

We started 2017 very bullish, with indices looking for a 12.6% SPX rally in 8 months without a 5% correction and a minimum 13,400 DAX, 10,000 Nifty, 8,140 FTSE and 22,700 Nikkei. This bold view was partly based on a hitherto very accurate 1920s and 1980s blowout template. Both even more boldly projected an August 25th top leading into an October crash. And yet after hitting our 2515 SPX target on the last day of September the US market continued aggressively higher for three months to finish the year up 20.6%, and no sign of a top let alone a crash even though European markets such as DAX turned down in the last three months. 2017 ended having broken many records , many correlations and indeed many resolves—all a predictable but extremely challenging feature of a blowout.

This is the longest S&P streak ever without a three per cent correction.

It is only three working days away from being the longest bull run ever without a 5% correction (see ‘Next Week’ below)

The outlook for the equity markets in 2018 is dependent on the interaction and trends of FITS (fundamentals, intermarket relationships, technical and sentiment) and in particular the main driving force behind the global uptrend, the US. Although 2017 has been dominated by rotation and a collapse in correlations, a global view of stocks still relies on the FITS that drive the American stock market. Hence the US centric focus of this introduction.

In a series of articles starting back in 2016, Milestones in Mania, we defined the FITS milestones we had used (for most of this US bull market) to guide us through the same sequence as the 1920s and 1980s:

All three FITS sequences have developed in a similar fashion.

a. An extreme bearish sentiment at the low.
b. A government inspired recovery that gained momentum as …
c. The powerful fundamental uptrend with breadth. This continued until …
d. A major technical correction that sowed the seeds of …
e. A final aggressive sentiment driven rally leaving the fundamentals behind and where rotation became extreme even beyond a very top until …
f. All markets turned lower into a crash.

Pretty much a carbon copy so far but we are yet to see a top let alone a crash. After revisiting our analysis we have identified the main reasons why the market has gone further than we anticipated and therefore a new set of more robust conditions to help identify not just the top but any buying opportunity in the interim and how to identify and manage a turn.

The following table provided by JP Morgan is an interesting comparison of all bull and bear markets and shows the scale of the current uptrend but does not fully explain the underlying causes nor its likely end.

Indeed neither does a simple price comparison of last year with 1929 and 1987 which would appear to apply DJIA is very close to a major top.

For each of these phases in the rally from 2009, we created a set of conditions that, we believe, needed to be met before the stock markets could turn. Understanding the phases is important to appreciating where we are now and what will cause a reversal into a possible major adjustment or crash.

Many of these milestones have now been met.

And yet the markets continue to rally—preventing the appearance of any of the key reversal indicators. Why? Are we wrong? No. Just we were almost inevitably early. These reversal indicators will help us know a top at least after we have seen it. And fortunately, there should be enough time and retracement to gear up for an eventual crash rather than chase it. But that’s not necessarily enough. What about the interim?

The rally has surpassed even our original extremely aggressive targets and taken much longer than either our projected 1929 and 1987 style blowout. The reason we believe is fivefold. All are ironic and therefore self-perpetuating until the spiral turns around.

1. Data underestimation. We did not anticipate the extent to which prices needed to rally to meet some of our fundamental milestones such as the collapse in dividend yields (note it is now 1.73% below the 1.75 minimum target) or indeed the ramp in US 10 year yields that we are now seeing.

2. The significance of VIX (one month SPX volatility). A surrogate long stock trade is to sell VIX and as bullish stock sentiment has grown so implied volatility has fallen slowing actually volatility and therefore increasingly delaying the appearance of a top.

3. A self-defeating sentiment circle. VIX has helped create a self-defeating sentiment circle, where traders have been too quick and early in identifying a top—so fuelling the rally even more. The sequence of possible real triggers such as North Korea, Russiagate, tax and healthcare bill doubts have all encouraged premature bears and ironically served to prolong the bull market. Now we have come this far, one thing is increasingly clear. There will be no trigger for a top (although there may be one for a crash). It will be purely sentiment where no one is short any more and market is compulsively long and just wants to buy dips. The start of 2018 should produce a mini dress rehearsal.

4. Rotation. Rotation between markets has increased well beyond even our 2016 projection of an aggressive correlation breakdown to the extent it has ironically got in the way of any possible turn. As one index has gone higher (eg DJIA) and another lower (eg DAX ) in the short term, rather than bring down the bullish market it has led to a squeeze in the weaker markets that has help fuel the rotationally favored instruments even more. Similarly, some of the surrogates in the foreign exchange markets have not indicated a top. Ironically the risk aversion vehicles: EUR, AUD and NZD have and all fallen in line with the 1987 crash template. But crucially the safe havens (CHF and JPY) have not. Until we are confident of a strong rally in these haven currencies not only will they deny a stock market turn but will also encourage further stock buying.

5. Fractal Nature of Sentiment. For all the right reasons, we ascribed Donald Trump’s election as the start of the aggressive blowout and our countdown clock. But ironically we neglected the fractal nature of markets and in particular this climax The sentiment driven blowout is itself going through the same sentiment—fundamental—technical—sentiment sequence.

This nuance – if it can be called that with such a huge impact – is something we hadn’t anticipated. Donald Trump’s election heralded an expectation of significant fiscal expansion and therefore growth/inflation – expectation is sentiment. Although the North Korea scare held the market back, as these fears dissipated and Trump’s tax bill has been passed providing a real fundamental aspect but still only to sentiment. The market is currently only in the latter stages of this phase and therefore approaching only a technical correction within the sentiment blowout. So although this market seems incredibly extreme, once we see a drop of more than 5% (we have an historically based precise % retracement target), there is a good chance the final sentiment driven leg of the sentiment leg will still take exactly the same 67 days that it did in both 1987 and 1929. This suggests there will be no need for a trigger for the very top except pure sentiment. The root causes of an eventual top and turn down into a crash can be found in each of the Fundamentals, Intermarket Relationships Technical and Sentiment:

The detailed exposition of these four FITS pillars for 2017 and 2018 are contained in the full introduction to INDEX 2018 and for the first time, the detailed set of conditions to differentiate only a projected correction from a reversal into a crash. We may find we are conceding only a correction, at the very top. But we doubt it. We have clear markers to guide us through the most incredible market I personally can remember.

Good Luck

Ed Matts
Matrix Trade

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