A Common Sense Reminder

End of Day Update:

The S&P500 surged to fresh highs in the biggest up-day since the election. Trump addressed Congress Tuesday night and clearly the stock market liked what it heard. Today’s move caps a 15% rally since the November lows. It’s been a great ride, but the pressing question is if it is time to get off, or if this thing has a lot further to run?

Let’s start with the basics, everyone knows the market moves in waves. Most traders acknowledge even the strongest markets move two-steps forward, one-step back. While we cognitively recognize this, we often forget it in the heat of battle. Human nature compels us to find patterns and extrapolate those patterns far into the future. This behavior worked well when it came to surviving in the wild, but many of these instincts are a liability in the financial markets.

Traders are excited, everyone is making money, and it is hard to resist the crowd’s enthusiasm. Everyone else is making money and we want to join the party. It is perfectly natural to feel nervous when everyone around us is nervous and relaxed when everyone else is relaxed. When a lion entered a camp, those that automatically ran when everyone else was running survived while those that waited to see what the fuss was about quickly became lunch. We’re pack animals by instinct. Rather than fight it, just recognize it and factor it into our trading decisions.

And this brings us back to the current market. We surged 15% in four-months with only the smallest dips along the way. Then today we experienced the largest single-day gain of the entire move. Let me ask the rational side of your brain, is today’s surge the start of a much steeper rally higher? Or is it more likely to be part of a near-term climax before a much needed pullback and consolidation?

Let’s just get this out of the way pullbacks are inevitable. It will happen because it always happens. The hard part is getting the timing right. Traders don’t get paid for knowing what will happen, they get paid for knowing when it will happen. And so the question isn’t if this breakout will stall and step-back, the question is when. Without a doubt this rate of gains is unsustainable. But the same thing could have been said yesterday, last week, or even last month. While I don’t know when we will peak, what I do know every day brings us one day closer.

While owners feel good and comfortable with their positions, we really should be asking ourselves if this is a better place to be adding new positions or taking profits. Risk is a function of height and by that measure this is the riskiest the market has been in quite some time. Momentum is clearly higher and will likely continue, but I feel much safer buying discounts than paying a premium. It is simply a matter of risk versus reward. This breakout carried us to record highs and has already moved us 15% above the November lows. While we can keep drifting higher, what are the odds we rally another five, ten, or fifteen percent? With history as our guide, a near-term dip is more likely than a continuation. As we started with, markets move in waves. You know it, I know it, everyone knows it. Unfortunately many in the crowd have temporarily forgotten it.

All of that said, we need a something to shake the confidence of stubborn owners. Something to get them to sell this market they are so excited about. Two bogies on the immediate horizon are the Fed’s interest rate decision and Republicans getting together to repeal Obamacare. If either of these don’t go the market’s way, that could be what gets traders to start looking down and realize how high they are and convince many to start taking profits.

Don’t get me wrong, I’m not a doom-and-gloom perma-bear. I’m simply being a realist. The biggest up-day in a nearly straight-up 15% move makes me nervous. Markets move in waves and it’s been some time since we took a step back. Be careful.

Jani

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