Are things a little too good?

By Jani Ziedins | End of Day Analysis

Jun 06

End of Day Update:

The S&P500 finished lower for a second day, but the losses were minor and we are still well above the 2,400 breakout. The lack of material selling tells us most owners are more inclined to keep holding for higher prices than taking profits. Even though there are several ominous headlines floating about, it doesn’t matter if no one is selling the news. While conventional wisdom tells us markets are complacent just before they collapse, what conventional wisdom often forgets is those periods of complacency last far longer than anyone expects. The path of least resistance definitely remains higher, but expect the rate of gains to remain slow. While confident owners keep supply tight, we are running out of people willing to throw new money at these record highs and that is keeping a lid on prices.

Just because the path of least resistance remains higher doesn’t mean we shouldn’t be shifting to a defensive mindset. Even though I expect prices to continue rising over the near-term, we have never been closer to the market’s top. It’s been a great ride since the 2009 Financial Crisis bottom and I’ve been long-term bullish the entire time. As the saying goes, be greedy when others are fearful. Up until last year the market was afraid of its own shadow and traders thought every bump in the road was leading to the next market crash.

But eight years later, those traumatic memories are fading and being replaced with fear of being left behind. Starting last year the market experienced a major shift in sentiment as we went from a nervous, half-full outlook to this confident, half-full assumption that everything will turn out alright. Long gone are the fears that a Fed taper or interest rate hike would derail this market. Instead we have gotten to the point where the market is fairly blaze about an investigation into our president that could end in impeachment. While I agree the chances of this outcomes is remote, the consequences will be catastrophic for a market that is built entirely on Trump’s promised tax cuts.

It isn’t hard to see why most traders shifted to this half-full mindset. Every defensive sale over the last eight-years was a mistake because the prices rebounded even higher a short time later. After the third, fourth, and fifth time of feeling stupid by selling prematurely, traders learned it is best to hold through these periods of uncertainty and spooky price-action. And so far every trader who has become patient and confident has been rewarded as we climbed to record high after record high. It has gotten to the point where almost no one is reacting to headlines anymore. Rate hikes are no big deal. Missing employment expectations is met with a yawn. Heck, this cynical market finished in the green following the latest terrorist attack. Even a scandal that threatens to derail the Trump administration was hardly good for more than 24-hours of selling. Traders have been conditioned to hold through every dip and as a result no one is selling ominous headlines. The lack of supply means we stopped dipping at all.

While this complacency makes me nervous, I know it is foolish to call a top. This will go higher and longer than even the bulls think possible. The thing is this isn’t about predicting a top but finding good enough. To recognize the risk/reward is no longer stacked in our favor. That this is a better place to be taking profits than adding new positions.

I’m certain this market will keep going higher over the near-term, but I doubt this is the last time the market will trade at these levels. I don’t know when or why the next bear market will happen, but it isn’t unreasonable to expect our next bear market to cut 30% out of the market. That means even if we rally another 1,000 points and peaks above 3,400, we could still find ourselves tumbling back to these levels. The key isn’t about picking the top, but finding a level that is good enough, taking profits, and waiting for a better entry point. It is impossible to buy a dip if we are fully invested and ride our positions all the way down.

The post-election rally is built entirely on expectations of tax cuts. The market has been more than willing to give benefit-of-doubt to Trump and the GOP, but if they fail to deliver, expect the market to give back a huge portion of those gains. Given the high prices and low implied volatility, this might not be a bad place to look at a black swan trade. Buy longer-dated, out-of-the-money puts. While they will most likely expire worthless, the costs are relatively low and the payoff is huge if things turn out worse than the market is hoping for.

Jani

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About the Author

Jani Ziedins (pronounced Ya-nee) is a full-time investor and writer who has successfully traded stocks and options for more than a decade. He earned a B.S. in Mechanical Engineering from the Colorado School of Mines and an MBA and M.S. Marketing from the University of Colorado Denver. His prior professional experience includes manufacturing engineering at Fortune 500 companies, structural engineering, small business consultant, collegiate instructor, and managing investment real estate. He is now fortunate enough to trade full-time from home, affording him the luxury of spending extra time with his wife and two young children.