The Window is Getting Smaller

Bottom Line: Prior market comparisons can be taken too far, but the action in the S&P over the past year and a half, including the pattern in the number of stocks at new highs, is a fairly close approximation to what we saw in 1998.

One of the stronger aspects of the move off the August lows is the increasing momentum that accompanied the rising prices. Now, despite the recent breakout in the S&P 500, we are seeing some evidence that the momentum in many of the underlying stocks is not carrying through.

This type of behavior is quite similar to another time in history – 1998. Let’s look at the 5-step structure of the two markets.

The structure of the two markets are not exactly the same, of course. The upward sloping trading range in step 2 was much steeper in 2003 than 1997; the multi-month trading range (step 4) in 2004 was significantly longer than the equivalent one in 1998; and the divergence in the number of new highs in 1997/1998 ran over the period of that entire time, as opposed to the current divergence which only goes back to the end of 2003.

While comparisons to past markets can certainly be taken too far and become useless, I think some generalizations like these can be instructive. Market patterns do repeat in a general sense, and this potential loss of momentum in the underlying market may be a telling sign, especially since the latest push higher looks quite similar. In 1998, the S&P rallied about 10% to break out of the range while new highs contracted by around 50%. Currently, the S&P has rallied about 13% from the August lows while new highs were 262 today compared to 662 last December – a decline of about 60%.

After price momentum finally stopped, the S&P went into a tailspin, losing nearly 20% over a couple of months. Excessively bullish sentiment, combined with a loss of internal momentum, lead to a price vacuum once the music stopped.

Whenever I talk about breadth I get several emails about decimalization and the numerous rate-sensitive issues now in the NYSE. Those may be valid issues, but again I don’t want to take these comparisons too far. The type of price action we’ve seen is quite similar to 1998, as is the sentiment situation and the deteriorating number of new highs. It’s compelling enough to mention and I think it is beneficial to keep the possible precedent in mind.

Bottom Line: When both stocks and bonds rally on a day the Fed raises interest rates, we have consistently seen weakness in equities thereafter.

In a comment from September 21^st, I noted the market’s tendency to decline after days when both the S&P 500 and the 30-year Treasury Bond rallied on a day the Federal Reserve raised interest rates. Here is that blurb:

“…Anytime both stocks and bonds closed higher on a day the Fed raised rates, the S&P was lower after 30 days every time, with an average return of -3.6%. There were only four instances, however, and all were in 1999 and 2000. I’ve noted before how it is extremely difficult to use past reactions to economic data as a guide for future reactions, since what is considered “good” news is constantly changing, but this at least gives us a little perspective.”

That quote was from a comment on June 30^th (quoted again in September), which certainly followed the historical pattern of reversing any strength shown on a day the Fed raised rates. Again in September, when both stocks and bonds rallied on the day the Fed raised rates, that strength was immediately reversed. The S&P declined for a few days before enjoying one more failed rally which ended up leaving the 30-day return just barely positive.

Date of Fed meeting	S&P gain that day	30-yr Bond futures gain that day	S&P 500 change 30 days later
06/30/04	+4.5	+30/32	-77.6
09/21/04	+7.1	+12/32	+1.3
12/14/04	+4.7	+7/32	?

As always, interpretations of economic news are ever-changing and what is good is sometimes bad for the market and vice-versa. But watching the stock and bond market reactions can be more useful than trying to gauge the news itself, and so far we’ve seen a pretty consistent pattern of strength on Fed day being immediately reversed in the days thereafter.

In intraday notes the past two days, I have mentioned that whenever the S&P has made a new yearly high before December 15^th, it was higher 20 days later 9 of 12 times. Also, whenever it had rallied at least 3% in the 30 days leading up to mid-December, the second half of the month was higher 17 of 20 times. This is relatively strong support for the idea that the broader market is unlikely to just fall apart here, as the combination of a strong market meeting strong seasonality tends to keep uptrends intact.

It’s hard to reconcile that type of historical precedent with what most of our sentiment measures are saying, and even non-sentiment-related data as discussed above. I think it’s highly unlikely that we will see any meaningful decline between December 23^rd and the first few days of January, so if these other measures are going to have any affect, it will likely be either before or after those dates. If we see a decline before that time, it should be mild and just set up another rally attempt. After the first few days of January pass, however, and should we continue to see what we’re seeing now, there should be a good bet on the short side.

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.