Only the Short-Term Forecast Looks Bearish
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The market took a breather last week following two consecutive weeks of gains, as most major U.S. stock indices finished just fractionally higher. The strongest performer was the tech-heavy Nasdaq 100, which gained just 0.4%, while the small-cap Russell 2000 brought up the rear, losing 0.2%.
Bigger picture, the S&P 500 remains situated right in the middle of a three-month period of sideways investor indecision as two key questions overhang the market: 1. When the Federal Reserve is going to raise interest rates; and 2. Who is going to win a hotly contested presidential election.
Investor Complacency Still a Red Flag
Over the past several months, I have been stating in the Market Outlook that my overall forecast for the U.S. stock market would remain bullish as long as the late-June Brexit lows were not broken. However, I have also been saying since July that extremes in investor complacency have been putting a damper on market gains.
The first chart shows the relationship between extreme investor complacency, as measured by the Volatility S&P 500 Index (VIX), and the broader market since January. A decline to 12 in the VIX has closely coincided with the past six near-term peaks in the S&P 500.
After trading as low as 12.14 on Thursday, the VIX finished last week at 13.29. Since 2013, there has only been one instance where a decline to 12 in the VIX did not put a lid on a meaningful advance in the S&P 500. That was between May and July of 2014 when the broader market index still managed an additional 100-point advance before quickly giving most of those gains back by early August of that year.
The current extreme in investor complacency, which indicates a lack of fear of a meaningful market decline, can also be seen in a number of investor sentiment metrics.
The next chart plots the Nasdaq 100 along with the Market Vane Sentiment Survey. This survey measures the collective bullishness of market advisors and futures funds.
These professional trend followers, who focus on the intermediate to long term, are currently hovering at a historic bullish (i.e., complacent) extreme of 79%. This survey is a contrary indicator, and it has either coincided with or led most of the significant declines in the market-leading index since 2010. And this is despite the fact that its effectiveness at finding market tops has been greatly diminished since the Federal Reserve launched QE3 in September 2012.
So, while I currently see no immediate need for investors to liquidate all long equity positions and hide their money under their mattresses, the combination of extremely low volatility and extremely bullish investor sentiment warns against putting a lot of new money to work at this level. Near-term downside risk appears to exceed upside potential.
OPEC Rescues Oil Prices
In the Sept. 19 Market Outlook, I pointed out that oil prices were breaking down from three months of sideways investor indecision, noting it indicated the larger 2014 decline was resuming. For the PowerShares DB Oil ETF (NYSE: DBO), which is intended to reflect changes in market value of light, sweet crude oil (WTI), the breakdown targeted a 16% decline to $6.90.
The bearish implications of the recent breakdown were negated late last week as the Organization of the Petroleum Exporting Countries (OPEC) announced plans to lower production by up to 700,000 barrels per day.
When a pattern like this is broken, it indicates that investors have collectively changed their mind on price direction — often due to an unexpected or significant event such as OPEC’s announcement. And it typically precedes more follow-through in the direction of the reversal, which, in this case, is bullish.
The good news is that, if this is truly an important bullish reversal in oil prices, it bodes well for global economies heading into 2017.
Gold Still Looks Vulnerable
In the Aug. 15 Market Outlook, I pointed out that the SPDR Gold Shares (NYSE: GLD) had broken its June uptrend, saying it targeted a 3.7% decline to $122.75.
The next chart shows that the mid-August breakdown has since evolved into a bearish triangle pattern, indicating investor indecision. The $122.75 near-term downside target, which is 2.3% below Friday’s close, remains valid below $129.76.
Bigger picture, however, gold prices are still in the midst of an uptrend off their February lows. So, once prices correct a bit lower and I start to see signs of a bottom, I will be looking for a new buying opportunity.
Putting It All Together
My intermediate-term outlook for the stock market is positive. I expect an additional 10% to 12% advance in the major indices by the early to middle part of 2017. Near term, however, history suggests that downside risk currently exceeds upside potential due to historically low market volatility, overly bullish investor sentiment and the threat of more seasonal weakness during October before a year-end rally starts to gain traction in November.
Meanwhile, if last week’s OPEC-inspired bullish reversal in oil prices continues, it will support stronger global economies heading into 2017.