Steps From A Correction

There is no doubt that last Thursday's 20 point drop in the S&P500 marked the Half Cycle Low.  The midweek (members) report detailed that the current Daily Cycle was consolidating via time and not price, a bullish development which points to further short term gains ahead. The report also suggested that a quick drop to the 20dma would mark the Half Cycle Low. The drop came on Thursday, with price subsequently spring-boarding off the 20dma in a classic buy-the-dip move. I expect speculators will again chase the market higher, but this time to a top across multiple Cycle time-frames.

It is difficult to analyze an asset that is behaving as irrationally as are the current equity markets. The theme is the same week in and out, and searching for justifications for the market’s extremes becomes pointless. The facts are simple – equities are in a late stage cyclical bull market which is being speculatively driven. The idea that the FED is supporting and feeding the market is only marginally correct, but the idea has nonetheless taken root and become a rallying cry for equity bulls.   

Speculative markets are always a reflection of market participants’ collective greed. To support speculative behavior, participants formulate justifications which are often delusional. The “madness of crowds” is a well-known phenomenon that is all-too-common in the investing world. Each time – whether the late-90’s internet bubble, the mid-00s real estate bubble, or the current equities bubble – participants find a way to convince themselves that this time is truly different. 

The speculative frenzy always reaches the point where those prudent investors who have remained on the sideline can no longer tolerate feeling foolish while everyone else is making so much money.  So they dive in too, and each passing week brings more conversions to the bullish case.  Eventually, everyone is a bull…and there are very investors left with the courage to stay out of the market. At present, this phenomenon likely explains why Investors Intelligence sentiment data is hitting extremely low numbers of bears. The spread between Bulls & Bears is now at its highest since April 2011, which was precisely where the market last topped. A 20% correction followed shortly after.

Sentiment readings from multiple sources are universal in their alignment – equity markets sentiment is at levels which accompanies significant Cycle tops. One example, Sentimentrader’s Smart/Dumb money indicator, currently reflects a “dumb money” level last seen at the 2011 top. And the spread between the two – Smart and Dumb money – is now at its widest levels since 2011. Both metrics are reliable indicators of an impending Investor Cycle top.

Courtesy Sentimentrader.com – The Smart Money Confidence and Dumb Money Confidence indices are a unique innovation that allows subscribers to see, in one quick glance, what the “good” market timers are doing with their money compared to what the “bad” market timers are doing. 

Newsletter writers are also fully behind the current bullish move, as shown in Newsletter Sentiment readings. In the past, similar levels of bullishness have occurred at market peaks, leaving newsletter writers and their subscribers on the wrong side of subsequent moves. Although sentiment readings are not a perfect timing tool, they are directionally reliable. Current sentiment indicators reflect levels that are found only at major Cycle tops.

In equities, Investor Cycles typically average 20-22 weeks in duration.  The average duration to the Cycle peak is 16 weeks, and the average duration from the peak to the Cycle Low is 6 weeks. The current Investor Cycle is stretched – it’s on week 20, yet is still making new highs. This is very unusual, especially with a preceding Investor Cycle that both rallied for 27 weeks before topping, and then experienced only a mild consolidation. 

The current Investor Cycle is both stretched and extremely overbought technically. The move during the past year has been so relentless that the trade is now extremely and dangerously one-sided. Such stacked trades, after prolonged and impressive moves, almost always give way to rapid, wrenching reversals.  And when Cycles align – in this case the Investor Cycle aligning with the longer Yearly Cycle – the reversal generally surpasses a typical reversion-to-the-mean event. 

It’s clear that the Investor Cycle is well past due for a Cycle Top. A typical, mild retracement into an Investor Cycle Low (ICL) is 5-8%, but since the coming ICL will also mark a Yearly Cycle Low (YCL), we can expect the decline to be extra-deep. A YCL typically occurs every 12-14 months, and normally includes a 50% minimum retracement of the entire yearly advance.  On occasion, the severity of YCL declines marks them more as “Corrections” than mild profit-taking events. A more severe Yearly Cycle Low can easily yield a greater than 10% correction of the top of the market.

During the past 100 years, these “corrective” Yearly Cycle Lows have occurred, on average, every 26 months. This generally equates to a more severe correction every 2^nd YCL. The most recent YCL in Oct 2012 was extremely mild. The summer of 2011, 25 months ago, was the last instance of a YCL that was also a true market correction. 

Although I believe that a YCL – and a market correction – is clearly overdue, I do not believe we are at the end of the bull market. Although sentiment is stretched, and the current move is clearly speculative, over-bought, and over-extended, the divergences that typically accompany major 4 Year Cycle Tops are not present.  So I don’t believe the current cyclical bull market will end with the coming Yearly Cycle correction. In fact, most breadth indicators support a further rally in early 2014, one where a final 4 Year Cycle high is made. This is the point where I believe the next bear market decline will begin.   

That said, make no mistake – I believe a market correction (10% or more) is literally just days from beginning.  The move should be rapid and punishing, taking just 4-6 weeks to complete.  Every attempt to buy the dip will fail, and weak support levels built during the past year will offer little resistance.  Recent market entrants will be slaughtered, and perma-bears will awake from their 24 month slumber. As profits mount on the Short side, new bears will gain confidence and their numbers will swell. Continued selling and the conversion of recent bulls will cause the decline to deepen, ensuring that the Yearly Cycle decline turns into a rout.

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