Ari Wald: Here is What Will Trigger the Pullback

One of the more exciting new guys to begin contributing to StockTwits / Twitter of late is Ari Wald, chief of technical strategy at PrinceRidge.

In a note from the middle of this week, Ari made an extremely important point about how rallies like this one usually end. It’s a combination of the seasonal cycle along with the waning of the positive feedback loop once supply catches up with demand. He gives us the signs to watch for as well.  Even more impressive is that he got this out the morning after having beers with me and the crew Tuesday night 🙂

Enjoy and learn! – JB

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One factor we contribute to the S&P 500’s 13% rally from its November low is a positive feedback loop. Specifically, the initial price surge off of the mid-November low, catalyzed by a belief that a year-end budget agreement would occur, turned a mixed sentiment setting increasingly optimistic and roused additional gains as new longs entered the market.  These additional gains subsequently incited more optimism and yet another round of new longs; repeat process.

This loop establishes a basis for why momentum exists and why trends form.  The assumption is that the loop will continue until bullish positioning is stretched and sentiment is consequently at an extreme.  When fewer longs are left to propel stocks higher, the market’s rate of ascent subsequently declines and price will generally level off.  Then as supply and demand come into balance, a small disturbance can be intensified by a negative feedback loop and initiate this circuit in the opposite direction.  The tendency for these sentiment shifts to be gradual rather than abrupt is why complex formations (double bottoms, head-and-shoulders, etc.) are more common than “V” reversals, but they can unwind quickly if market liquidity is scarce.

Timing this exercise is a formidable task and was likely a motivation for the popular quote attributed to John Maynard Keynes that “the market can remain irrational longer than you can remain solvent.”  Nonetheless, an ability to detect sentiment extremes in an unbiased manner remains useful when managing risk.  Extreme sentiment readings tend to be the first warning of a potential top, and the evidence becomes compelling when confirmed with deterioration in trend, distributive volume, selective breadth, diverging momentum, or weak seasonals.  This belief anchors our 3-6 month Neutral outlook on the S&P 500; extreme sentiment is an early warning, but tactical indicators remain supportive on balance.

The index’s seasonal trend from recent years is providing a roadmap as well.  In particular, it is noteworthy that our % Bullish Composite has swung to an optimistic extreme above 80% as it did in the first quarters of 2011 and 2012.  In the prior instances, sentiment peaked ahead of price action and lingered while divergences were formed into the seasonally weak Q2 period (pages 4 & 5).  The S&P 500 ultimately corrected peak-to-trough by 21% and 11% in 2011 and 2012, respectively.  The maturing age of the index’s long-term cycle makes this seasonal scenario probable yet again.

As a reminder, our % Bullish Composite is a normalized gauge of four surveys; Investors Intelligence, Consensus Inc., Market Vane, and American Association of Individual Investors (AAII).  Since the start of our data in 1987, the S&P 500 has averaged a 1% gain over the next 26 weeks when the composite is above 80%, 4% when bullish readings are between 20% and 80%, and 8% when the composite is below 20% (page 6).  The current 86% bullish reading is the chief reason why we believe that the best rally gains have been achieved.

In terms of S&P 500 levels we continue to view the index’s rising trend channel as resistance (directly overhead at 1520) and 1475 as support (page 7).   On-Balance Volume for the index hasn’t confirmed recent price highs indicating early evidence of light volume strength.  However, we would not become too concerned until a divergence develops measuring weeks to months, rather than days.

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Great stuff.

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PrinceRidge