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  • The Dow Jones Industrial Average is up 20% from its lows, a commonly accepted threshold for a new bull market.
  • However, the much larger indexes have yet to reach that signpost, and the NASDAQ failed to increase after achieving a 20% rally from June to August.
  • Rising interest rates and increasing recession risks mean the economy remains on shaky footing.

The media machine is making a lot of noise about the 30-stock Dow Jones Industrial Average being up 20% from its low, a “textbook” definition for the start of a bull market. What many of these articles fail to say, however, is that the more comprehensive indexes, including the S&P 500, haven’t crossed that threshold and that we’ve been-here-done-that already this year.

The 500-stock S&P 500 index is up 17% since the October low. The 2000-stock Russell 2000 is up 14%. The 5000-stock Wilshire 5000 is up a little over 13%. Impressive returns, yes. However, these major equity market indexes have yet to confirm the move in the relatively tiny subset of stocks comprising the DJ 30. Could they? Sure. But recognize that bear market rallies can fail even after indexes eclipse the ‘mystical’ (dare I say, arbitrary) 20% mark.

For example, the 2000-stock NASDAQ Composite gained 25% from its lows in June to its peak in August before tumbling to new lows in October.

Bear market rallies begin with short-covering from deeply oversold sentiment readings and mature with FOMO-driven bargain hunting. Unfortunately, they die at resistance when trapped sellers, including institutional funds, hit the sell button. In the process, hopium-driven euphoria on Wall Street turns to despair. Of course, the bottom happens eventually, but when it happens is only knowable with hindsight. In the meantime, you have to ask yourself, "where are we on this chart?" Somewhere between panic and discouragement? Anxiety? Denial? It's tough to know at the moment.

mamis sentiment chart

Reasons for skepticism

My father used to have a sign in the garage, “proper planning prevents p*** poor performance.” It’s the root behind my mantra, “plan trades, trade plans.” 

Without a plan, you’ll likely react emotionally to the price action. With a plan, you're more likely to stick to your discipline. Of course, you’ll still make mistakes, but at least you’ll know they're not because of seat-of-your-pants decisions.

For example, Real Money Pro’s Doug Kass has been writing for months that his expected S&P 500 range is between 3700 and 4100. This range acts as his guide, helping him proactively tilt his net long and short exposure depending on how close we are to either end of the spectrum.

In his diary today, Kass made a bold projection, likely influenced by his target range. He writes:

“Given the magnitude of yesterday's market advance, for that matter, the climb since early October, coupled with cautionary reports after the close at Salesforce  (CRM) , Snowflake  (SNOW) , CrowdStrike  (CRWD) , and Costco  (COST)  - I would expect a short term market pullback…Nothing in other asset classes, most importantly in the credit markets (interest rate levels, high yield OAS spread, etc.), and the absence of follow thru strength on the European exchanges suggests that this is a new Bull Market leg. Unlike most, I don't expect a meaningful December market rally, and despite the difficulty in making such a forecast, I would not be surprised if we are at or close to an important market top [emphasis mine].”

Kass isn’t alone in being suspicious this market rally “has legs,” particularly given a suspect economic backdrop that includes higher interest rates and a potential earnings-busting recession.

Action Alerts PLUS Co-Portfolio Managers Bob Lang and Chris Versace write:

“While "news" the Fed is exploring letting up on the rate hike accelerator pedal is positive, it should be noted the Fed remains committed to raising rates until "real signs of progress emerge on inflation.”...Months ago, Powell warned there is likely to be some pain on that path…The November Challenger Job Cuts report showed the rate of job cut announcements at U.S. employers in November was more than five times greater than a year ago…consumers are increasingly turning to debt to fund these purchases. The concern we have is higher borrowing costs to be faced may impact future spending potential, a headwind for the largely consumer-driven domestic economy… In recent days we shared the close relationship between S&P 500 revenue and ISM's Manufacturing PMI data, and should the November data fall into contraction territory, it is likely to signal another round of revenue and EPS cuts ahead.”

The fact that central bank interest rate increases will be smaller is a plus, but the Federal Reserve is still signaling higher rates. With more interest rate hikes on the horizon, headwinds remain for economic activity and, thus, corporate revenue and profit growth

The technical outlook for stocks is becoming suspect, too. Top Stocks’ Helene Meisler's advance/decline indicators kept investors bullish following oversold readings in October. Soon, those indicators may flash warnings. She writes:

“The S&P is now a mere 20 points from that early September peak around 4,100, but the cumulative advance/decline line is about 5,000 issues below that same level…I believe the window is still open for a few more days of rallying, enough to really change sentiment if they want to -- but take a look at the numbers we're dropping off the 10-day moving average (the short-term Oscillator) and the 30-day moving average (intermediate-term) of the advance/decline line in the coming days. You can see the big red numbers to be dropped Thursday and Friday, but starting Monday, those numbers are not very red at all. And that's what makes us back to overbought early next week.”

Advancing stocks minus declining stocks. Source: Helene Meisler.

Advancing stocks minus declining stocks. Source: Helene Meisler.

The Smart Play

A lot of attention has focused on seasonal strength in December; however, stocks may have a tougher-than-usual time delivering gains this year if history rhymes.

Meisler shared an intriguing table on Twitter today compiled by Bank of America. It showed December’s returns in years when the S&P 500 is down over 10% exiting November, like this year. Unfortunately, the month posted a gain above 1% in only four of ten instances, and the best was a 2% return in 1973 – hardly inspiring.

Of course, that doesn’t mean we can’t have a rip-roaring rally this month or that individual stocks won’t perform better than others. However, it does remind us that just because stocks rallied last month doesn’t mean they’ll rally this month. Recall stocks don’t go up or down in a straight line. Instead, they stairstep and zigzag their way higher or lower.

So, while it’s OK to rejoice that account values have risen since October’s low, there are still plenty of risks, given the S&P 500 is flirting with resistance and the recent rally has increased its valuation. For perspective, J.P. Morgan cut its estimate for S&P 500 earnings next year to $205, translating into a forward S&P 500 P/E ratio of nearly 20. According to FactSet, the index's 5-year and 10-year average P/E is 18.5 and 17.1, respectively.

The takeaway? If you’re an active investor, this rally is hard to trust. It needs to prove itself by decisively closing above resistance and then rallying again after a pullback. If so, I think you’ll have more conviction to increase net long exposure. Until then, lock in some profits, move up your stop losses, and avoid the temptation to chase. There will be plenty of opportunities to make money later.

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