Do We Have A BIG Drop Ahead?

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I have a feeling that most of you would say “Yes, there’s no way we’ve reached bottom.”

Let me start by saying that calling tops and bottoms is GREAT if you get it right. For me, it’s not about calling every stock market move perfectly. Instead, it’s about evaluating risk and trying to avoid the worst outcome. To give you a golf analogy, imagine that you’re stepping up to a lengthy dogleg par-4 with water all the way down the right side from tee to green. The safe play is to aim left and leave a longer approach shot to the green. It would be a much easier hole, however, if you could fly it over the water and land it in the fairway, cutting off perhaps as much as 50 yards and leave a shorter approach shot into the green. The reward of such a shot is obvious, but you have to evaluate the risk of dropping it in the water.

Now back to the stock market. In December 2021, staying long in the market with all the warning signs I discussed back then was the equivalent of trying to drive the ball over the water. If you stayed long, you dunked a few in the water and probably made a 10 on the hole. However, if you chose safety back in December and moved to cash (or even shorted), then you probably walked off the hole with a par. Most everything in life is about evaluating reward vs. risk and then making a decision that makes sense to YOU. No one else. I can’t tell you what the right decision is for you, but I know what risks I’m willing to take and which ones I’m not.

Listen, we’re in a rough bear market, no doubt. I tried my best to warn back in December 2021 and throughout 2022 that the RISKS were extremely high on the long side. Did I know for a fact that the stock market was topping and would fall 25% over the next 9 months? Absolutely not. I just knew that water was all the way down the right side of the fairway from tee to green and I chose to play my shot WAAAY left. I didn’t want to risk the water (being long in the market).

Now let’s fast forward to where we are today. The S&P 500 has fallen 25%. Economic conditions have worsened. Inflation remains a problem. Interest rates are rising rapidly. The Fed is hawkish. What’s to like, right? Well, I’d say the reward to risk has shifted considerably and that many of the issues/risks present in December 2021 are GONE. A lot of bad news is priced in. Is it enough? I’m not sure – we’re going to find out together as we have another tee shot over water approaching.

But I believe that being in cash or being short right now is the equivalent of taking the risk to drive the ball over the water. History tells us that drops of 25% in the S&P 500 should be bought, not sold. Could it get worse from here? Absolutely. The market can do anything it wants. Just keep in mind that we’ve had 14 bear markets since 1950 and 3 have morphed into “secular”, or long-term, bear markets that have lost 50% or more. 11 have been of the “cyclical”, or short-term, variety. Of these 11, we’ve seen an AVERAGE of a 42% gain over the one-year period from its ultimate bottom. You DO NOT want to miss that rally as it’s the most powerful rally during a secular bull market. In the most recent cyclical bear market in March 2020, during the COVID-19 pandemic, the S&P 500 jumped 78% in the year following its March 23, 2020 bottom. I don’t believe we’ll see that type of one-year return, but I absolutely believe a 40% rally off the bottom is likely. If we jumped 40% from where we sit today, the S&P 500 would be at an all-time just above 5000 in October 2023. Is it possible? Absolutely.

So, based on history, let’s look at the S&P 500 and where we might be heading:

So which way are we heading? Honestly, I don’t know. However, based on all of my historical research and the current technical and sentiment signals I’m seeing – namely, the elevated equity only put call ratio, positive divergences everywhere, bullish rotation since June, etc. – I am of the opinion that being bearish right now is the equivalent of trying to drive the ball over the water and the “safe” play to the left side of the fairway is to be long.

It always comes down to how much risk you’re willing to take to achieve your return objectives. The odds favored the bears in December and they favor the bulls now.

Happy trading!

Tom

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