In our annual Market Outlook, I mentioned that 2017 was one of the smoothest years for the market in history.  I also wrote in the written supplement to this year’s outlook that if you added up all the days that the market was down in 2017, the total was equivalent to only -27.36%, which is the lowest percentage of cumulative lows since 1915.

In addition to these huge record-breaking numbers, Mark Zinder (one of my early mentors) pointed out last week two statistics I found extremely interesting.

  • For the first time in history, the S&P 500 posted positive returns in every single month of 2017.
  • The end of the year was closed out with six full positive weeks on the Dow, and the last time this happened was in 1954.

However, while the stock market continues clawing its way northward, there’s another number that’s breaking records, but not getting nearly as much attention – and that’s momentum.  There are many ways to measure momentum, but we’re just going to focus on RSI (Relative Strength Index) because I think it’s the simplest to understand.

Nerds Note:  RSI is a momentum indicator that measures the number of recent gains and losses over a pre-determined period of time (i.e. – daily for shorter term, weekly for intermediate-term, or monthly for long-term) in order to observe the speed and change (momentum) of an investment.

In a nutshell the higher RSI is, the more overbought or “overheated” it is.  The lower RSI is, the more oversold or “cold” it is.  I use RSI in three ways:

  1. To determine the best time to buy in the short-term,
  2. To recognize divergences in momentum vs. price, which can offer “warning” signals for good and bad, and
  3. To determine how bullish or bearish a security (or market) is.

With that all behind us, let’s take a look at the market and paint a picture with some of the records that are being hit today.

The first picture below is a weekly chart (or intermediate-term) look at momentum in the S&P 500.  Just one week ago, I was posting on social media and explaining that there had only been two times in the last 6+ decades that the market had been this overbought.  Thanks to the 2nd week of January, the market is more overheated today than it’s been in more than 67 years!

Now let’s go long-term and take a look at a monthly chart.  You can see in the bottom pane at the far right that RSI is now sitting at a value of 87.01.  I circled the only two times since 1950 that the market was more overbought on a monthly basis than it is today.  Further, I found it interesting that, over the months that followed the peak in 1955, we saw increased volatility.  However, following the peak in June of 1996, we observed a mere -4.6%, 1-month pullback in the market.  You have to scan all the way forward in time, to 1998, before you’d find an actual market correction that followed a peak in momentum.  So, should these “overheated” moments in the market be setting off alarms, or are we simply experiencing F.E.A.R. (False Expectations Appearing Real)?

Well, sticking to the long-term picture, I wanted to see how long it took for the market to correct or crash after momentum peaks in the past.  What I found was interesting.

The highest peak in 67+ years occurred in July of 1955 and it took a full 12 months before the market began its next correction (of around -18.6% in 1956-57).  What was even more interesting was the fact that it took a full 5 ½ years before we saw an actual bear market (a drop of roughly -23.5% from December ’61 – June ’62).  Similarly speaking, it took 4.8 years from the RSI peak before the dot-com bubble burst, and 3.8 years from the peak in RSI to the top of the market just prior to the mortgage crisis market melt-down.

If you look at the chart above one more time, you’ll see that declining trends in momentum (lower pane) can precede and warn of future declines in market prices (upper pane).  This is what we in the technical analysis field call “divergence.”  Specifically, the declines above represent “negative divergence” in momentum, relative to price.

Our final chart of the day gives us proof that, while these peaks and subsequent down-trends in momentum can warn of lower prices in the future, the market doesn’t have to deliver a “crash” to make our lives miserable.  Zooming in on the 50s, 60s, and 70s from the chart above, the image below paints a picture of volatility over the following decades.  Being a retired (or soon-to-be retired) investor during these three decades was a difficult one for taking withdrawals from your portfolio to supplement your income.  Not fun – at all…

Given the long-term time frame of all the charts above, potential warning signals such as the one we’re living through today can take some time to play out.  In the 50s, 60s, and 70s, you had anywhere between zero to 18 months of warning before a correction or crash.  In the 90s and 2000s, RSI peaks gave us years to prepare for the subsequent crashes…but that’s what makes this so difficult.

One can’t simply use a single metric to manage risk in their retirement portfolio.  It takes a suite of indicators, observing them all in unison, and making buy and sell decisions based on the weight of the evidence at hand.

I expect at least a -5% pullback (or more) in the next six months.  I would welcome such an event as it would be perfectly normal.  Further, a -10% (or lower) correction would not be out of the question in the next nine months or so – but again, this would be “healthy” for the market.  In either case, I would treat both as buying opportunities for the time being, unless the long-term picture for the market drastically changes.

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Warmest regards,