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Why the next 10% move in the stock market might be down

The market could go down before it goes up again. Image Source: Justin De La Ornellas/Flickr

Before I begin this article, I would like to state that I am not one of those perma-bears who consistently calls for the end of the world. I simply observe the price action of the market and do my best to interpret what it is telling me.

For example, in 2016, I called for Dow 20,000 nine months in advance, wrote about a Trump victory a month before the election, and then called for “at least another 10% gain” in 2017. You can find links to all these calls here. Right now, the market’s technicals are very weak and we could see another 10% down for the following reasons:

1) Very few people are talking about the number of large hedge funds that are currently closing. In late September, I read that 6 or 7 hedge funds were shutting down on October 1, and we saw indiscriminate selling during the first few weeks of October. Keep in mind that these weren’t small funds, as many of them had assets of $5 billion or greater. Since most hedge funds allow for redemptions on a quarterly basis, we are likely to see another large exodus at the beginning of 2019. Unfortunately, many active managers have underperformed and most investors make their investment decisions at the end of the calendar year. If this happens, this could lead to more forced liquidation that has nothing to do with the current news headlines.

2) Speaking of the news, it seems like everyone is obsessed to pinpoint the EXACT reason for the market’s weakness. It is impossible to do so because there are too many headwinds facing the market right now. We are all aware of its two major hurdles (rising interest rates and the China trade war) but the market could also be declining due to problems with European banks, global growth slowing worse than most are expecting, the ECB bond purchase program ending in December, or something that hasn’t even happened yet. All I know is that the market tends to be vulnerable when it is below its 200-day moving average and any unforeseen news could lead to an accelerated selloff.

3) Sentiment is too complacent. There are more people worried about missing a rally to the upside than fearing a further move down. Keep in mind that the stock market is a master manipulator. It conditions us to think a certain way over and over and over until we are finally convinced of a pattern. Then, just when we think we have things figured out, the market magically changes character. The reason I bring this up now is that the market has conditioned us to buy the dip for years, and has rewarded people for doing so. After years of this pattern working out, I can understand why many are complacent because they are conditioned a certain way and forgot that we can actually have corrections.

4) One positive note from a growth point of view is the strong price action in many Enterprise Software stocks. These companies continue to show strong earnings and sales growth, and they will most likely be my area of focus when this correction is over. However, when I look at major companies that are a better indicator of the overall economy, many of these charts look severely damaged and will need time to recover. Examples include Apple, FedEx, Goldman Sachs, and the Homebuilder Index. In addition, the strength in the Utilities sector is clearly a sign of a defensive market. 

Charts are provided by MarketSmith.
Charts are provided by MarketSmith.
Charts are provided by MarketSmith.
Charts are provided by MarketSmith.

While I always try to be optimistic, the technical damage is telling me to remain defensive and that we will most likely see more downside. The biggest thing that would change my cautious stance would be a definitive word from the Fed that they will stop raising rates and a firm resolution on the China trade war. Unfortunately, I think both of these major headwinds will take a long time to resolve themselves. December is traditionally the best month of the year, so we might see the market hold up over the next few weeks and not decline until early 2019. Either way, I remain defensive and hold a larger than normal cash position for my clients until I see healthier conditions. In the meantime, surviving the volatility over the next few months will require a great deal of patience and discipline.

Read more:

4 things to do during market corrections

Why it makes sense for traders to hold some cash

I can be reached at: jfahmy@zorcapital.com.

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