Take Your Profits!

Most stock market analysts don’t like making overall stock market calls in the short-term or long-term.

We think they are wrong. Some calls CAN be made that are high probability.

The long-term call is the easy one. The stock market goes up over the long term, and the data is irrefutable over decades.

Ben Carlson of A Wealth of Common Sense is one of our favorite authors. Here is a chart from his firm, Ritholtz Wealth Management.

Since 1950, if you take holding periods of longer than a decade and own the S&P 500, you have a 100% hit rate. The evidence is irrefutable.

In the short term, however, the data is much different. Here is another chart from him…

This shows that the stock market, from day to day, is a coin flip or slightly better.

It isn't easy to make short-term high-probability calls.

This is true most of the time, but there are a few times when the probabilities change.

We made a call on March 21 that the stock market needed to take a break. You can read that note here.

Here is a chart of the S&P 500 from the start of the year…

We put a red arrow on the date that we made our call.

Our view at the time was that the stock market had a great start to the year but that many macroeconomic factors were going the other way. Interest rates and commodity prices had begun moving higher.

We also thought it would be impossible for the stock market to keep up that pace of return.

It turned out that we were correct, and over the next month or so, the S&P 500 corrected a little bit more than 5%.

We are now making a similar call. We think that it is time to take profits on trading positions.

We think it is highly likely that we will enter a correction that could last weeks or months.

We think it could be similar in magnitude to the last one.

If the S&P 500 were to retrace back to the 50-day moving average, it would be down -4.5%, and to the 100-day moving average, it would be down -6.6%. We think this correction will be in the -5% to -10% range and last six to eight weeks.

What gives us this conviction?

Our first data point is our favorite technical indicator, the relative strength index, or "RSI.”

Regular readers are familiar with this metric, which measures the short-term velocity of an asset's price. It can be seen as a measure of “overbought” or “oversold” and a contrarian indicator. Usually, overbought is considered any reading over 70, and oversold is any reading under 30.

We included the chart of the RSI of the S&P 500 below the price chart above.

We consider it a strong oversold contrarian indicator and use it as the base for our TRADING strategies.

As an overbought contrarian strategy, however, it is not useful unless it gets extremely high—usually over at least 80.

For significant stock indices and commodities, reaching that level is quite rare. Well, the S&P 500 did it last week, which has only happened 12 times since 1985.

Here is a table showing what happened next after the S&P 500 reached at least 81 during that period…

The data looks pretty similar to any other stock market period in the next two trading weeks.

Across three and four weeks, however, the data is ugly. The three-week data is particularly bad. Looking across all three-week rolling periods in the history of the S&P 500, a 17% positive hit rate is rare.

Does this mean the stock market is guaranteed to go down?

Not at all! The last time the S&P 500 had an RSI of 81 was in December 2023, and the market was higher in three and four weeks.

Also, most of these losses are not that bad.

There is one other piece of data that we are looking at, though: seasonality.

Many folks ignore it, but we don’t.

Seasonal patterns happen because of the seasonality of our lives. Here is the table showing the returns of the stock market by month…

This data is for the Dow Jones Industrial Average, but the same seasonality applies to the S&P 500.

You can see that while July is a great month – and that is playing out again in 2024 – August and September can be rough. They average some of the lowest returns and positive hit rates - especially in September.

Why does this happen?

We think there are particularly good reasons. During the month of August, many (most) investors are on vacation and simply do not pay as much attention.

When we get to September, companies that were going to miss their numbers for the full year can no longer avoid the situation. There is not enough time to make up for it.

The combination of bad news surprising investors back from vacation creates a difficult stock market.

Can it be that simple?

We can’t know for sure, but we feel confident that taking profits from your trading positions right now is a good move.

As a trader, you would rather sell early than late. We encourage you to do so now.