Chart Advisor: Staring Into the Danger Zone Ahead

By Gordon Scott, CMT

1/ A Historic Moment of Failure

2/ The Looming Threat of a Selloff

3/ Sometimes the Market Shrugs it Off

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1/

A Historic Moment of Failure

The quiet start to the week may portend nothing more than the investors’ unwillingness to commit to any direction before the nonfarm payroll report is released on Friday. However, the notably small trading range delivered on Monday and Tuesday for State Street’s S&P 500 ETF (SPY), is a bit of evidence that something more sinister may be lurking around the corner.

The analysis goes like this: professional fund managers know that there are higher tax consequences for closing a position in less than a year. They try to avoid doing so when they can, so they tend to hold positions for at least one year. When that year happens to be unusually strong, it becomes difficult to avoid the temptation to take siome profits, so they do. 

Of course this behavior would be meaningless if only a handful of portfolio managers took action in this manner. However if many of them do so at the same time, it could create a nasty selloff in the market. It has happened before, most notably in the 13 months that followed the low point (March 9, 2009) of the financial crisis. May of 2010 brought an unexpected flash crash which was never fully explained away by computer glitches or bad orders. 

No other selloff has been as drastic as that, but many such smaller ones have shown up. If such a selloff were to take place, would there be any way to anticipate it? One way might be to identify a significant press of buyers in a one-month period. If a critical mass of buyers were to enter the market, enough so that it would push index prices unusually high in a one-month period, that might start the clock ticking in a coordinated way for many investment positions.  

If you look for a quantity, for SPY, a 7% rise or better seems to be enough to do the trick most of the time, while 10% or more is an even stronger indicator. Over the past 25 years, the average gain for SPY during any given month is just over one half of one percent. During months that lag a 10% gain in SPY by 13 months, the average performance is just under 0%. Meaning, selloffs often (though not always) will occur just over a year from the time a critical mass of investments gets started. If you’ve followed along so far, you’re probably now pondering the question: where are we now on this timeline?

2/

The Looming Threat of a Selloff

November of 2023 saw an unusual rise in prices on SPY. That month saw a 10.2% gain take place. It isn’t difficult to surmise that many portfolio managers opened or enlarged positions during that time.

Since then, with a rare exception, the market has trudged higher each month, marking a year over year performance of 32%. It will be tempting to lock in gains at the beginning of the calendar year in January. If more than a handful of professional investors decide to sell, the indexes could see a significant pull back in January.

3/

Sometimes the Market Shrugs it Off

This kind of a pullback doesn’t always happen and it doesn’t always create a drastic pullback or the start of a bear market. But it is possible that it could provide the catalyst to spark significant selling. The last time this phenomenon appeared, the result was mild.

February of 2023 produced a period where prices rose 10.1% in 20 days, and 13 months later, March of 2024, SPY underwent an 8% pullback from its previous apex. The market barely took notice, but even so, it was the only significant selloff of last year other than the moments of uncertainty created by the emergence of the Harris campaign. 

There will be plenty of uncertainty to go around, politically and economically, in the January upcoming.  If investors decide en masse to move to the sidelines, the unexpected selloff could be noteworthy, and something worth preparing for.

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Originally posted 4th December 2024