What's The Market Going To Do When The Tax Bill Is Passed?

• General thoughts on the discounting process
• Short-term indicators poised for, but not yet signalling a decline

General thoughts on the discounting process

There is an old adage on Wall Street to the effect that traders should, in the case of war, sell the rumor and buy on the sound of cannon. In other words, market participants liquidate in anticipation of war, but buy when it actually starts. That happens because all the knowable bad news will already have been factored into prices by the time hostilities begin. It’s the same principle that applies to a person standing on a railroad track when they know a train is coming. They discount the train’s arrival by getting off the track ahead of time. Once the train has passed they get back on again. That approach worked very well in both Gulf wars, where prices sold off prior to the commencement of hostilities, and literally exploded to the upside when war actually broke out. At that time, it appeared to be irrational to accumulate stocks, yet the principle proved to be quite profitable.

This same idea can be applied to the tax bill.We already know that the market has been rallying for the last year or so in anticipation of its passage. Following that same wartime investment strategy, the strategy would suggest that market participants are likely to sell on the good news of its passage. Will it happen? I have no clue, but one thing that does cause me some concern is the widespread complacency I see, whether it’s expressed in low VIX readings or bullish Investors Intelligence sentiment numbers. Historically, the vast majority of bear markets have begun prior to recessions or growth slowdowns, when the economic growth path slowed but did not actually go negative. By far the worst instances though, were associated with actual recessions. At this point, none of the key economic indicators I follow are sporting signs of weakness, so if anything, any correction would likely fall into the intermediate classification or less. Bearing all that in mind, let’s take a look at some of the short-term indicators to see whether they are positioned for a possible correction.

Short-term indicators poised for, but not yet signalling a decline

Chart 1, compares the NYSE Composite with two A/D Lines, one for common stocks and the other for total listed issues. Both are in uptrends and neither has yet diverged negatively with the Index. That does not rule out a correction, but it certainly does not warn of one.

Chart 1

I mentioned the $VIX earlier, and in that respect Chart 2 plots a 10 and 15-day EMA. Since the $VIX moves in the opposite direction to prices, I have plotted it inversely. The vertical red arrows flag periods when the 10-day EMA reverses to the downside from at-or-above the red horizontal dashed line. Solid arrows represent valid short-term sell signals and dashed ones, false negatives.Note that the last two sell signals were not followed by any serious correction. That suggests that the next one may not be so lucky. Also, this inversely plotted indicator peaked in early October and has been setting up a series of declining peaks in contrast to the rising ones for the S&P itself. That to me, is a subtle sign, that under the surface these recent new Index highs are being achieved with less and less complacency. The current situation is not totally unlike the late 2015 setup, flagged by the two dashed blue arrows.

Chart 2

Chart 3 also features the $VIX. This time it has been plotted in its “raw” form with no inversion. What strikes me is the fact that it has been in a declining trend of volatility since September 2015. The number to watch, in case of a volatility rally would be 14, since that would take it above the down trend line, flagging the declining trend. A trend of rising volatility would, of course, indicate lower equity prices.

Chart 3

Chart 4 shows a 30-day ratio for NYSE breadth data. The red arrows point up periods when this oscillator has peaked from a position in excess of the red dashed line flagging an overbought condition. Most result in a small correction, but the largest seem to be reserved for situations where the indicator reverses to the downside from a relatively low level. That weak oscillator rally indicates the fact that higher prices are being achieved with a tiny amount of upside momentum, which potentially can be a subtle signal of weakness, against what otherwise would appear to be a solid price rise. This indicator has started to turn, but certainly not sufficiently to call an actual reversal at this point.

Chart 4

Chart 5 looks at it from the other extreme as the red arrows flag extremely overbought readings from our Dow Diffusion indicator. This one monitors the stocks contained in the DJIA that are in a positive trend. Even during a powerful bull move, such as that shown in the chart, reversals from at or above the red horizontal line have resulted in some corrective action. As at December 13 this series was still rising, so we cannot say that it has yet reversed. You can always follow it yourself by clicking on this chart for an update. Alternatively you can plot the symbol !PRDIFDOW.

Chart 5

All of the oscillator charts featured above point out near-term vulnerability, but it’s always a good idea to make sure that the price is confirming. In this instance, no distribution in the form of ranging action is apparent. The best chart point offered by Chart 6 would be a drop below the red trendline that holds below 2630.

Let’s get one thing clear. I am not forecasting a short-term decline, which is usually a fools errand in an on-going bull market. I am merely pointing out the current high level of complacency, widespread expectations for higher prices in 2018 and vulnerable looking short-term indicators. With that kind of a background, we should not be surprised if investors decide to take profits, and do so on the sound of a newly minted tax bill.

Chart 6

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group of Walnut Creek or its affiliates.