Much has been written since the election about the stock market’s future. I have long been convinced that certain hard, cold measures of the market are of far more value in estimating the market’s future than qualitative speculation based on political or economic developments. The most important consideration for a long-term investor arguably is the likelihood of a severe bear market in the near future. My approach, which I describe in The Modified Davis Method has revealed some facts that I think have definite value in that regard.
The most important harbinger of danger in the market that I have found is the behavior of the NYSE daily cumulative advance-decline line relative to the S&P 500. In the early stages of a bull market, both advance dramatically. Corrections occur along the way, and for a time the recoveries are strong enough to propel both to successive new highs. However, eventually the smaller stocks begin to falter, and the S&P makes a new high while the cumulative a-d line does not. This phenomenon, which I call “breadth divergence”, has occurred prior to the end of virtually every bull market since 1929, and there is no reason to think that it will be any different this time.
My method doesn’t rely just on breath divergence. It takes other factors going red before I trigger a short trade.
In an earlier posting titled Sweet Spot for Shorting, I provide a full list of the short trades my method would have generated and their ultimate performance. I show the relationship between the length of breadth divergence (in weeks) prior to a method short signal, and the severity of the subsequent bear market. As this article concludes, a considerable period of divergence is usually required before a bull market ends, where the “end” is defined by a short signal from my method.
The post-election rally has resulted in a breadth divergence, but as of 25-November-2016, it has lasted only 2 weeks. And it will take a decline in the Russell 2000 for my method to issue a sell or short signal. In all likelihood, the divergence will be erased in the next few weeks. This all suggests that, most likely, the current bull market has at least several months longer to run.