Another Rally, But Geopolitical Issues Loom

Market Starts The Year Extremely Overbought

On Thursday, the market continued where it left off in 2019 by rallying sharply. Markets might face trouble on Friday. For now, let’s review the action that has occurred already. S&P 500 rose 0.84% on Thursday.

Predictions of renewed volatility this winter goes against the recent action in the past few years. 7 of the past 8 years have had max drawdowns below the long term average. Average max drawdown is upwardly manipulated by terrible bear markets. However, that still doesn’t refute the point that stocks have been mostly placid especially in 2 of the past 3 years.

Max drawdown in 2017 was only 2.8% and the max drawdown in 2019 was 6.8%. Stocks will likely have corrections greater than both of those this year. And stocks fell 19.8% in late 2018 in what was a mini bear market in my opinion. 

Interestingly, 0% of asset classes were up 5% or more in 2018 and 100% were up 5% or more in 2019. 2018 was more of an outlier than last year for that stat. However, the median asset class’ gain in 2019 was 20% which was the highest since 1982, meaning the scope and size of the rally was unusual. And many see commodities having a good 2020. So at least one asset class will have 5% or more gains.

As of the end of the year, the NDR trading sentiment index was at 78.89 which is above 62.5 which is the threshold for excessive optimism. Anything above that level means stocks fall an average of 7.8% per annum based on data since 1995. The index fell on the last trading day of 2019. But it likely rose on the first trading day of 2020. 

Either way, it’s in excessive optimism territory. CNN fear and greed index rose 4 points to 97 which is extreme greed. This is the highest reading many have ever seen. Let’s see if it correctly predicts weak returns in the next month.

Some experts claim extreme greed is normal. However, this is not a normal market just because stocks have been overbought for a few weeks. A correction is coming soon. The chart above quantifies the sentiment on financial Twitter. Accounts Arbor Data Science who are decidedly permabears have shown improved sentiment. Pragmatists are slightly less bullish and journalists are much more neutral.

Review Of Thursday’s Action

Nasdaq was up 1.33% as tech did really well again. Tech was led by Apple which was up 2.28%. Short trades started off weak. Apple’s weekly RSI is 87. It’s very overbought. I think it will have a terrible next few months. Russell 2000 continued its recent stretch of underperformance as it fell 0.1%. It has fallen in 4 of the past 5 trading sessions. 

Best 2 sectors were tech and industrials which rose 1.73% and 1.81%. Energy rose 0.85%. Worst sectors were utilities and real estate which fell 1.38% and 1.33%. Those sectors fell even though the 10 year yield also fell. It was down 4 basis points to 1.88%. Since the 2 year yield was stuck at 1.57%, the curve flattened 4 basis points.

Update On Democratic Primary

We have the official final numbers on money raised in the 4^th quarter from the Democratic candidates except Warren and the ones who are self-funded (Steyer & Bloomberg). Estimates of how much Bernie raised based on him earning the same average donation as the previous quarter were too pessimistic. He actually raised $34.5 million which was by far the most out of any candidate. 

Bloomberg can easily outspend him. However, money raised isn’t just about advertising. It’s a signal of the support the candidate is getting from the grassroots. Bernie has the most support and the most loyal followers. Buttigieg raised $24.7 million and Biden raised $22.7 million. This is a bad sign for Biden who is leading in the national polls. President Trump raised $46 million. 

As you can see from the table below, the latest polls and news about fund raising have pushed Bernie’s odds of winning the nomination up to 24.7%. He’s only 5.4% behind Biden. If Bernie continues to close the gap he has with Biden and wins the first 2 states, the stock market will start to price in Bernie winning which means it will decline.

U.S Airstrike Kills Qasem Soleimani

Stocks could face trouble on Friday. That’s because on Thursday evening, the U.S. military issued an air strike that killed Qasem Soleimani who is the head of the Iranian Revolutionary Guard Corps (Quds Force which is a U.S. designated Foreign Terrorist Organization). In response to this, the stock market sold off and oil rallied after hours. Geopolitical events usually push oil higher at least in the short term.

We don’t know how Iran will react. As markets wait for a reaction, there will be volatility in stocks and a rally in oil. The chart below shows the short term historical reactions to U.S. airstrikes in the past 27 years (outside of declared war). Average 5 day return in stocks is -0.1%. That’s not as bad as many fear, but there were 3 instances where stocks fell at least 2.4%. Oil does the best as its average 5 day gain is 2.1%,

Conclusion

CNN fear and greed index is at 97 which is the highest many have ever seen. Stocks might not fall because of geopolitics. But it’s an easy excuse to take profits. Politically, It looks like Sanders has a commanding lead in terms of fund raising. This supports my thesis that he will win Iowa and New Hampshire next month.