Reading the Short-Term Tea Leaves

To reiterate a comment I think I have made each and every week for at least three years, the bull market may be old and wrinkly, but it’s not dead. It continues to be the most disavowed and hated bull market of the modern investing era and that’s why it will live on. On an almost daily basis, another “market professional” comes out of the woodwork on why stocks should not be at these levels.

Several good friends of mine in the industry have been calling for a 20% decline since early 2012. They tell me that the stock market is manipulated and is heading for doom. Those are the same people who when on the correct side of the market, tell me that it’s all just the normal functions of the capitalist system. To me, it all sounds like sour grapes and rationalizing a wrong position. I have been wrong many times in my 25 year career and will be wrong many more times before all is said and done. It’s okay to be wrong, but it’s not okay to ignore the evidence and stay wrong.

Given my long-term view, that doesn’t mean that the stock market won’t pullback or correct from time to time. It’s been just about three years since the last full fledged 10%+ correction which ended up being roughly 20%. Stocks are long overdue for significant downside, but that doesn’t mean it will happen tomorrow. I have been in the pullback (4-8%) camp for several weeks and remain there today.

At this point I see three possible scenarios for stocks over the coming months, two of which can be seen below. The first one is labeled “bullish scenario” as it has the current bounce running out of steam sooner than later, followed by a decline that exceeds last week’s low by a small margin into the “cushion zone”.

The “cushion zone” is an area where the market spent most of its time between mid February and late May recharges its batteries for that powerful spring rally to all time highs. On the way back down, it’s also the area where stocks should find some cushion as if someone leaped off a ledge and into a giant mattress. That zone should cushion the market’s fall and start a new rally to all time highs next month.

On the other hand, the chart below is the “bearish scenario” which has the stock market actually rallying further than the “bullish scenario” in the very short-term, but stopping before hitting new highs. From there, stocks roll over again, similar to the path we saw in 2011, falling more than 10% and through the “cushion zone”.

The good news is that we won’t have to wait long to eliminate one of the aforementioned scenarios. There is a third path that is also possible, but I won’t fully flesh that out for now.

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