On one hand, stocks are enjoying surging, positive momentum — you don’t want to miss out on a market that simply wants to go higher. On the other hand, we’re at historically-high valuations — you don’t want to be exposed to a market-top that suddenly reverses and gaps lower. Here’s how our technical experts, John Jagerson and Wade Hansen, described this tension in their most recent Strategic Trader update: Confidence surveys are at extreme highs, so “being fearful when others are greedy” as Warren Buffett once said would seem like a good idea. However, as Keynes is supposed to have said, “the market can remain irrational for longer than you can remain solvent.” So, what’s the right short-term approach then? That’s what we’ll find out in today’s Digest, which features John’s and Wade’s update from last Wednesday. For newer Digest readers, in Strategic Trader, John and Wade combine fundamental and technical analysis, along with historical market data, to profitably trade options in many different types of markets. Today, let’s see how they’re positioning themselves for this tradeoff between positive momentum and nosebleed valuations. I’ll let them take it from here. Have a good weekend, Jeff Remsburg

 

Waiting on Congress and the Fed

By John Jagerson and Wade Hansen

As we mentioned last week, the market is overvalued as a whole. There are still opportunities for bulls, which we will use to our advantage, however, because valuations are so extreme, we plan to continue being very conservative about our overall exposure to the market.

As we reach the end of the year, there is growing optimism that Congress will pass another stimulus bill. Reporting this week suggests that the bill will contain approximately $750 billion in aid, which is precisely the number we said had been priced into the market in our Nov. 18 Weekly Update.

If the stimulus passes in December, the market will have dodged one of the major X-factors that could lower prices over the next 60 days. As long as 10-year Treasury bond yields don’t climb above 1%, we expect the S&P 500 to hit our price target of 3,872. Transportation and small-cap stocks are still confirming that upside potential.

 

Daily Chart of the S&P 500 — Chart Source: TradingView

An important factor for keeping interest rates low and optimism high will be how the market settles after the Federal Open Market Committee’s (FOMC) statement (on Wednesday).

Economic projections from the Fed are low for next year at 4.2%, but that is compared to a lowered estimate of 2.4% for this year. So far, this was largely expected and is probably good news because investors need to believe that the Fed will continue buying assets in 2021 at the same rate as it did in 2020.

If the Fed continues to buy assets at its current pace, we expect rates to remain relatively low, and high stock valuations won’t be as worrisome. However, as usual, the Fed’s statement was a little vague about the duration or magnitude of those asset purchases.

The statement also included language indicating that the Fed wouldn’t start tightening again until inflation and growth projections were on track to meet expectations for “some time.” Although that too is vague, we feel that the sentiment is in favor of more easing for a long time, which is likely why the market popped back up after the announcement.

If the Fed’s statement contains any real issues the market needs to contend with, we will probably be able to detect that weakness later this week.

We are watching the high yield bond market for any cracks in investor sentiment. The high yield market, or “junk” bond market, has already been lagging stocks during the most recent rally, and if investors feel that the Fed wants to slow asset purchases, we should see it in this asset class first.

 

Daily Chart of iShares High Yield Bond ETF (HYG) — Chart Source: TradingView

What about Selling the News?

There is an old trading adage that you should buy the rumor and sell the news. Essentially, this means traders should consider selling assets after the thing they have been looking forward to happening has passed.

For example, if investors have been buying the market ahead of the Fed’s announcement, expecting continued support from the Fed and another stimulus package, they will likely take profits and sell the market once those expectations — or “rumors” if you will — become a reality.

Besides high valuations, a “selling the news” cycle of profit-taking is one reason we continue to position ourselves cautiously bullish.

But remember, selling the news is not the same thing as a bear market. For example, following the passage of the original stimulus (CARES Act) on March 27, 2020, the market dropped 5% as some traders took profits.

The dip was only temporary, though.

We plan to use any dips as entry opportunities on the few value plays that are available. There are still stocks that could benefit from the new distance learning/work-from-home culture, and retail spending should help put a floor under consumer sector stocks.

We have already reopened one of our “stay-at-home” stocks this week with short puts on Logitech (LOGI), even without a dip.

The Bottom Line

We have heard some concerns that since the consensus is so positive, we might be at risk of being caught unprepared in a sudden reversal by being bullish ourselves.

If we look at market prices in isolation, being bullish wouldn’t make much sense, but we must think more broadly. Confidence surveys are at extreme highs, so “being fearful when others are greedy” as Warren Buffett once said would seem like a good idea. However, as Keynes is supposed to have said, “the market can remain irrational for longer than you can remain solvent.”

So, instead of committing entirely to one direction or the other, we recommend remaining very nimble, so we can make changes as needed. Although we are heading towards the holiday weeks, a few events could help provide a bit more certainty in either direction:

1. A Brexit “deal” is still a possibility between the UK and the EU. Traders seem optimistic that a deal is likely, and we should know more before the Dec. 31 deadline.

2. The Philadelphia Fed manufacturing report will be released on Thursday and could confirm an accelerating recovery in the Northeast.

3. A spending bill needs to pass through both houses of Congress and be signed by President Trump before this Friday at midnight to avoid a shutdown. We don’t think there is a serious risk that it won’t happen, but politics are hard to predict these days, so we should keep this in mind as the deadline approaches.

Sincerely,

John Jagerson and Wade Hansen