By Chris Ebert
Stock prices recently had one of the longest rallies in history. But all traders know the rally won’t last forever. At some point folks are either going to get exhausted and sell their stocks to take profits, or else some sort of troubling economic news or perhaps some sort of unforeseen natural disaster will disrupt the market and send stock prices plummeting.
While a pullback after such an impressive rally would not necessarily be a bad thing, because it could provide enough relief to keep the rally going in the long run if stocks can find solid support during the pullback, it is inevitable that a pullback is on the way. Just when that pullback will occur is anybody’s guess. It could come tomorrow, or it could come after the S&P puts in more weeks of impressive gains. There really is no way to predict when – just that it will come eventually.
One way of predicting that a pullback is on the way is through the Options Market Stages. They offer a back-tested method which correlates the S&P Temperature to pullbacks. Over the past 20 years, pullbacks have tended to be imminent when the S&P Temperature gets above 300, generally within a few weeks of reaching the 300 mark. The S&P surpassed the 300 mark on February 17, 2017 and has continued to soar ever since, now approaching a record-setting 400.
The stock market is clearly overheated, but without a catalyst, a stock market where prices are rising week after week just attracts more buyers and adds to the overheating. Traders who buy stocks now face a quandary: “Do I buy now and get in on the rally?” or “Has this rally exhausted itself and I should wait for a pullback?”
The following chart shows how the S&P has slightly exceeded the limit that normally serves to put a cap on stock market rallies. While not unprecedented, exceeding that limit has occurred only a handful of times in the past 20 years.
There is one truth in the stock market: Things never change. The stock market is the same today as it was 100 years ago. The same rules that applied 100 years ago still apply today, despite intervention by large entities such as Central Banks or governments. Rallies still have limits; and one of the ways to determine the limit of a rally is to look at Lottery Fever in the Options Market Stages. Rarely does the S&P 500 exceed the upper limit for more than a few weeks, because when it gets to such a lofty level traders start to get nervous that they could lose all the profits they earned in the rally, and they sell.
The chart below from 2014 shows how few times the S&P exceeded the upper limit of Lottery Fever over a 10-year period. The few times that it did exceed the limit were short lived. The upper limit of the green Lottery Fever zone tends to exist at an S&P Temperature of approximately 300. Therefore, it is safe to say that while a Temperature above 300 is achievable, it is unsustainable based on decades of evidence. Lottery Fever has its limits, even if it exceeds those limits occasionally; and even if the Temperature exceeds 300 for a few weeks from time to time.
A line in an old Johnny Mandel song from the 1970s “Suicide is Painless” (also known as the theme from the M*A*S*H television series) sums up the current market. “The game of life is hard to play. I’m gonna lose it anyway. The losing card I’ll someday lay. So this is all I have to say”.
Eventually Lottery Fever will end with that losing card. But until then, traders of the stocks in the S&P can “take or leave it if they please”.
The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca
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