Picking up where we left off last week, we discussed the sell-off after the initial breakout to all-time highs and the continuation of the bull market rally. To wit: 

“Currently, it is pathway #2a which continues to play out fairly close to the prediction from two weeks ago. But it is make, or break, next week as to whether pathway #2b comes into play. 

As I have repeatedly noted, we remain primarily allocated in our portfolios. However, we were looking for a pullback to support which holds before increasing our existing holdings further.”

Here is the updated chart through Friday. The market has followed the pathways precisely over the last several weeks.

The pullback to the previous breakout support level did allow us to add further exposure to our portfolios as we said we would do last week. 

Next week, the market will likely try and test recent highs as bullish momentum and optimism remain high. Also, with many hedge funds lagging in performance this year, there is likely going to be a scramble to create some returns by year end. This should give some support to the rally over the next couple of months. However, as shown above, the short-term oversold condition which fueled last week’s rally has been exhausted, so it could be a bumpy ride higher.

As I wrote on Tuesday, our current projected short-term target remains 3000 on the S&P 500:

“Regardless of the reasons, the breakout Friday, with the follow through on Monday, is indeed bullish. As we stated repeatedly going back to April, each time the market broke through levels of overhead resistance we increased equity exposure in our portfolios. The breakout above the January highs now puts 3000 squarely into focus for traders. 

This idea of a push to 3000 is also confirmed by the recent ‘buy signal’ triggered in June where we begin increasing equity exposure and removing all hedges from portfolios. The yellow shaded area is from the beginning of the daily ‘buy signal’ to the next ‘sell signal.’”

While we are long-biased in our portfolios currently, such doesn’t remain there is no risk to portfolios currently. With ongoing “trade war” rhetoric, political intrigue at the White House, and interest rates pushing back up to 3%, there is much which could spook the markets over the next 45-days.

Moving into next week, we are currently running portfolios primarily unhedged at the moment. We have taken prudent steps in our overall portfolio management process:

We continue to use dips in bond prices to be buyers. This is because the biggest gains over the next 5-years will come from Treasury bonds versus stocks.

This has to do with valuations, and what I want to discuss next.

Which Year Is It?

As noted above, there is little argument the market is bullish. The trend is positive, we just came off of a correction process which has now broken out to new highs. In fact, the 2015-2016 correction, while deeper than the correction earlier this year, had many of the same characteristics. Of course, the Fed was quick to intervene at the bottom of the market in 2016 as concerns of “Brexit” weighed on the market. This year, it was “tariffs” and a stimulus carry through from the slate of natural disasters last year, combined with tax cuts, and a massive increase in Federal spending which provided the necessary liquidity support to drive prices higher.

Looking back further, 2011 also looked much the same. As market turmoil increased following the end of QE-1, the Fed intervened with QE-2 as the Fed fretted over a market decline that would potentially quench the early flames of an economic recovery. That advance ended in 2012 as QE-2 came to its conclusion.

The commonality between 2011, 2015, and 2018 is the extremely loose monetary conditions which have remained a constant throughout. As Jesse Colombo recently noted in his Forbes column:

It is very helpful to adjust the Fed Funds Rate for inflation (known as the “real Fed Funds Rate”) because that is a more accurate way of determining how loose, or tight, monetary policy really is. If inflation is higher than the Fed Funds Rate, that means that the real Fed Funds Rate is actually negative. To put it simply, negative real interest rates mean that interest rates do not compensate for inflation well enough, so capital tends to flow from savings or other conservative investments into rapidly-rising speculative assets.

Negative real interest rate environments are the most conducive to the formation of dangerous economic bubbles. The only time in recent decades that the U.S. has experienced negative real interest rates for a significant amount of time was during the mid-2000s housing bubble and during the current bubble period that started after 2009.”