2018 Market Lessons – Extremes Can Become Even Extremerer

Authored by Sven Henrich via NorthmanTrader.com,

Before I issue my 2019 Market Outlook in the days ahead I wanted to highlight some key practical lessons from 2018 as they will help set the stage for next year. Firstly, I think it’s fair to say that markets ended the year quite differently from how most people expected them to at the beginning of 2018. Before you think this is going to be an exercise in “I told you so” it’s not. As I outlined in Lessons on Being Wrong

“Everybody will be wrong at some point or another. Markets are boss and will ultimately humble you”.

Pivotal years such as 2018 can humble, or should humble, a lot of people. Unless one can claim to have gotten every move right (which I seriously doubt and I know I haven’t) everyone will have been surprised by some aspect of markets in 2018.

Recognizing of some of the drivers of the market action is hence key to understanding of what happened and to ultimately help formulate a thesis for what investors and traders will likely face going into 2019.

Key lesson: Extremes can become even more extreme.

Blame the algos and computerized trading if you wish, but 2018 became a year of seeming reason defying moves to the upside and downside.

2018 consisted of 3 distinct phases: Firstly a massive momentum driven move to the upside soaked in optimism and artificial liquidity courtesy tax cuts. It didn’t matter how stretched and one sided the action was, stocks just kept flying higher and fading this move was atrociously difficult. Money kept pouring in, investors threw their cash into passive ETFs and programs kept allocating on autopilot benefitting the largest big cap stocks disproportionally.

How extreme was this move in January? How about the most overbought RSI reading on the $DJIA ever?

Ever is a long time and if history teaches anything it’s that if things get too extreme to the upside something bad will eventually happen.

Hence the initial correction in February was not a surprise, things just got way too hot. That initial 10% correction then initiated phase 2 of 2018 and it was the long road to new highs driven by record buybacks and on ever shrinking volume bringing us to the next lesson.

Key lesson: Patterns matter

Following the March lows key indices engaged in a tight channel ping pong game of higher lows and higher highs. Recognizing what action algos and markets pivot off of is then key to finding tradable entries and exits:

These type of patterns matter big time and while they are active they are highly relevant, but watch out when these patterns break.

In October the pattern broke and unleashed phase 3 of 2018: Investor hell. Two key questions to address: What caused the break? What caused the massive downside that followed?

While they are a myriad of factors to consider for the purpose of this article I want to hone in on 3 key factors.

Key Lesson: Long term trends matter.

What triggered the break? From my perch: Yields. Specifically the 10 year reached its multi decade trend line, the end of the line since the early 1980s:

For decades we’ve had the same trend: Unemployment reaches a cycle low while yields rise to lower highs during a period of recovery following a recession. And during each of these cycles markets engage in multi year trends to the upside until yields peak near or at their trend line and then stocks break their trends to the downside. 2007 was such a year and 2018 may have shaped up to repeat the same script and I’ll discuss this further in my upcoming 2019 Makes Outlook.

Key Lesson: Divergences matter.

In each cycle there are warning signs ahead of time, but they tend to get ignored as divergences take a long time to build and evolve. Divergences show up in the form of relative strength, underlying participation and concentration in gains in ever fewer stocks. We saw all of this in the summer of 2018. This is the phase where ever higher target prices are issued and some sectors seem bulletproof while others fall to the wayside.

One of the key warning signs in 2018 was the $BKX (banking sector) making lower highs while $SPX went on to make new highs which was evident in September:

Banks were supposed to benefit from rising yields. The fact they they didn’t while the 10 year ran above 3.2% and tagged its multi decade trend line was a major warning sign. Divergences don’t matter until they do but once they do they matter big time.

Key Lesson: Technical disconnects matter

In every bubble we see prices extend to the upside well above historic norms. These extensions are incredible difficult to time as momentum begets momentum and people throw all caution to the wind.

One of my favorite technical indicators is the 5 exponential moving average. Be it on the daily, weekly, monthly or even yearly time frames. Stocks and markets ALWAYS reconnect with them at some point. They can extend and they can stay disconnected to the upside or downside for sometime, but the reconnect is coming. Always.

And it is the extent of the technical disconnects in 2018 that then explain the ferocity of the declines once the 10 year yield tagged its trend line.

Markets seek balance and imbalances don’t last. I trust you all remember the $1 trillion market cap headlines and calls for $2 trillion market caps to come for some of the $FAANG stocks. These calls came while these stocks were massively extended above their yearly 5 EMA, $AMZN being a prominent example:

Yes trends can extend and stocks can stay disconnected for a long time, but telling people to buy stocks that are this far extended above technical norms is bound to cause major pain. And it did just that with massive yearly reversal action evident in many individual stocks:

The price action in Q4 was then an attempt by markets to rebalance and seek technical reconnects and hence it must be stated clearly: In a long term context it was the upside of 2018 that was the extreme, but not the downside. The downside may have been extreme in the short term, but it is not in the long term as in many cases we have yet to reconnect with the long term moving averages.

In conclusion: The first part of 2018 was a year of excess to the upside driven by optimism and abundant artificial liquidity producing massive technical extensions and negative divergences amid waning participation. The latter part of 2018 was a wake up call when all the factors that didn’t matter previously suddenly did matter.

2019 then will not be a new beginning, but rather part of an ongoing cyclical journey in context of what we just witnessed. I’ll leave you with perhaps the most important lesson: As Wall Street so aptly demonstrated again this year: Nobody has all the answers. Rather we all are navigating through the treacherous waters of a late cycle environment that will offer surprises to everyone and in every direction in the year ahead.

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