Bulls Looking for a Cinderella Scenario

The complacent
and overly optimistic received a rude
wake up call last week. A wide swath of poor earnings surprised the market,
while Oil and geopolitics made traders all the more jumpier. I imagine investors
who have ignored the warning signs and cyclical patterns will be caught ill prepared
if a significant sell off were to begin in earnest.

Putting aside the doom and gloom for a moment, let us consider this question: What would need to occur for 2006 to be the strong market so many are expecting?

Forget the Goldilocks economy, we would need a Cinderella
scenario: One
where nothing goes wrong, and nearly everything goes right. Earnings would have to stay robust; Energy prices would need to moderate; Inflation would have to go appreciably
lower; The Fed would need to end their rate tightening cycle; Consumer Spending could not falter – despite signs
of its tiring. Businesses would need to build on third-quarter Capex Spending, and would have to begin Hiring in earnest. All of the vulnerable Blue chip stocks would have to avoid major hiccups.

Those are just the macro economic issues. For Cinderella to get to the ball, none of the universe of negative "externalities" can come to pass. These include a major bird flu outbreak, protectionist legislation or other policy mistakes, an energy shock, a dollar crash, further geopolitical crisis over Iran’s nuclear ambitions, Chinese  decoupling of the Yuan, tax increases, or worsening deficits.   

 Those are just the foreseen issues, much less something currently not on the radar. Finally, equities would have to somehow avoid the regular corrections that were so common in all of the secular bear markets of the past.

Which brings us to the December Low Indicator: This technical signal has a good track record (which can be seen here) of
warning weakness. Anytime when the December closing lows have been breached in
the first quarter (on a closing basis), it has been an excellent warning sign
that markets are in for a correction later that year.

 Why bring this up today? The lowest actual closing price for the DJIA in December was 10,717.50 (12/30). Friday’s expiration mess closed 50 points below that, at 10,667.39.

The Stock Trader’s Almanac notes every prior December Low Indicator since 1952 (except one – 1996) has seen markets down at some point later that year.
The average drop is about 10.7%; it has been as small as 0.3% (1993), and as
large as 25% (1962, 2002).

This is another potentially confirming technical
indicator that the equity markets remain a volatile and dangerous place in
2006.

What's been said:

Discussions found on the web:
  1. David Silb commented on Jan 23

    You should connect this to the December low threat.

    All in one nutshell. Again this is my as well a lot of things must turn around or level off for the economy too turn around and move towards a more positive trending equity market.

    The momentum is against the market and this says it very clearly.

  2. anon commented on Jan 23

    Even if we are in a protracted 15 year bear market until year 2015 or so, we could see a spike to a new high well-before 2015 (only to be followed by a big drop).

    So I am bullish on year 2006. Stocks are going to surge.

  3. blue][erring commented on Jan 23

    it seems like the bully pulpit takes the situation as; if it didn’t break yesterday, what will make it change tomorrow?

    something like, if Oakland, CA is 45% overvalued, then at some point it was 38% overvalued and it continued… so what’s to keep it from being 54% overvalued?

    there is something to it (though it is a bit like testing fate), but whatever was structurally unsound with any economic measurement below any current level serves as a kind of ‘proof’ that things can be out of balance.

    ok, 54% of first time homebuyers are using no money down… but last year it was less but still alarming. why not 66% next year? that’s what i see as the permabull’s argument, basically, whaddayouknow? it’s the predictor’s dilemma, how out of balance is too out of balance?
    there is an opportunity cost to being wrong on the market, both ways.

    -][

  4. Isaac Greten commented on Jan 23

    Digging into the data from the link, the average return for the rest of the year after the December low was crossed was 15.11%, with a standard deviation of 9.44%. So, not to sound too Cindarella-ish, but couldn’t this be an opportunity to buy low?

  5. Barry Ritholtz commented on Jan 23

    Anytime we get a deep sell off, its usually a buying — at least for a trade — opportunity.

    Its a question of timing . . .

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