Over the last few weeks, I have been tracking the markets’ ongoing consolidation process. As I noted on Tuesday:

“The breakdown on Monday has not yet completely broken the ‘bullish case’ for the market yet, however, a failed rally from current levels will bring “Option 3” into focus.

With the recent failure at the previous resistance level, we can now adjust our consolidation process for the market.”

“As long as the pattern of ‘higher lows’ remains, a breakout above the current downtrend line and resistance should signal a move to old highs and the current 2018 target of 3000.

However, a break below the uptrend line will confirm a change to the current market and will require a shift in allocations to a more neutral stance.

We are potentially at a very critical juncture of this particular ‘bull market cycle,’ and as Doug Kass noted yesterday:

“I expect a 2018 trading range of 2200-2850 – with a ‘fair market value’ (based on higher interest rates, disappointing economic and corporate profit growth, political and geopolitical uncertainties) of approximately 2400.

Compared to the expected trading range, downside risk relative to upside reward is approximately 5x.

Against ‘fair market value’ (based on my probability distribution of a host of independent variables – interest rates, inflation, corporate profits, economic growth, valuations, etc.) downside risk relative to upside reward is about 3x.”

On Friday, the break to the downside occurred putting the bull market cycle at risk and “Option #3,” the least favorable path, has come into focus.

Interestingly, I received several comments on my predicted paths when I first laid them out 3-weeks ago:

  • “Option 3 is TOO pessimistic. It will never happen.” 
  • “Why are you so bearish, this bull market is still running….”
  • “You can’t predict the future, so why even try.” 

You get the idea…but here is the important point:

“Analysis is not about trying to PREDICT future outcomes, but simply the ANALYSIS of ‘possibilities,’ (things that might happen,) versus ‘probabilities,’ (things that will likely happen.)”

Without understanding what the various outcomes “might be,” action can not be taken to reduce the risk of capital loss over time.

So, where are we now?

With the breakdown of the market to the 200-dma, the market is now at a much more critical “make or break” juncture. Here as some points to consider:

  • The market triggered a short-term “sell signal” last week with a break of the 75-dma. (bearish)
  • The market is “oversold” on a short-term basis which provides fuel for a reflexive bounce. (bullish)
  • As I will discuss in a minute, the longer-term uptrend of the market remains intact.(bullish)
  • Support held, again, at the rising 200-dma on Friday. (bullish)
  • The short-term downtrend of the market continues to gain strength. (bearish)
  • Considering all those factors, I began to layout the “possible” paths the market could take from here. I quickly ran into the problem of there being “too many” potential paths the market could take to make a legible chart for discussion purposes. However, the bulk of the paths took some form of the three I have listed below.

  • Option 1: The market regains its bullish underpinnings, the correction concludes and the next leg of the current bull market cycle continues. It will not be a straight line higher of course, but the overall trajectory will be a pattern of rising bottoms as upper resistance levels are met and breached. (20%)
  • Option 2: The market, given the current oversold condition, provides for a reflexive bounce to the 100-dma and fails. This is where the majority of the possible paths open up. (50%)
    • The market fails at the 100-dma and then resumes the current path of decline violating the current bullish trend and officially starting the next bear market cycle. (40%)
    • The market fails at the 100-dma but maintains support at the 200-dma and begins to build a base of support to move higher. (Option 1 or 3) (20%)
    • The market fails at the 100-dma, finds support at the 200-dma, makes another rally attempt higher and then fails again resuming the current bearish path lower. (40%)
  • Option 3: The market struggles higher to the previous “double top” set in February, retraces back to the 100-dma and then moves higher. (30%)
  • IMPORTANT NOTE: Regardless, of any potential outcome from Friday’s close, ANY rally back to the 100-dma should be used to reduce equity holdings in portfolios. As noted in the 401k plan manager below, the triggering of coincident “sell signals” and the breach of the consolidation process has reduced equity holdings in the model by 25% which is the first reduction since late 2015.

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