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Stocks Pullback, But Friday's Reversal Brings Optimism

The S&P 500 declined -0.96% this week with Friday's close at 3,663.46.

The index traded up to a new all-time high on Wednesday at 3,712.39 before trading down to our weekly low on Friday at 3,633.40, a drawdown of -2.12%. However, Friday finished the week on a positive note with the index closing Friday's session at 3,663.46, a gain of 0.83% relative to Friday's low. Let Friday be another example of market participants demonstrating eager buying interest into lower prices for the S&P 500.

If you read our commentary last week, then this week's decline should come as no surprise. The bears snagged the football last week and actually appeared to have a nice drive going for themselves at Friday's low. However, Friday's upside reversal now leaves us wondering who has the football. Was last week's -2.12% pullback all the bears could muster, meaning they fumbled the ball away to the bulls on Friday? Or, was Friday's upside reversal just a nice play for the bulls, only causing the bears to face 3rd down rather than forcing a turnover?

Friday's bounce originated from almost exactly the ascending 20-day simple moving average (solid green line), and there were no violations of key support levels this past week. It feels like we should trade down into the red shaded region, and perhaps test our 50-day simple moving average (solid blue line), but feelings are never a great guide of what's to come.

Analyzing the market's internals, the S&P 500 (SPX) slightly outpaced the S&P 500 Equal Weight (SPXEW) for the week.

This marks the first trading week since election week where SPX outperformed SPXEW. While we continue to believe investors are best served prioritizing SPX over SPXEW, the gap is certainly closing. Market breadth should no longer be considered a "canary in the coal mine" (more on this later).

From a sector perspective, energy (SPEN) was once again the top performing sector this week, gaining 1.14%. SPEN has now increased six weeks in a row, the second six-week winning streak of 2020 (the other being from late April). SPEN has been a gigantic laggard for years, but maybe its day in the sun is coming in 2021.

Small-cap stocks, as measured by the iShares Russell 2000 ETF index fund (ticker symbol IWM) had a nice week too, rising 1.12%. IWM has also increased six weeks in a row and has gained a whopping 24.31% over its six-week winning streak. As we wrote last week, the performance of SPEN and IWM in the present is pricing in an "economic bonanza" into the future, ironically right as the vaccines are ready to arrive (click here).

For the week ahead, the key levels to watch are for a trade above 3,712.39 or a trade below 3,633.40. Whichever comes first probably suggests who has possession of the S&P 500's football.

S&P 500 Primary Trend - Up

The S&P 500 is presently higher by 1.16% thus far for the month of December. Our work continues to label the primary trend as up, or "bullish".

During uptrends, long-term investors are generally best served maintaining an equity overweight across their portfolios' asset allocation and relying mostly on passive investing methodologies. Less is more during uptrends, and the name of the game is to "be right and sit tight".

The S&P 500's trailing 3-, 6-, and 12-month returns are presently 8.93%, 18.17%, and 13.39%. The sum of these trailing returns is 40.49%, a sign of strong momentum.

The default position to take when it comes to long-term investing is to be optimistic, to have faith that the price of the S&P 500 will trend higher over time.

Historically speaking, the path of least resistance is proven to be to the north, and being an optimist has paid. For example, the S&P 500's average forward 12-month return over all calendar months since 1970 records at 8.82% and has closed higher roughly 75% of the time.

Given these odds, you would think it would be easy for long-term investors to "set it and forget it" and have faith in the idea that the S&P 500's future is similar to its past no matter how volatile things get over shorter time periods. However, that's anything but easy since investors have to deal with the psychological battle between their innate biases and the "wall of worry".

We define the "wall of worry" as the "bearish" case as to why the S&P 500 is destined to decline into the not too distant future. The "wall of worry" is almost always articulate, specific, and convincing since it deals with issues that are known and knowable. It can be found all over the internet and financial outlets since fear sells (look no further than the success of www.zerohedge.com as an example).

Prospect theory then mostly proves our innate biases toward being risk averse with portfolio gains.

The better our portfolios do, the more money we make, the more we tend to be risk averse and afraid of a potential downturn. We become anchored to our account values. Furthermore, we're all mostly terrible at accurately weighing probabilities. The better our portfolios do, the more money we make, the more we tend to put extra weight toward low probability scenarios (market crashes and/or "bear markets") and underweight higher probability scenarios (the S&P 500 making ~9% the next 12 months).

Putting it all together, it's a somewhat challenging time for long-term investors to stay the course with their long-term investing plan right now since we have a gigantic "wall of worry" and the S&P 500 has been absolutely roaring the last nine months. The TV constantly reminds us that valuations are at nosebleed levels. The political climate is anything but calm (yet). Everyone knows COVID is running rampant throughout the world, and our fearless leaders are once again proving inept at finding a deal to help those most affected by COVID. 

We can also observe the IPO market running wild like it's 1999 (see Doordash and Airbnb as the most recent examples). And most importantly, everyone knows the S&P 500 has gained ~64% on a closing basis since March's closing low. This fuels the "this can't continue" narrative, so "worry" still outweighs "greed" in our anecdotal experience.

This is where studying history can play a vital role. History can't tell us what's coming, it can't predict the future, but it can help us demolish the "wall of worry" in an effort to stay the course and remain optimistic with our long-term investing plan. History provides an effective antidote to our biases.

A recent example: December now records as the 17th calendar month since 2003 where the NYSE McClellan Summation Index (NYSI, click here) crossed above the 1,000 level. Broadly speaking, this is a form of breadth thrust and it's been a great sign regarding the S&P 500's forward returns over the coming months.

Following calendar months where NYSI crosses above 1,000, the S&P 500's forward 6-month returns have closed higher 15 out of 16 times for average returns of 6.85%.

The lone decline was a loss of just -2.41%. The S&P 500's forward 12-month returns have actually never closed lower. They're a perfect 14 for 14 to the upside for average returns of 13.10%. You won't find this context on www.zerohedge.com.

So, if you've thought to yourself "this can't continue", reference the table above and remember that this absolutely can continue.

The best of long-term investors conquer their biases, they prioritize faith over the "wall of worry", and they never let the fear of striking out keep them from playing the game!

Bonds Hold the Line, Gold's Steady, Warren's Still Struggling

In last week's Update we wrote about how the iShares 20+ Year Treasury Bond ETF index fund (ticker symbol TLT) was face-to-face with support and at a fork in the road. Well, TLT pivoted to the north, support arrived right on schedule. TLT gained 2.30% this week with Friday's close at $158.77.

Gold climbed as high as $1,879.80 this week before reversing back to the downside, finishing the week higher by just 0.20%.

Like TLT, gold is trying to find a durable bottom. The verdict is still out on both as to whether the bottom is truly in. It remains imperative that gold find further upside in the near term.

Finally, Warren Buffett's Berkshire Hathaway (BRKB) continues to struggle here in 2020. BRKB declined -2.14% this week with Friday's close at $226.39.

BRKB is now down -0.05% thus far in 2020 while the S&P 500 total return index (SPXTR) is higher by 15.39%. BRKB has underperformed SPXTR massively the last decade, proving once again just how challenging investing actually is. Even the "Oracle of Omaha" faces periods of underperformance.

Happy Sunday!

Steve & Rick

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