Everyone is bullish on stocks all of a sudden — why you should rein in your enthusiasm

This post was originally published on this site

Two potential scenarios are developing in the U.S. stock market. Both should be considered red alerts by prudent investors.

Let’s explore with the help of a chart. Please click here for an annotated chart of S&P 500 ETF SPY, +0.45%, which tracks the benchmark S&P 500 Index SPX, +0.43%.

Note the following:

• The chart shows that the stock market has undergone a strong rally.

• The chart shows that the price action in the stock market after the breakout is subdued. This is a negative for the stock market.

• The chart shows that the top trendline is indicting a potential resistance zone. This is a negative.

• The relative strength index (RSI) shows that the market is overbought. This is a negative.

• The chart shows that the volume is low. This is a negative.

• The chart shows that if there is a breakout above the top trendline, the stock market may experience a significant acceleration to the upside. This is a positive.

• Stocks of popular large-cap stocks such as Amazon AMZN, +0.71%, Apple AAPL, -0.27% and Facebook FB, +1.98% are seeing strong momo (momentum) crowd money flows. This is a positive in the very short term.

• Going into the launch of its new streaming service, Disney DIS, +1.44% stock is seeing very strong momo crowd and smart money flows. This is a positive indicator in the very short term.

• Semiconductor stocks are often early indicators. Momo crowd money flows in popular semiconductor stocks such as Intel INTC, +0.54%, AMD AMD, +1.85%, Applied Materials AMAT, -0.10% and Nvidia NVDA, +1.62% are very positive. This is a positive indicator in the very short term.

Read: ‘Fear of missing out’ triggers huge fund manager shift from cash to stocks, Bank of America Merrill Lynch says

Ask Arora: Nigam Arora answers your questions about investing in stocks, ETFs, bonds, gold and silver, oil and currencies. Have a question? Send it to Nigam Arora.

Two scenarios

Either one of these two scenarios is a potential red alert.

• We are approaching the end of the year. It appears that a large number of money managers are lagging behind their benchmarks. Time is running out for them to catch up. We already know that President Trump excels at moving the markets. (Please see “President Trump might just be the best stock market timer ever.”)

Trump is capable of making statements that may run the market higher. If the market runs higher and breaks the top trendline shown on the chart, the pattern will be set for a big jump. Many lagging money managers will throw caution to the wind, adding fuel to the fire by buying the strongest stocks in the strongest sectors to catch up. Such behavior is certainly reckless, but that is exactly what happens.

You may be asking, “Why are you calling it a red alert; this is a very positive scenario?” The reason I am calling it a red alert is that such a scenario may lead to a blow-off top, followed by a large decline.

• If it weren’t for three ingredients — end of the year, lagging money managers and Trump’s skill to run up the stock market — the pattern shown on the chart would be set up for a pullback. If a significant pullback does occur, money managers with significant gains may want to lock in those gains by selling or hedging. This may put additional pressure to the downside.

What does it all mean?

A big part of The Arora Report’s success has been due to scenario analysis in advance and using probabilities to make decisions.

Investors ought to start with Arora’s Second Law of Investing and Trading: “No one knows with certainty what is going to happen next.” The only realistic thing investors can do is to analyze scenarios in advance and use probabilities to make decisions.

The probability of the first scenario is about 20 percentage points higher than the probability of the second scenario. This should guide investors in terms of cash, hedges and which positions to hold.

Disclosure: Subscribers to The Arora Report may have positions in the securities mentioned in this article or may take positions at any time. Nigam Arora is an investor, engineer and nuclear physicist by background who has founded two Inc. 500 fastest-growing companies. He is the founder of The Arora Report, which publishes four newsletters. Nigam can be reached at Nigam@TheAroraReport.com.