Will the Stock Market Crash in 2021?! (FINANCIAL HORSE)

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We've been getting lots of requests to discuss whether a stock crash is imminent. Today's article will examine some big picture market technicals. The focus is on the big picture. Within averages, individual sectors and stocks can outperform.

Retail Sentiment is very strong

Daily trading volume growth has soared this year, surpassing even the dot-com levels of growth.

IPOs are hot, hot, hot – traditionally a late cycle indicator. Airbnb, Doordash, Snowflake all doubled on IPO. The last time tech IPOs were this hot was in 2000.

History tells us that when sentiment is this strong, it usually doesn’t end well. But it doesn’t offer any clues as to timing – the party could go on for quite a while before it ends.

What do the market technicals tell us?

So we need to look at something a bit deeper.

200 Day Moving Average (DMA)

The chart below shows the points where more than 90% of S&P500 stocks trade above their 200 DMA (as it is right now).

Historically, when that happens, stocks either (1) experience a short term decline (9 – 12 month horizon, 6% to 19% drawdown), or (2) stay rangebound for a while.

Composite Valuation

The takeaway here is that usually when things get this bullish, short term returns from 3 to 12 months out tend to be negative, but they start improving from 12 months out.

Breadth Momentum

Breadth momentum is also really strong. And historically, such strong breadth momentum is usually not a sign of a bear market rally, or a market top.

Most of the time, this happens within a broader bull market and higher highs lie ahead – But with a risk of a short-term drawdown.

What does this mean?

What history suggests, is that:

· When sentiment is this bullish (based on stocks above 200 DMA), stocks usually have a drawdown or stay rangebound for a while (6 to 12 months)

· When breadth momentum is this strong, it usually means we are not in a bear market rally or a market top. It’s usually part of a broader bull market with higher highs ahead – But with the possibility of short-term drawdowns.

· Certain segments of the market (IPOs, disruptive tech) are showing bubble like tendencies. Retail participation in the market is also very high and slightly euphoric, which is not a good sign, but doesn’t offer clues on timing.

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As any history student knows, history rhymes, but never repeats. So there could be any number of reasons why this time is different.

So we need to add another layer of analysis –reasoning from base principles. What do macro fundamentals tell us?

Macro Perspective – the Insolvency Phase

I believe that 2021 may be the insolvency phase of this crisis. Some retail demand has moved online permanently, and some office demand has moved to flexi-working permanently.

So far, the government has bailed everyone out on a blanket approach. At some point in 2021/2022, governments will need to become kingmakers – deciding who lives and who dies. So there will be insolvencies, especially in the old world sectors permanently impacted by COVID.

What is the trade-off here?

Real GDP growth will stay low for the foreseeable future, as the economy manages this structural transition. Sure, year on year numbers will be high because 2020 is such a low base, but trend numbers will look very different.

US nonfarm payrolls are set out below, and I suspect economic growth will track something like this. A sharp recovery from the bottom, but slow growth going forward, and significantly lower than the pre-COVID trend.

BUT – Monetary Policy

That’s the economy. Today we’re looking at the stock market. For stocks, we also need to look at the other critical component – monetary policy.

And the bottom line is, the Feds have your back for the foreseeable future. Easy money is not going away until the economy is roaring again. That’s a very, very powerful tailwind for stocks and financial assets in general. Sure, the economy will decline for a few years, but as long as money is easy, asset prices can still continue going up.

FH, can you summarise everything so far?

This post has been a pretty technical one, so I’ll do my best to sum it up simply:

• Market technicals suggest the possibility of a short-term pullback (6-to-12-month horizon), but that the midterm trend is positive.

• Bullish retail sentiment suggests the possibility of an eventual short term retrace

• WWI/WWII suggest that the post-war recovery will be long and hard. Economic growth and inflation (consumer price) will likely stay low for a while. Policy support from governments will be crucial to watch.

• Macro fundamentals suggest that economic growth will stay low for a while, as economies and governments manage this structural transition.

• Monetary policy will stay easy for the foreseeable future, until 2023 at the earliest. Monetary stimulus will not stop until there is significant economic recovery, which will take a while.

What is my take on this?

How to invest will depend a lot on your holding period. I’ll share my own thinking as a long term investor.

I’ve become tactically cautious since the Nov elections.

I’m still buying, but I’ve slowed my rate of purchases. And going forward the bigger the rallies, the more cautious I will get.

But in 2021, I would view any pullbacks as a buying opportunity.

I think with the Feds in play, any stock market crash will not be allowed to last. If things get really hairy, I do expect the Feds to step in.

With a broader 3 – 5 year perspective, I do expect the economy to manage the structural transition, and be nicely set up for a new phase of growth (just like post WWI and WWII). This is where I think a broader fiat currency depreciation will come into play, setting the stage for a new long term cycle.

For those who are keen, you can check out my portfolio positioning (with weekly buy/sell updates) on Patron.

Closing Thoughts: Diversification is a free lunch

You can invest into a bull market where everything goes up, and make a ton of money without really knowing what you’re doing. But holding onto the returns longer term is a different story.

This article is what I think as at mid-Dec 2020. I could be wrong, or something could happen tomorrow that changes this entirely.

With diversification, you ensure that regardless of the outcome, your portfolio will continue to hold its value, and it will continue to perform. And that’s why diversification is the only free lunch in investing. Start with a diversified portfolio as the base, and then tilt accordingly based on your risk appetite.

I would absolutely love to hear your thoughts. Let me know what you think!

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