It’s not news that the stock market has been on a tear since the November 2016 presidential election. But recently, the market—as represented by the S&P 500 Index (SPX)—broke below an intermediate-term trendline, something that might be of concern to some investors.
In response, buyers came into the market last week and pushed the SPX back up a little less than 1%. Now the question is, where does the market go from here? Let’s look at three potential scenarios and how they might play out.
But first, let’s talk a little bit more about that broken trendline.
The following scenario analysis is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation.
What Makes a Trendline?
A market in an uptrend is generally driven by the amount of money flowing into stocks. The more money that comes in, the faster the market climbs, and the higher the angle of the trend becomes. Trends can co-exist in different time frames at once, including the short-term (days to weeks), intermediate-term (weeks to months), and long-term (months to years).
The chart in figure 1 shows a long-term trendline that begins in early February of 2016 and is still active. But in early November 2016, a new trendline – the intermediate-term trend – began to move higher and at a steeper angle. That trendline was broken on March 21st (red arrow) and the price continued to drop until last week’s relief rally kicked in.
There’s nothing magical about a trendline, and just because one is broken doesn’t necessarily mean that the market is going to do anything dramatic. Instead, it’s a signal—like someone yelling “heads up” on a foul ball at the ball park—that the trend may be slowing, stalling or even reversing. It’s a reason to take note and pay attention in case the ball comes your way and you need to act.
Breaking Down the Possibilities
In the first scenario, the market may do nothing drastic, and instead just meander sideways for a while, unable to break resistance at all-time highs or support at last week’s low (denoted by the two parallel white lines). This might actually be healthy action, in that it may give the market time to digest the 10+% run it’s had since the election. This type of “basing” action might also set up a stronger foundation for the market to make another move higher.
A second possibility would be for last week’s rally to have legs and continue driving price back up to all-time highs and beyond. Though this might seem like the most satisfying action for investors—at least in the short-term—trees don’t grow to the sky. Market trends tend to rest at some point. And attempting to move into new highs so soon after the trendline break might be getting ahead of things.
Finally, the market could test and fail to hold the recent low. In this scenario, we would look for the long-term trendline to provide the first opportunity for support. Below that and the 200-day moving average (denoted by the purple line) might be the next line of defense. And below that, we’d be looking at the early November low, and start of the intermediate-term trendline, as the next possible level of support.
Dissecting the Scenarios
So, which of these scenarios is the most likely to play out?
Nobody knows. On one hand, last week’s rally occurred on lighter volume, which some traders would use to call into question its sustainability. But on the other hand, the CBOE Volatility Index (VIX) is near the bottom end of its historical range, indicating that many investors are not yet exhibiting the fear that usually accompanies market corrections.
Ultimately, the job of the active investor and trader is not to try and predict what the market will do, but to be aware of what it might do, and prepare to act in accordance with strategies and contingency plans, depending on which scenario plays out. By studying these scenarios and deciding ahead of time what you’re likely to do in each one, you might be better able to execute your strategy in a calm, cool, and collected manner.
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