Counter-Trend Rally Redux

“Good investors gather information, put that information into current and historical context, then make sound decisions.”

This is the third Monthly Commentary this year when we are discussing counter-trend rallies. Why?Because equity markets have been in a downtrend since the first of the year. Counter-trend rallies are formative devices that give us important information that may be useful in effective asset allocation as well as planning for future activity. One of the first formations we are looking for is a short-term base that can define a trading range. It appears that the June lows and the September lows may be providing that base for equity markets. This base could also set up an effective trading range. This is all technical in nature, but it is useful in understanding the nature of the financial marketplace.

To continue the technical insight, October has also introduced another interesting device called a ‘reverse head and shoulders’ pattern. Without going into more detail, this pattern is a bullish indicator, which in turn could launch an effective counter-trend rally. A reverse head and shoulders pattern needs a little space of its own to develop, and we have seen that carved into the bottom 8% of the trading range for the S&P 500 Index (SPX), which is about 24% from the October bottom to the August top. That leaves ample room for a nice counter-trend rally. There are additional factors in play that we won’t get into, but it’s looking good so far.

One significant factor that is fundamental and not technical (I can hear the sigh of relief) are the mid-term elections that are just around the corner. There is tremendous speculation as to how the outcomes will affect the balance of power at the federal level. In addition, there are the implications for the elections in 2024. Political cycles are most certainly important indicators of social change. They impact business cycles to a lesser degree, except when drastic actions are taken such as the COVID shutdown. The mid-term elections are not likely to reverse the downtrend in equities all by themselves. But remember that we are in an intermediate-term trading range, and political news can spark a market run in either direction in a charged environment.    

Despite the Ukraine-Russia war, international equity markets are following suit with domestic market activity. The EAFE Index is setting up like the domestic equity indexes, and even the S&P Europe Index has formed a double bottom of sorts that might represent a short-term positive. The MSCI Emerging Markets Index has set a similar short-term double bottom. So should the U.S. market pop up into a productive counter-trend  rally it could have international reinforcements.

Bond markets, unfortunately, are presently not providing any base, trading range, or potential counter-trend rally indications. While they did rally from the June lows, their performances in October have been far from inspiring. Interest rate pressure and inflationary pressure has been relentless. The Federal Reserve has not budged on their stated intentions of taming inflation with higher interest rates. A three-quarter percent increase in the federal funds rate in November is widely anticipated, to be followed by a half percent increase after the elections. That would bring the federal funds rate to their goal of 4%, which is the rate where the Fed currently expects inflation to decline and level off. When that occurs, bond markets should level off. Until then, bond markets remain in a long-term downtrend, as well as intermediate and short-term downtrends.

Finally, we want to note some significant upcoming historical equity market tendencies. November to January continues to be the most profitable contiguous three months of the year. The sweet spot for the four-year Election Cycle begins in the fourth quarter of the mid-term election year, and runs through the first quarter of the pre-election year. Finally, the eight trading days surrounding mid-term elections have only had one losing period since 1934, (in 1954,) with an average gain of +2.8% for the Dow Jones Industrial Average (DJIA). All more fuel for a counter-trend rally in equity markets.

Edward D. Foy, Manager, SELECTOR® Money Management, Chief Investment Officer, Foy Financial Services, Inc.

© 2022 Edward D. Foy.   [email protected],

Sources: StockCharts, Morningstar, Stock Trader’s Almanac 2022.