Exploring the right tail
Risk is the right tail
"If you can learn to create a state of mind that is not affected by the market’s behavior, the struggle will cease to exist." — Mark Douglas
How can you not be affected by this loco market?
Recap of my last note from March 26: I analyzed key S&P 500 levels using different fundamental metrics and economic forecasts. I observed that cyclicals have outperformed defensives for two weeks, and the SPX might be attempting to establish a bottom near the important 6450 level.
What’s notable about the 6450 level? It represents the 1-SD P/E low according to the P/E versus Profit Margin analysis. Refer to the chart below.
As a trend follower, my role is to monitor key levels, watch for signs that SPX is either maintaining or losing these levels, and be prepared to take long positions when momentum turns positive and aligns with the overall uptrend, provided the trend remains bullish.
It looked pretty scary toward the end of March, but I mentioned in my chat thread on March 31:
“I don’t think the downside is over since we haven’t seen proper capitulation, and the war situation remains unclear. However, I make a living by ignoring my emotions and sticking to my system.
Because the current weekly trend is positive, I need to stay alert for a potential shift in momentum.
I’m not particularly excited to start adding longs in a few days, especially with Vanna as a headwind. But I keep my nose to the grindstone and follow my system.“
Current Setup
The basics: We saw a +10% move in SPX over 10 days on lower volume, reaching a new all-time high. The AAII bull-bear sentiment remains negative. But we may have come too far, too fast, and with OPEX out of the way, a pullback in SPX may be around the corner.
Options picture: Short term setup turned slightly bearish last week, but overall the picture is mixed. No edge here. The 25D IV put-call is nearing oversold levels.
My Regime Model: It issued a buy signal on April 10. Chat thread here.
Technicals: The rally looks climactic to me, especially given that we did not see capitulation at the lows.
But the current setup of ‘positive momentum+uptrend+falling VIX’ has a 48.1% win rate (lower as SPX has run up), but a PF of 3.2 with a 5.1% MAE 75perc stop.
In plain English, expect a pullback, but you have to be leaning long.
What’s next?
This is a tweet-driven market, so who knows?
But let’s focus on what we know and can control —> We have a sharp rally on thinning volume to new all-time highs in less than 2 weeks.
Looking back at SPX data since 1990, there are six cases of a sharp 10-day rally to a new high with a flat or lower volume profile.
Only two analogs reached new highs on lower volumes: July 2016 and August 2024. In both cases, upside potential was limited over the following few weeks.
May 1997 rose sharply after just two weeks of pullback. This is the pain trade.
Other periods experienced choppy action with sharp downward moves, but no sustained follow-through.
Here’s the median projection: expect a sideways market for the next three months, followed by a rally up to 7500.
Exploring the right tail risk: 1997 run-up
The May 1997 analogy, in which SPX continued to rise amid internet bubble discussions, represents the pain trade here. I want to dive into this further.
I understand the bearish perspective on the US economy. The argument is that disruptions in energy supply chains, along with elevated crude prices or higher insurance costs, could lead to higher inflation and slower global growth. I also agree that US stocks are currently in a bubble, as I noted in late 2024.
However, I strongly disagree that US stocks have hit bubble levels of 2000.
Here is my machine learning based S&P 500 fair value model.
By applying the overvaluation premium and trend from the above model (1997–2000) to the current S&P 500 EPS projection for the next three years and assuming slightly higher US yields this year that gradually decline to 3% (see lower panel), my model estimates a SPX level of 15,000.
Therefore, if the 1997-2000 bubble analogy holds and US yields decline after any brief inflation scare this year, the SPX could reach 15,000 within three years. This is the right-tail risk.
I understand the bear case and am prepared for it with my position and portfolio stops. But I am mentally unprepared to handle the right tail of the 1997 bubble analog.
Thankfully, I am a trend follower with limited need for mental capacity. :)
The next few years should be interesting! Focus on quality reward-to-risk investments and trades.
Cheers and good luck!
Great stuff!