The S&P 500 is about to hit a new all-time high. How much upside can you expect?

August 8, 2018

The S&P 500 is about to hit a new all-time high. How much upside can you expect?

Since the beginning of July, the market has shown quite a bit of bullish momentum. As of this writing, the S&P 500 (SPY) has rallied more than 150 points from a pivot low in late June in the 2,700 area – a total gain in a little over a month of 9%. The index is now poised to match, and quite possibly exceed the highs it reached in late January. For most technical traders, a new high marks a break above resistance that should give the market momentum to keep pushing even higher. If you’re not the type of person, however to simply “leap before you look,” then like me, you want to try to figure out how much room is left.

How much upside remains in the market isn’t an easy question to answer, simply because nobody can make anything more than a semi-educated guess about future events – or the way the investing world will interpret them. The same technical traders who look for new all-time highs to extend trends even further also like to use historical price action to come up with estimates. Economists and fundamental investors try to use geopolitical and macroeconomic data and events to identify keys and trends. I hesitate to say that any one approach is better than another. Instead, I like to consider a combination of a couple of different technical techniques, along with economic and, yes, even geopolitical conditions to try to come to my own opinion.

I spent some time this morning going over some of that data, and here’s what my early conclusions are. Keep in mind, these are just a few of my own best attempts to make a semi-educated guess, so you can take it or leave it as you wish.



Some Fuzzy Math

I’ll start by giving you a look at a technical chart of the S&P 500.

 

There are a couple of elements of this chart that I think are useful right now. The first is the Relative Strength (RSI) indicator shown in the lower portion of the chart. RSI is a sentiment and momentum indicator that oscillates between upper and lower extremes to gauge a trend’s strength and give traders a way to estimate the likelihood the trend will continue or reverse. At the upper extremes (above 70), reversal risk to the downside is increased, while at the lower extremes (below 30), the opposite is true. The other element that comes into play about RSI is that stocks will often continue to follow their current trend even as RSI hovers near, or even beyond extreme levels. That reality is what makes RSI interesting to me right now. Even as the S&P 500 is pushing near to the all-time high it set in January of this year, RSI remains just a little below its uppermost extreme. It has also managed to oscillate within its upper and lower extremes since that high was reached in January, with its general pattern of highs and lows since April closely approximating the pattern of the index. That is a confirmation of the market’s trend over the last four months, and the fact that the indicator still hasn’t pierced its upper extreme band suggests there could be more room to run.

At this point, it’s worth taking a moment to discuss a basic tenet of trend-based analysis. Trends tend to move in what I like to think of as stages. Typically speaking, most long-term trends can be broken into three different stages. Stage 1 is the earliest portion of a trend, when the market begins to reverse from an extreme or high or low. That’s the hardest stage to recognize, simply because it moves against the grain of the current longer trend, when most people will simply see that counter move as a minor correction or pullback within that trend. Stage 2 is the longest portion of a trend, and the area where the most money is likely to be made. It’s where the new trend is easiest to identify, and so more and more investors jump on board in that direction, making it easier and simpler to maintain. Stage 3 is the latest stage of the trend, and what I like of as the “last gasp” stage of that long-term trend. There is often still quite a bit of room to move along the trend in this stage, and so this stage can still yield very profitable results; but it also means that reversal risk is greatly heightened during this stage.



The challenge about the stages of a trend is predicting how long any given stage will last. Stage 2 can last 4 to 5 years in many cases, while Stages 1 and 3 are usually considerably shorter. The problem is that word – usually. I’ve been saying the market is in Stage 3 of its long-term upward trend for more than two years, which is undoubtedly longer than that stage should last. I maintain that attitude, however, simply because I think it is smarter to estimate conservatively; plan for the best, but be prepared for the worst. That means that I want to recognize and take advantage of upside opportunity when it’s there, but be ready and positioned to react quickly and effectively when the market reverses back the other way.

If you operate on the idea that the market is in Stage 3, any upside that remains should be somewhat limited. That is where the “291.78 Total Distance” estimate I highlighted on the chart comes into play. Some people will take the total distance of the last market correction to estimate how far the market’s new opportunity will be after a new high is reached. I think it’s reasonable to use the total distance as a reference point, but I prefer to think in somewhat more conservative terms.

Another technical method of market analysis that I have learned to appreciate over the course of my years in the market is Fibonacci analysis. It’s pretty fascinating to see how market trends, and their swings from high to low correspond with Fibonacci mathematics. Those calculations can also be used to estimate a market’s extension of a trend. Here’s what we get if we apply the .618 Fibonacci ratio to the total distance of the market’s correction from January to April of this year:

291.78 X .618 = 180.32

We can add this number (roughly 62% of the total size of the correction) to the last market high to get an estimate of how much further the market could run if the resistance from that high is broken.

2,872.87 + 180.32 = 3,052.87

180.32 / 2,872.87 = 6.27% total upside

Forecasting broad market upside of about 6% if the market makes a new high seems like a pretty conservative estimate; if it is even remotely close to correct, that should translate to some pretty healthy gains on individual stocks. How long that kind of a run will take is anybody’s guess. I decided to look back at the last two bull markets to gauge how long Stage 3 of their respective long-term trends lasted.



The bull market that ran from 2002 to 2007 hit a high point in October 2007 before beginning its reversal; the “last gasp”, final stage of that five-year trend began in August, meaning that Stage 3 in that case covered about a two-month period of time. Prior to that, the March 2000 high that marked the end of the “dot-com boom” started its “last gasp” push in February of the same year. Saying the market could move about 6% in one to two months isn’t unreasonable given the increased level of volatility we’ve seen from the market this year; but I also think it’s useful to think about how long it has taken the market to recover from its latest correction (assuming, of course, that a new high is actually made). The bottom came in April, so a conservative estimate could suggest that it may take between 2 to 4 months. That certainly implies the market’s trend could last through the rest of the year, or possibly even longer since my estimate intentionally errs on the conservative side.

There are some important elements from a fundamental and economic view that I think support the idea the market has some room and reason to run a little longer. Earnings continue to come in generally strong, and most economic reports (jobs, housing etc.) are also showing pretty broad-based strength. A healthy economy should generally lend itself well to continued strength in the stock market. While interest rates are rising, the Fed has maintained a conservative pace and degree of those increases, and the economy seems to following that lead pretty well. As they currently stand, interest rates remain historically low despite the increases we’ve seen so far. That is also a positive, bullish indicator.



There are risks to my forecast. Frankly, many come from the geopolitical arena at this stage. Trade war concerns are still on everybody’s mind, and the Trump administration’s reimposition of economic sanctions on Iran could put a cap on oil supply that could drive oil prices near to their historical highs. While corporate earnings have yet to really show a negative impact from tariffs between the U.S. and its trading partners, more and more CEO’s are starting to cite tariffs as a risk. If that risk starts to manifest itself in an actual deterioration of revenues, and of earnings, the market can be expected to react negatively. Increased oil prices, at the extreme, could have the net effect of muting demand for a wide range of goods all over the globe. Real estate prices in many parts of the U.S. have also been showing some remarkable increases over the last year or so as well, while wage gains have generally been quite muted; at some point, those increases, along with increasing interest rates could very well put home ownership – a big indicator of broad economic strength – out of the reach of the average working person.

Is there good upside left in the market? I think there is. I also think we have to be careful to factor risk into our evaluation and our investment decisions. Be conservative and selective about how you jump into a new opportunity, and plan ahead about how long you intend to stay or how much gain you want to chase. Put a plan in place to limit your downside risk if you’re proven wrong and the market turns against you, and limit the size of the new positions you take.