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After last weeks bitcoin plunge, many wonder if stocks will share the same fate.
Despite an overbought short-term condition, U.S. equities are firmly supported and should dodge this bullet.
Bitcoins crash may even boost interest in equities in Q1 2018.
The event that many observers have been predicting for months finally happened last week. Bitcoin, the highly-touted cryptocurrency, slumped 30% late last week and retraced much of its impressive gains of the last two months. The dollar-denominated price of bitcoin collapsed amid a chorus of I told you sos as many observers feel vindicated that the cryptocurrency finally experienced a sharp reversal after several weeks of rallying virtually non-stop. In this commentary, Ill build the case that what were seeing in the crypto market is merely a temporary setback of a still ongoing speculative mania. Well also examine the possibility that the equity market will avoid a similar fate in early 2018 as stocks gear up for what should be a bullish first quarter.
The collapse in bitcoin prices was not news-driven but was apparently a technical affair due to an extremely overbought condition. Buyers eventually emerged to reverse some of the damage last Friday, but bitcoin was still well below its all-time high from Dec. 18 before the Christmas holiday. The Bitcoin Investment Trust (OTC:GBTC) chart below illustrates the damage over the past week.
I would liken bitcoins plunge to the October 1997 mini-crash in the Dow and NASDAQ. That sell-off was primarily a technical phenomenon in that it followed close on the heels of a runaway rally fueled by excessive speculation and unrestrained enthusiasm for equities, especially in the tech sector.
The October 97 stock market slump was only a temporary a temporary setback, however. It was precipitated by over-speculation and was quickly corrected after weak-handed investors were shaken out. Stronger hands then stepped in to staunch the selling and the major averages recovered within three months and went on to make new highs early in 1998. The graph of the NASDAQ Composite shown below illustrates the progression from overbought to oversold in that parallel event some 20 years ago.
The similarities between the stock market of 1997 and the bitcoin market of 2017, however, cant be applied to todays stock market. Aside from an obviously overheated technical condition prior to crashing, the bitcoin market also suffered from a surfeit of bullish sentiment. In fact, an argument can be made that bitcoin was overexposed in the mainstream media and financial press in the weeks leading up to the plunge. Seeking Alpha readers couldnt help but notice the many feature articles dedicated to bitcoin in November-December. Then there was this gem of a magazine cover, courtesy ofModern Trader:
The magazine cover indicator tells us that whenever a widely touted asset begins showing up on the front covers of magazines, the asset is over-owned and therefore vulnerable to a correction.
Now that bitcoins extraordinary run-up has been corrected, investors are wondering whats next for the cryptocurrency. While additional downside cannot be ruled out in the coming weeks, I believe the October 1997 stock market correction will serve as an analog to the bitcoin market in the coming 2-3 months. The bottoming process in bitcoin may well be a volatile and drawn-out affair, but if the 97 stock market analog holds true, we should see a strong recovery in bitcoins price by March.
The stock market bears will of course disagree with this outlook. But observers who draw parallels between last weeks bitcoin crash and the current stock market environment are missing one important ingredient: widespread participation. The level of stock ownership among the small investors today is smaller compared to previous decades, especially given how high equity prices have risen. The following graph shows the 11-year progression of theAAIIbulls minus bears. When individual investors are especially bullish on stocks, the graph tends to reach the 40 level or higher. Currently, the bull-bear reading was only 24, a long way from that level.
Major stock market declines are historically preceded by spikes in the AAII bull-bear differential. At current levels, market psychology doesnt suggest that investors are overly committed to the bullish case for stocks. This decreases the odds of a stock market crash in the near term.
The following graph showing the progression of the NYSE Composite Index (NYA), the most comprehensive view of the broad U.S. equity market, is another argument against a bitcoin-type crash happening in ealry 2018. The NYA graph compares favorably with the near-vertical runaway rally in the bitcoin price prior to last weeks sell-off. The steady, measured rise in the equity price level for most of 2017 stands in marked contrast to the emotionally-charged run-up in cryptocurrency prices of recent months. Whats more, the absence of frothy speculative fervor for equities makes it far less likely that the stock market will share bitcoins fate in Q1 2018.
In aprevious article, I suggested that the bitcoin bubble could actually serve to stimulate interest in the stock market among individual investors. I wrote:
For equity investors, a bitcoin bubble could also eventually have a desirable outcome. When the multitudes of young Millennials who comprise a substantial portion of bitcoins investor base have experienced enough success in this medium, many of them will undoubtedly warm to the idea of equity investments. The stock market at some point will need a fresh injection of youthful investors, and bitcoin could conceivably serve as a conduit. Thus, the runaway success of bitcoin may yet serve as an additional prop to the long-term bull market in equities.
The above prediction will soon be put to the test. It could also be that the bitcoin plunge could convince investors that the relative stability of stocks vis–vis cryptocurrencies in the last year is reason enough to rotate money out of bitcoin and into equities.
As 2017 winds down, the stock market is technically overbought on a short-term basis but remains in fine shape overall. Heading into the last week of 2017, stocks remain buoyant with all six major indices above their rising 15-day moving averages. This confirms that the immediate-term (1-4 week) trend remains up as we finish out the year. The NYSE Composite Index (NDX) best reflects the controlled upward drift of the equity market with the potential for higher prices before New Years (see above chart).
NYSE market internals also remain supportive of the broad market uptrend. NYSE new 52-week highs are outpacing new lows by an average of about 5:1. New highs-new lows are my favorite measure of the incremental demand for equities and they continue to point to strong internal momentum for stocks. Market breadth is still strong as the advance-decline (A-D) line shows (below). NYSE cumulative volume is also still supportive of the upward trend.
In view of the current NYSE technical and psychological profile, investors should maintain a bullish position in the stock market. While there is a chance the market will pull back in the immediate term, any such pullback should be treated as a buying opportunity. As long as NYSE market breadth and internal momentum are rising, as discussed above, the odds favor higher stock prices in the coming months.
Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.