Trader’s Narrative

A while back I presented a historical study which looked at the behaviour of the S&P 500 relative to its long term trend line: what happens this far above the 200 day moving average? If you haven’t yet, go check it our for full details because what follows will make much more sense.

When the Dow broke 10,000 (for the nth time) in the middle of last month, I cautioned that stocks had risen into thin air (again). The S&P 500 meandered around 1090 for a few days and then fell back.

Now, once again, looking at the same technical metric, I would be remiss to not issue another cautionary note:

As of today’s close, the S&P 500 index is 18.6% above its 200 day moving average. That is very close the 20% ceiling that seems to exert an almost magical restraint on momentum.

In the days left in the week we could potentially move up to 1120, which would expand the distance between the close and the 200 day moving average to approximately 21%. That’s really the maximum distance that it has been able to roam away from its long term trend in the past. So that’s about +2% further gain in equities from where we are.

Also, remember that tops that form at the 20% ceiling tend to cluster. So just like mid October, we may see a few days where the S&P 500 hovers around the 1120 area before either dropping as it did before or simply plateauing (to wait for the long term average to catch up).

Although this message may appear bearish in tone, it is only in the short term. If my prediction is borne out, then the S&P 500 will have made yet another higher high (and higher low) - the very definition of an uptrend and a rather beautiful chart formation.

Finally, it seems that every time I write along these lines, someone comments to remind me that the “markets can do anything”. So allow me to nip that in the bud.

Well, yes, of course the market can do anything. I’m not under the illusion that I can restrain them or to make them do my bidding. I’m simply observing a pattern of behaviour that they have exhibited in the past and projecting from that a probability. So I hope that is crystal clear.

When you take a step back and get a very long term perspective on the stock market, you realize that an apt analogy is a dog pulling on its leash. There is an overarching trend - which is the path set by the owner - but like a distracted puppy, the market can pull in one direction for short, intense spikes.

By watching the relative distance to its moving average we can tell where we are and how probable it is that we revert back to the very long term trend. This is what I referred to when I built a case for being bullish in March 2009: Another Reason We’ve Seen the Market Low. To my shock and horror, on November 20th 2008 the S&P 500 closed almost 40% below its 200 day moving average. It had never done that in the entire history of the index!

And in keeping with every other similar spike down, 60 days later, the index had recovered. In fact, we saw the sharpest rally to match the never before seen spike low.

We’ve now come full circle and are at the other end of the extreme. Last week, the S&P 500 closed 20.27% above its 200 day moving average. To give you an idea of how rare this is, here’s a chart of the S&P 500 relative to its long term moving average from 1950 onwards (click to see the larger version open in a new window):

Not only have we never seen this measure sink so low, we’ve also never seen it recover so fast! It took only 206 trading days for the S&P 500 to go from being 39.79% below its 200 day moving average to being 20.27% above it. The only other time we saw a similarly quick lurch from the abyss to the heavens was when bell bottoms and butterfly collars were the rage.

Back then, it took the S&P 500 only 185 trading days to go from being 28.8% below its 200 day moving average (on October 3rd 1974) to being 21.6% above its moving average (on June 26th 1975). That tidbit may be fascinating to know but I’m sure you’re wondering, so what happens when we are this far above the 200 day moving average?

To answer that, I went through the daily S&P 500 data and marked the appropriate dates where we approached or crossed the 20% Maginot line. Since such instances tend to clump together, I only considered the first date and ignored the repeats during the same month.

So for example, on May 5th 1975, the S&P 500 traded at 90.08 which was 19.66% above its 200 day moving average. Then a few days later on May 9th it closed slightly higher relative to its long term moving average (20.10%). I ignored all such repeats. I then calculated the forward 1 month, 3 month and 6 month returns (excluding dividends) from the first date. Here are the results:
Continue reading ‘What Happens This Far Above The 200 Moving Average?’

What a wild day. Everyone knew coming in this morning from the markets which opened in Asia that this would be one for the books. The intense and indiscriminate selling that we saw today can only be characterized as forced liquidation.

People are not selling just because they are fearful, or because they think the market is going lower. They are selling because they have to. We’re seeing massive deleveraging. Here are some more highlights:

• the volatility index (VIX) goes to 52.05
• even “safe”, boring stuff that held up until now is getting liquidated
• brokers put in stricter margin rules
• down volume was overwhelming - do the specifics really matter anymore?
• NYSE new lows goes to half securities traded, matching Black Monday 1987
• surprise! the bailout plan doesn’t live up to its name
• less than 6% of S&P components are above their 50 day moving average
• S&P 500 is about 20% below its own 200 day moving average (see below for graph)

Here is the chart of the S&P 500 index (SPX) compared to how stretched it has become from its long term moving average. For more details about this indicator, check out: How the Stock Market Resembles a Dog on a Leash.

Ultimate Fade?

“Whatever money you may need for the next five years, please take it out of the stock market right now, this week…I don’t want people to get hurt in the market.”

Remember, this is the “Paris Hilton” of the investment world speaking. Someone who froths at the mouth almost daily, dresses up in diapers to recommend Kimberly-Clark (KMB)…. uses a ridiculous sound board to accentuate his manic “advice”… and now he is as somber as a funeral parlor. Watch:

I don’t want to be mean and kick Cramer when he’s down. I’m just pointing out something that he himself has said. When he gets overly emotional, either way, he is wrong and a great fade. At his old hedge fund he had his wife (who he calls the “Trading Godess”) who would force them to take the other side when this happened. Most famously, she did this before the 1987 crash and not only saved their hides but made them very wealthy. Unfortunately, she is otherwise engaged these days and can’t pop in front of the camera and save regular folks who may be contemplating taking her husband’s advice.

Yesterday Bill asked me to take a look at the crude oil market. So here is a quick overview of what I think is going on.

Here is a long term chart of the price of crude oil along with its distance from the 200 day moving average:

OPEC Tax
The price of oil, above a certain point, becomes a tax on western economies. The higher it goes, the less will be consumed and the less economic growth we’ll have. One of the reasons we had an amazingly powerful economy between 1998-2000 was that oil fell to single digits. So there is a built in mechanism in place to moderate price but due to structural reasons it doesn’t work with instantaneous or perfect regularity.

Indexing Fever
The recent parabolic rise may be explained by something other than a supply demand imbalance. In the past few years we’ve seen a trend towards commodity index funds which creates a positive feedback loop. The better the performance of commodity markets, the more funds are allocated to it by pension funds, hedge funds, and other institutions.

And we’re talking about billions and billions of money. And it is flowing to long only strategies. Just buy, and buy some more! It is somewhat similar to the hyper indexing phenomena we saw happening in the tech bubble years. As the Nasdaq 100 index went sky high, it attracted a lot of hot money who would buy ETFs or index mutual funds to chase performance. This would then propel the index higher as these funds would create new baskets to put this money to work in the market. So a positive feedback loop legitimized itself through self-created performance:

Source: It Takes Crude To Contango by Howard Simons at thestreet.com

The problem with a scenario like this is that it becomes increasingly difficult to call an exhaustion point. You can easily be steamrolled flat by the tremendously robust trend. Believe me, many very smart and well capitalized traders were flattened trying to short the internet bubble stocks. The trend will last until it doesn’t. That’s about as lucid an explanation as you can get.

Contango
The normal situation when the price of oil is rising is for future prices to be lower than spot prices. This is called backwardation. But right now the oil market is in contango - where future prices are higher. This is a rare occurrence which creates incentives for speculators to purchase oil, take it off the market, store it and then sell it at some point in the future to gain arbitrage profits.

So now we have speculators who are piggybacking on the commodity indexing trend, pushing it even further, as well as buying contracts in an attempt to “front run” the inevitable buy orders coming down the pipeline.

Flying Turkeys
All of this is happening in the derivatives markets and it is rather complicated for most people to wrap their minds around. Here’s a simple sign of froth in the oil market which most people can identify much easier. We are seeing small, extremely speculative stocks in the energy sector fly off into the stratosphere. For a quick example, take a look at the charts for Pyramid Oil Corp. (PDO) and MEXCO Energy Corp. (MXC).

Most of the stock spam is now pumping oil, gas and energy related over the counter penny stocks. This is the last stage of a parabolic blow-off. When the lamest and sickest of turkeys start to fly as if they were hawks. But good luck in actually pin pointing the top.

Today’s market really tests any bullish resolve that may have developed over the weekend. The financials were especially hit hard due to reported layoffs at Citigroup (C) - the shares hit a five year low.

As I sift through the technical damage, the whole market seems extremely oversold. Taking a look at the percentage of stocks above their 50 day moving average shows less than 20% fitting that bill on the S&P 500:

This level of technical damage has in the past marked the end of selling pressure in this most recent secular bull market. Will it do so again this time?

Just remember that there is no magic to lines on a graph, price can and will do anything. This particular measure can go all the way to zero (and it has before) and stay there for some time.

In a comment, gosu asked for an update on the ratio of “percentage of stocks above their 50 day MA, to the percentage of stocks below their 200 day MA”. Here is the chart (note it is for the S&P 100 not the S&P 500 index):

To understand this ratio better, a little explanation is in order. Usually I watch the area in 0.4 to 0.5 but the spikes lower occur when the percent above 50 day moving average goes lower while the 200 day moving average sits at a higher level. It is telling when the long term uptrend is strong and we only see a short term weakness.

Right now we don’t have that because both the short term and the long term are weak and stretched to the downside. The percentage of stocks above their 50 MA is 19% while the percent above the 200 MA is at 33%. The last time the percentage of stocks above their long term moving average was lower was in the jaws of the bear market in late 2002.