Trader’s Narrative

Guest Post by Nico Isaac

The following article includes analysis from Robert Prechter’s Elliott Wave Theorist. For more insights from Robert Prechter, download the 75-page eBook Independent Investor eBook. It’s a compilation of some of the New York Times bestselling author’s writings that challenge conventional financial market assumptions. Visit Elliott Wave International to download the eBook, free.

Once upon a time, the term “Black Monday” was to Wall Street what the name “Lord Voldemort” was to Hogwarts. It turned the air freezing cold and sent traders flinching around every corner in fear of a repeat of the October 19, 1987 or October 28, 1929 meltdown.

Case in point: The 2008 “Black Monday” anniversary. At the time, the U.S. stock market was locked in a ferocious downtrend that included regular, triple-digit daily declines of 400 points and more. Needless to say, when the final two Mondays of October arrived, the least superstitious investors surrounded their portfolios with more good-luck talismans than a Bingo player. See October 19, 2008 AP headline below:

“Black Monday: Stocks Sink As Gloom Seizes Wall Street. Prolonged Economic Turmoil” is seen.

That was then. Today, the usual dread surrounding the back-to-back string of “Black Mondays” is nowhere to be found. In its place, media reports abound of a new, global bull market “shrugging off,” “ignoring,” and “making a distant memory” of the event.

For one, “gloom” hasn’t “seized” the U.S. stock market in quite a while; from its March 2009 low, the Dow has risen more than 50% to above the psychologically important 10,000 level. For another, the mainstream experts insist that today’s financial animal is unrecognizable to that of 1987, and especially 1929. In their eyes, it’s a completely different — i.e. safer, smarter, and sounder system.

We beg to differ.

See, while the usual experts want to put as much mental distance between today’s market and those that facilitated the 1987 recession and 1929-1932 Great Depression — the physical similarities are impossible to ignore; more so, in fact, to the latter scenario.

Here, the October 2009 Elliott Wave Financial Forecast presents the following news clip from the October 25, 1929 New York Daily Investment News.

Now, take a look at these headlines from the week of October 12-17, 2009:

“The Great Recession Is Over.” (Reuters)

“80% of Economists Say The Worst Is Behind Us.” (CNN Money)

“The Bull Is Back” (AP)

“The Economic Recovery Is Well Underway” (Wall Street Journal)

They’re interchangeable — Eighty years later.

Along with a similar extreme in bullish sentiment, the performance of stocks between now and the 1929 situation is cut from the same cloth. After an initial plunge from August 1929 through late October 1929, the US stock market enjoyed a powerful rally well into the following year. NOW: After a steep freefall from its October 2007 peak, the US stock market is once again enjoying the fruits of a powerful rally back to new highs for the year.

Also, on closer examination, the October 19 Elliott Wave Theorist (EWT) uncovers an even deeper parallel between the 2009 rally and the 1929-30 one. Here, EWT presents the following snapshot of the Dow during the Depression-era advance:

As Bob Prechter points out — in 1930, stocks rallied to the level of the preceding year’s gap. Bob then reveals that the same level has been reached now.

So, we all know how the 1930 rally ended. The question is whether the 2009 advance will experience the same fate. As Bob explains in the Theorist, the only way to know for certain is to “look at the reality of the situation.”

For more information, download Robert Prechter’s free Independent Investor eBook. The 75-page resource teaches investors to think independently by challenging conventional financial market assumptions.

While his work on valuation and bubbles receives more attention, Prof. Robert J. Shiller has been studying stock market sentiment for a long time. He has created several surveys which measure different aspects of sentiment. One of these is the Buy-on-Dips confidence index which we explored back in March. Unfortunately it has only about a 100 data points and doesn’t seem to provide much value added.

Today I wanted to check in with another one of Shiller’s surveys, the Crash Confidence Index. This new index, like the Buy on Dips confidence index, is limited in sample size but from the brief available data it seems to be provide much more insight.

The Crash Confidence Index is the percentage who think that “the probability of a catastrophic stock market crash in the US, like that of October 28, 1929 or October 19, 1987″ is less than 10%. So the higher the number, the less likely a crash is perceived as being imminent.

The highest level for institutional respondents was 58 on April 2006. While individual investors were the most confident on October 2003 when 49% believed that a crash was unlikely.

Not surprisingly, we tend to extrapolate the present into the future so during the darkest days of the stock market, further catastrophic declines in the form of a crash appear more likely. During the low of the last bear market cycle (November 2002) the institutional respondents were very pessimistic (only 21% believe a crash unlikely).

During this bear market cycle, institutional investors were the most pessimistic in February 2009 while individual investors took longer to be persuaded that things were improving. They were most pessimistic in April 2009. Since then both camps have recovered sharply. However, if you notice, we are still at very low levels historically.

If we compare the sentiment during the recovery from the last bear market bottom the difference is remarkable. In the six months from November 2002 to May 2003 the institutional Crash Confidence index almost doubled while the stock market as measured by the S&P 500 had hardly budged at all.

Today, we have a stock market that has rallied almost 60% and yet, the Crash Confidence index in relation to that performance, has gone from 18 to 28. While that is a respectable recovery in sentiment as measured by this index, it is hardly commensurate for the performance that the stock market has lavished on us.

To learn more about the Crash Confidence index visit the Yale Center for Finance.

The stock market’s resilience was in good form today as it inched ahead, managing to recover from the shallow pull back of 3 weeks ago. The Dow Jones even managed to put in a new high for the year while the S&P 500 index and the Nasdaq were not far behind. I’m not sure if this shallow pullback is what Lowry had in mind when they cautioned against jumping with both feed into their intermediate buy signal.

The tongue in cheek title of this post is inspired by the classic Kubric film, “Dr. Strangelove“. I thought of it when I looked at today’s chart of the day showing the subsequent returns for the worst yearly returns of the Dow Jones:

Source: Chart of the Day

The 15 largest annual declines in the history of the Dow usually lead to a reversion to the mean. But not always. The 1930’s were as you’d expect, a wild card where bad simply got worse. Of course, back then you didn’t have the Fed opening the liquidity spigots like today. The only other outlier is 1978 which was slightly down during the brutal 1970’s bear market. Not surprisingly, when we step back and get some real perspective, cycles are obvious and we tend to go from bad to better. This is basically what I argued that Why Long Term Investors Should Consider Buying:

Can things get worse? Of course. But at this point, if you have a long term time horizon, a cast iron stomach for risk, the data suggests you should be taking small positions and slowly adding to them cautiously, even if the market continues to tank. That may sound crazy, but where we are right now in market history, only comes about very rarely.

Boy did things get worse. And if you were foolhardy (or smart?) enough to have an unemotional take on the market and a long term view, stepping into the abyss wouldn’t have been all that horrible. You would have been buying into a decline but in 4 short months, it would be all over.

In fact, we’re starting to see signs of real strength in the market. For example, the number of new 52 week highs in the US markets has recovered to pre-crisis levels:

Source: Bloomberg

Usually any measure reaching bear market tops sends shivers down one’s spine but keep in mind that this metric has not reached an extreme level. For example, consider that it was much, much higher towards the end of 2003 or early 2000 (not shown on the above chart). Both extremely unfortunate times to be long the equity markets. Right now however, we’re just seeing some resilience not speculative mania.

Yes, yes, I know the market is pricing in some insane numbers, including ginormous positive GDP growth and totally ignoring unemployment and a half-a-dozen other factors. What you have to remember is that the market does this all the time. In a bear market, it ignores bullish arguments repeatedly - until it doesn’t. And vice versa. So why argue?

Well, that didn’t take long. The S&P 500 is only down less than 5% from last month’s peak and already we’re seeing signs that this shallow correction has reached important levels.

Take for example the percentage of stocks closing above their 10 day moving average. This simple breadth measure is surprisingly accurate at finding inflection points, both in the short and intermediate term. According to a study from Lowry Research which I shared with my readers a few years ago, it has an almost perfect track record: Latest Research Report From Lowry Research (2007).

The key level to watch is 10% - which we breached on Friday. Here is a chart of this breadth measure for the components of the S&P 500 index:

This wasn’t limited to just the most popular stock market index. Other indexes provided a similar outlook. Take for example the Nasdaq 100 index where 9% of the stocks closed above their 10 day moving average. Lowry’s operating company only version of this breadth measure was 8.13%, which is the lowest since March 2009.

We can add to this the McClellan Oscillator which is another measure of market breadth. If we strip out the ETFs, CEFs, and other ‘junk’ from the NYSE and just consider real corporations, this operating company only index’s (Ratio Adjusted) McClellan Oscillator is as oversold as it was in March 2009.

But other metrics like the short term average of the daily Nasdaq advance decline numbers are still quite high. So is the percentage of S&P 500 components which closed above their 50 day moving average. In an important bottom, this number can fall to 20% (and lower) but so far the lowest it has reached is a lofty 53.6%.

A note of caution before you jump to conclusions. Interpreting this type of data can be rather tricky. That’s because these measures of internal market breadth act differently during different market conditions. In strong bull markets they can levitate for prolonged periods of time at atypically high levels. While in bear markets they oscillate with much more volatility.

The best way to look at this market juncture is to see it as a litmus test of the spring rally. Just as we went over when we updated Lowry Research’s latest views on their intermediate buy signal, this correction was expected. The best way to take advantage of it is to see how the market reacts to it and specifically how the market internals deteriorate in the face of a decline in stock index prices.

A shallow correction followed by a sharp rebound with very limited damage to the underlying breadth of the market would be a tell that this is a real cyclical bull market and not just a prolonged bear market rally.

The fabled trillion dollar cash hoard that US mutual fund investors are sitting on is well known by now. But what isn’t equally well known is just what they are doing with all that cash. We do know that after reaching a peak right at the March lows, the shell shocked US retail investor stopped stuffing cash into their accounts.

At its peak the cash hoard was about $4 trillion dollars. By the start of this month, it was down to $3.56 trillion and the most current data shows that retail investors have continued to slowly exit their safe haven, taking the number further down to $3.48 trillion. So where have all those billions of dollars gone?

From the fund flows data it seems that the vast majority of it has been funneled to the fixed income market, and more specifically, taxable bond funds. I showed a pie chart of the fund flows in last week’s sentiment overview to juxtapose the extremely skewed ratio of money flowing into bond funds vs. equity funds.

But a pie chart doesn’t really do the data justice. To get a much clearer idea of what is going on in the hearts and minds of the average US retail investor, let’s take a look at how they’ve allocated their money between domestic equity funds and bond funds:

The data for the bond funds is for both taxable and municipal bond funds. As well, this month’s data point (shown in a darker shade) is partial because it including only the first 3 weeks. Nevertheless, this chart is a telling a remarkable story.

First, not surprisingly, as the bear market took hold, people started to react by taking their money off the table. The worst month was October 2008 (not March 2009) when $72 billion was withdrawn from equity funds - $47 billion of that from domestic funds. At this point of maximum panic, US investors sold everything, even bond funds. They only trusted one thing: cash.

But by the start of the year, while they still distrusted the stock market, they began to change their mind about bonds. Each month they put more and more money into bonds, even as the stock market launched on an astonishing rally.

Month after month, as the S&P 500 went on to higher highs, US investors continued to ignore equity mutual funds. Then most shockingly, during the first 3 weeks of this month, they actually withdrew funds from this asset class! At this rate, by the end of the month, we’ll see outflows equivalent to December 2008. All the more astonishing as the S&P 500 is hundreds of points higher.

This is simply astonishing. What exactly does a stock market have to do to get some respect around here?

Bullish
There are two ways we could look at this. If you’re bullish, you would say that the fact that the retail investor (or “dumb money”) has not jumped on the bull market bandwagon means that this is the real deal. After all, secular bull markets are known for pulling out of the station and leaving all but the most savvy investors and traders behind. And as contrarians, we want to zig where the crowd is zagging. So let them shiver, coiled in the fetus position, terrified of the last (and past) bear market. This is a new dawn. A new day.

Bearish
On the other hand, if you are bearish, you would point out that retail participation is vital to create momentum in a trend. Unless the US retail mutual fund investors start to believe in a bull market, there won’t be a bull market. After all, if the considerable amount of money sitting in fixed income is not used to bid up equity prices, how will we create the virtuous cycle of higher prices (which pulls in more money and so on)? Every secular bull market feeds on this self-perpetuating mechanism.

Could it be that this bear market left a traumatic mark on the psyche of the average US investor? If so, then this generation of investors will simply not be the same. We know from previous brutal bear markets that while the wounds heal, the scars are not forgotten. The generation that lived through the Great Depression continued to distrust banks, the stock market and all manner of ’speculation’ even after the US economy righted itself and went on to new heights of prosperity.

Let me know what you think
In any case, those are my thoughts. What do you think accounts for this aberrant behavior of the US mutual fund investor?