Trader’s Narrative

From City Slickers

This is a guest post by Wayne Whaley (CTA):

Before I share some statistics with you on the impact that positive September’s have on the last quarter, I’m reminded of a scene in one of my favorite comedies, “City Slickers”. Billy Crystal’s character Mitch fancies himself a cowboy and in an attempt to bond with Jack Parlance’ character Curly he pulls up next to him on the cattle run and whimsically wishes Curly a good day and ask him if he’s killed anybody today. Curly stares at Mitch, unamused and responds, “Nope but the day ain’t over yet”. Mitch fades back into the pack of his wannabe cowboy buddies, fearing that he might not live through the day.

So with the fact that September is up 4.4% and still has 8 trading days remaining, I hesitantly share the following statistics with you, hoping that I haven’t jinxed the rest of the month. I preface the table with the comment that September is historically the weakest calendar month of the year and the ability for the market to buck the trend is a sign of strength for the rest of the year. The table shows all Up Septembers since 1950 followed by the Pct Change in both October and the total 4th quarter.

Positive Septembers vs. October & 4th Quarter (for the S&P500):

There were only two significant fourth quarter losses following a positive September: in 1973 & 2007. Using the logic that “if the market can buck the seasonal trend, go with the trend”, since most November-Decembers are up, the losses in 2007 and 1973 were a very timely harbinger of worse things to come.

This is a guest post by Wayne Whaley (CTA):

I have written over the last few months on the importance of the historic momentum thrust that we have experienced this year and how they could possibly push the market higher than most would anticipate.

Today, Sept 16th, 58% off the lows of 666 on the S&P, I am rolling my eyes, looking to the heavens in disbelief and sharing with you that today we had the third “Ten Day 2:1 Advance Decline” reading in the last 6 months. The previous two were on March 23rd and July 23rd. I haven’t had a great deal of time to study it yet, but it appears unprecedented with really very little to compare too. But I would caution against interpreting this as a sign of an overbought market. As I have shown in the past, single 2:1 advance decline thrust signals are very bullish. Two in a short period of time, even more so, and I am assuming until I find evidence to the contrary that a third is bullish as well. Since I have no tri-signal data, let’s take a look at the three other occasions where there were double signals in a short period of time.

The table below shows the three previous double signal dates, followed by the percentage change in the S&P 500 and the returns 3, 6 and 12 months later.

Double Ten Day 2:1 Advance Decline Signals in less than six months:

Note that these three previous double readings occurred in different decades and notice that although the second reading came well after the initial advance was launched, the S&P 500 gained an average of an additional 26.37% over the next year, with nary a less than 24.28% gain. The S&P 500 index is currently up 9.5% since the second thrust that occurred on July 23rd, 2009.

This market is similar to all three of these markets in some ways. But appears to correlate the closest with 1975, which similar to this rally followed a 48.4% sell-off in equities that lasted 20 months; was often postulated to precede the next great depression and was accompanied by massive federal stimulus.

For much of the last 6 months, analyst have compared the recent rally to the bear market rally that took place between November 13th 1929 and April 17th, 1930 - rising 48% over five months. One can not totally rule that possibility out, but a major difference was the fact that in 1929, the preceding sell-off in stocks occurred in only two months, while the current rally followed a 15 month long bear market. It seems that in just in the last few weeks such comparisons have dissipated.

I understand that it works against human instinct to buy the market this high off the lows, but I assure young readers that investors in 1975 and 1982 had the same dilemma. If you have been waiting and are tempted to reenter, I suggest dollar cost average into it.

I see a lot written on indicators that are at historic levels with many interpreting this market as overbought. But if you look back through history, anytime there is a 50% or more move in the major indexes, the oscillators, sentiment indicators, etc, that are bounded from x to y are going to be tested repeatedly. Divergence analysis between range bound indicators and a potentially rangeless market tend to mislead at such times.

Yesterday, the S&P 500 continued to make new highs for the year, almost reaching the round number 1050. But even as this major index continued to climb, several measures of internal market breadth haven’t kept up the same pace.

For example, here is the Nasdaq Summation Index chart showing that it is well below its high in May 2009:

The last time I mentioned a similar divergence was in June 2007 when the Nasdaq McClellan Summation Index was coiling as the S&P 500 was acting strong. Of course, armed with hindsight the S&P 500 didn’t soldier on much higher. While the breadth measure showed a weaker and weaker market internal, the index finally succumbed to a severe bear market.

Having said that, I’m not sure that this is necessarily a huge red flag for the market. Well, let me backtrack a bit. I think it could potentially be slightly negative but only in the short term. In the long term, there are other forces at play which seem incredibly bullish.

We’ve already covered the stupefyingly powerful rally: zero new lows and the intense positive breadth thrusts. For a clue about why there may be a very powerful underlying force driving the market, take a look at the ratio of new highs vs. new lows on the Nasdaq:

The last time we saw the stock market behave with the same single minded intensity was in the summer of 2003. And that set the stage for a cyclical bull market, of course.

Persevering readers would remember just a while ago when I was Comparing Market Breadth to 2003 and in trying to answer the main question on everyone’s mind (is this just a bear market rally or the real thing?), said:

… what this analysis tells us is that the recent rally was one where a small subset of the S&P 500 rallied, pushing the averages higher. To see a change in market tone, we need to see almost all shares trade above their long term moving average. We can not start a healthy bull market with a few extremely strong shares pulling the rest along for the rise.

I think we arguably have that now. In fact, if we look at the breadth chart which was featured in that past post, we see 95.6% of S&P 500 components above their 150 moving average. That’s higher than the brightest interval in the 2003 bull market launch.

And turning to the more short term breadth measure, there are 92.6% of the S&P 500 trading above their 50 day moving average. To see equivalent positive breadth, we would have to go back to the early days of the 2003 bull market.

The next trick the market has to perform to convince me that this is indeed a genuine cyclical bull market is to maintain positive breadth at this level (or close to it). And to do this, even if we have some profit taking in the S&P 500 itself. That is exactly what we saw throughout 2003 and into 2004.

So far, today’s market is showing promise in this regard as well. The shallow correction in July of this year was met with an equally shallow breadth damage: the percentage of S&P 500 components trading above their 150 moving average didn’t fall below 60% before recovering smartly.

Conclusion
Over all, this market has defied the vast majority of traders and investors in rising as far and as fast as it has. The recent divergences we are seeing are negative but the nature of divergences are that if they do not have a consequence in the short term, they can continue for much longer than most predict.

Much more important in my view is the powerful breadth which is propelling the index higher. Rather than just a handful of stocks taking the averages higher, we are seeing an almost unanimous participation. And that not only bodes well for the continuation of this rally, it speaks of a change in underlying tone.

This bear market we’ve just had (is it over?) has been one fit for superlatives. So why not its inevitable counter-rally (or is it a bull market?).

The chart below is from economist David Rosenberg who now plies his trade at Gluskin & Sheff. In it he points out that what we’ve seen since the spring of this year is the Sharpest Equity Market Rally Ever in the Context of Pricing Out of the Recession:
(Click to see a larger graph open in a new window)

That’s a 54% rise from March 9th 2009 to September 11th, 2009. The closest rally in comparison is 44% in 1929-1933.

Is this recession over? No one really knows. But the sharpest rally ever from within a recession is just one more notch in the belt of this bat$hit insane market.

I, for one, look forward to becoming a curmudgeon and poking my grand kids with my walnut walking stick as I regale them with tales from the bear markets of 2000 and 2008.

We’re getting a distinct message from the sentiment data that this rally, whether a bear market or cyclical bull market (or the first leg of a secular bull market) has overstayed its welcome.

If you have bearish leanings, then you wouldn’t mind comparing this recent 6 month old rally to ones that we saw in the aftermath of the great bear market that followed the 1929 top:

Source: Chart of the Day

This rally is now longer than almost all counter-trend rallies during the 1929-1932 bear market. It is only comparable to the biggest one (November 1929) which lasted 155 days and lifted the Dow by ~50%.

If, on the other hand, you have bullish leanings, then you would appreciate that we are following fairly closely the script provided by the aftermath of previous bear markets. Next up would be a shallow retracement and then a rather protracted trading range (click to see graph in previous link).

As well, looking back at previous cyclical bull markets since the 1940’s, we again seem to be following a familiar script. The data to the left is courtesy of InvesTech Research dividing each cyclical bull market into two phases. It is normal for the first 5 months of a rally to be robust while the following months are more lethargic. In fact, on average the returns in the first 5 months have been double those of the next 5 months. Which would again imply that going forward, we can not expect similar returns.

Seasonality
Don’t forget, we are also about to step into September - a most notorious month for stock market returns. Mark Twain famously wrote:

October: This is one of the peculiarly dangerous months to speculate in stocks in. The other are July, January, September, April, November, May, March, June, December, August, and February.

He was close, as he should have singled out September as the most dangerous time to be long. From 1896 to 2008, the average return for September has been -1.2%, the very worst of months. As well, in the more recent market history (20 and 50 years) the negative performance drag of September has been even more pronounced. Moving on, after September, the next worst month is February (probably because of profit taking after the January effect). And the best month? December, of course.

To illustrate just how damaging September is, imagine for a moment that you had a rich ancestor way back in 1900 who, for some masochistic reason, decided to invest the princely sum of $1000 in the Dow Jones but only during the month of September (and go to cash the rest of the time). Here’s the value of your inheritance over time:

Source: Have a happy September. Or not.

Believe it or not, after more than 100 years of investment in the Dow, the original $1000 would be worth just $251 today. That’s a heart-stopping loss of -75% for over 100 years of one month investment. So obviously, doing the opposite would give you a leg up. But you may not believe just how much of an improvement you would squeeze out of just skipping one single month! Compared to a simple buy and hold strategy through thick and thin over the 100+ years, skipping September would give you 4 times the return!