Trader’s Narrative

A few months ago I started to pay special attention to a remarkable but little followed technical indicator called the Coppock Curve or Guide. Peering ahead and assuming that the market would hold firm, I mentioned that by the end of May we would have a definitive buy signal. The market’s strength was impressive, as we all know and the signal did arrive for a new bull market.

Although of course, it remains to be proven beyond a shadow of a doubt that we have seen the low for this cycle, it looks to have been a valid signal. Returning to our hypothetical forward extrapolation of index levels, the Coppock Curve continues to act very bullish as it continues to rise out of the depths it had fallen to:

Source: InvesTech Research

If we assume that the S&P 500 index will close approximately where it is now by the end of August, then the Coppock Curve would continue to recover extremely fast, reaching -344. That is well above its February 2009 level and closing in on its January level.

That’s assuming that the market is unchanged until month’s end. But what if the market trips up from now until then?

In that scenario, the Coppock Curve still has a good chance of continuing to rise. In fact, the S&P 500 index would have to fall more than 200 points, below 780, for the Coppock Curve to stop climbing. That’s a hypothetical +20% decline.

And that is probably one of the positive consequences of this spring rally. Even if we were to give back 50% or even 65% of the advance, the market would still be able to carve out a higher low and a higher high - the very definition of an uptrend. Such a correction wouldn’t be surprising, especially when you consider the over confidence signaled by the various sentiment measures. But it would only wash out the weak hands and allow the market to continue higher.

While the track record of the Coppock Curve is impressive it is not perfect. If you squint hard enough, you’ll be able to make out the rare two times that its upturn did not mark a significant trend change.

But even so, since many are comparing this bear market to the one that came 80 years ago, it should be noted that the Coppock Guide was one of few technical indicators which allowed for the correct navigation of the bone crushing volatility of the 1929 bear market. During the aftermath there were several intense bear market rallies that fooled many. But they were all ignored by the Coppock Guide as it fell unrelentingly into the deepest level it has ever seen historically. Only in 1932 did it correctly give the all clear.

The Coppock Guide. Just a while ago no one knew it even existed. I’m willing to bet even if you mentioned it in a room full of TA buffs, you would get quizzical looks all around.

But now suddenly it is the belle of the ball! Everyone is talking about it. There is a buzz in the blogs, Bloomberg, MarketWatch (WSJ) have stories on it and even CNBC’s Fast Money, which normally has the attention span of a fruit fly gives it a mention (see below for video). To be honest this is exactly what I was afraid of when I first hesitatingly brought it to your attention in Conditions of a Bull Market. I’d rather it remain the esoteric indicator it used to be (hopefully everyone will forget all about it).

The question remains: is it useful?

I tend to think so but some disagree.

Mark Hulbert looks back all the way to 1896 and calculates the success of Coppock Guide signals on the Dow (see article). His conclusion is that the returns are not indicative of an edge.

However, what Hulbert doesn’t point out is that although the Coppock Guide for the Dow Jones Industrial may be a poor indicator, that doesn’t mean that it is for other, more respectable indexes like the S&P 500. What Hulbert does point out in a subsequent article is that even for the Dow Coppock numbers, the two false signals in the 1930’s skew the results and if we look at more recent data, the indicator does have an edge. So the question is how relevant is the 1930’s to the current market?

Guy’s analysis at the Technial Take also falls into the same trap as Hulbert by looking at the Dow Jones Industrial. I don’t want to rehash why the Dow is inferior to the S&P 500 (price weighted vs. capitalization weighing and small sample size of 30 vs. 500). The only time I give the Dow more respect is in the Dow Theory analysis of the market.

On the other side, there are those that see the Coppock Curve as a valuable guide:

James Stack of InvesTech is one of them. Formerly an engineer by training (who worked for IBM) Stack’s whole approach is a blend of quantifiable edges (whether technical or fundamental) and sentiment analysis. But he doesn’t rely on the Coppock exclusively.

Another is Steve Leuthold of Leuthold Weeden Capital Management. He calculates a similar indicator that he calls the VLT Momentum (”very long term”). I consider Leuthold as one of the ‘grey beards’ who get my respect for their successful navigation of the market over decades. Recently Leuthold has turned even more bullish (after nailing the March low).

Next is Jason Goepfert of SentimenTrader. Recently Jason did a complete analysis of the Coppock signals (using the S&P 500) and showed that it has a definitive edge, especially on a risk adjusted basis. To see the data get a 14 day free trial and take a look.

In the end, the headline is rhetorical because I’m not really going to defend this or any other indicator.

First of all, it is just that, an indicator, with all the inherent flaws and limitations. I don’t expect anyone to exclusively trade off it. In fact I think that would be nuts.

Second, one has to just look at the data. How you want to take advantage of the Coppock Curve, if at all, is really up to you. Above you’ll find enough information to make up your own mind. But treat it as a starting place and do your own research. Then drop me a note - whether positive or negative.

Finally, the Coppock Curve is just one of the conditions for a new bull market - I’ll cover the others soon. I pay much more attention to the weight of indicators, rather than just any one in particular, no matter how impressive its historical performance may be.

Here’s an incredibly shallow analysis of the Coppock Guide (what else did you expect from CNBC?):

While we were in the thick of the 2008 bear market, I looked ahead and provided a road map for the conditions of a new bull market. Among them was the Coppock Guide.

At the beginning of the year I provided a hypothetical projection to demonstrate that the stock market would have to go on one hell of a bullish rampage to pull the Coppock Curve up from its death spiral. A few months later, a rally that almost no one foresaw took us 40% higher.

Then at the beginning of May, I reiterated that a Coppock buy signal would be arriving by the end of the month, as long as the market held it together and didn’t fall any further.

Well, we are finally here and the Coppock guide has provided a definitive signal by turning up - this is the buy signal that we had been anticipating:

I know, I know, it is impossible to see on the chart but believe me, it is there. To see a zoomed in view of the chart, check out the previous links. The S&P 500 Coppock Curve stopped going deeper into negative and actually increased from -417 at the end of April to -409 at the end of May 2009. All it would have taken was a one point increase but we got 8 points.

Now that we have a signal, what does it mean?

Well, obviously, it means we have the wind at our backs. The Coppock Guide has been a reliable indicator of the long term market trend. But, like everything else, it isn’t full proof - as you can see from the false signals. So with that in mind, here are three major observations:

First: The signal isn’t just for one index or market. We are seeing the Coppock Curves for many different markets around the world turn up at the same time. The Australian All Ordinaries, the Nikkei, the FTSE and all 3 major US market indexes: S&P 500, Dow Jones Industrial and the Nasdaq.

While most of the signals are occurring concurrently, some like the (Chinese) Shanghai market and the Nikkei gave signals last month. Check out all the major world markets to see how just how much confirmation we are getting from them.

Second: Valid signals are those that turn up from under the zero line. And historically, the deeper the level at which the signal arrives, the more strength the following bull market has. This most recent signal is coming from a deeply oversold level - the most since 1938 (-417 to -400) and even further, 1932 (-643 to -616).

Of course, that doesn’t mean that from now on the market has only one direction - up! Based on the sentiment and technicals covered before (Wedge Formation), I think it is probable that we will head down, but won’t break the previous low. This will allow for the long term moving average to flatten out and begin to support, rather than hinder prices from going higher.

Third: Although the Coppock Curve has given its share of false signals, we haven’t seen any occur when the metric has curled up from such a deeply negative level. There are very few examples of this, so it is difficult to extrapolate a rule but so far, this has been the case.

There are many different ways to value the stock market. We are waiting for the Coppock Guide to give us a signal by month’s end (just a few more days left). The usually reliable price earnings ratio has gone haywire, but the dividend yield ratio is still valid.

But what if I told you there is an even better way to sum up the valuation of the stock market in just one number? A method that is both rational and comes with an astonishing track record, having identified every single generational buy opportunity?

Tobin’s Q was created by the late James Tobin, a pre-eminent economist and professor at Yale. His work garnered him a Nobel prize “for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices.” But he’s probably best known for his work on the stock market. Put simply, Tobin’s Q is a ratio of the current value of the market divided by the replacement value of those same assets.

Think of a factory. It has a market price at which it would be bought and sold. And it also has a replacement cost - what one would have to spend to rebuild it from scratch. The ratio of the two is Tobin’s Q. Obviously, that would imply that when the ratio is greater than 1 the market is overpriced because one could theoretically ‘rebuild’ it for a cheaper price than it would take to purchase it. The Q ratio for US equities has fluctuated between 0.3 and 3 in the past 130 years.

It has signaled all the great bear market lows: 1982, 1974, 1949, 1932, 1921. Tobin’s Q moves at such a glacial pace that other indicators - even the Coppock Curve - seem twitchy by comparison. But when it does approach an extreme, it pays to give it the respect it deserves.

The best book on Tobin’s Q is Valuing Wall Street by Andrew Smithers (of Smithers & Co.). It came out at the same time as Shiller’s more famous Irrational Exuberance.

Both books had the same message and both were published at the exact peak of the 2000 bubble, but Shiller’s work got more attention because it was written to be more accessible to the general public while Smithers is more targeted to educated traders and investors. Although both books are good Shiller’s book stole much of Smithers’ thunder. You can pick up a copy from Amazon for less than $4 - which is a steal really.

As you might imagine, calculating the replacement value of such a diverse set of ever changing assets is mind bogglingly complex. Thankfully, the Federal Reserve does the heavy lifting. They provide the data in the Flow of Funds Report (pdf document). Look for the numerator on B.102 line 35: Market Value of Equities Outstanding (on page 103) and the denominator: Net Worth on line 32 (same page).

So the ratio resolves to:

9554.1 ÷ 15389.8 = 0.6208

Due to the nature of the data, it is only available quarterly with a lag of a few months. The latest report was released March 12th, 2009 which means the above number is for the fourth quarter of 2008. We should be getting the release of data for the first quarter of 2009 soon. But some analysts also guesstimate the number ahead of time. John Mihaljevic, the former research assistant to Tobin says the current value of Q is around 0.43 - which would be extremely close to the historic low of ~0.30. Following the previous link, you can not only get further details but purchase his complete report.

Obviously the market could fall more and take the Q ratio down with it. But this is further evidence that we are much, much closer to a generational buy point here rather than somewhere along the line of a continuing downtrend. Similar to the Coppock Curve, the Q ratio is not only setting up for a bullish signal but one of epic proportions.

Here is a chart of the Q ratio (from 1952 onwards when Federal Reserve data is available):

While I was focused more on the shorter term technical wedge formation, I paid less attention the the more important downtrend line that is barreling down on price. Watch this video from INO.tv to follow along with this important analysis:

After today’s decline, we’ve broken to the downside, out of the lower trend line. Of course this could be a head fake but I don’t think so. Pretty every single measure of breadth, sentiment and technical indicator out there has been flashing a sell for a few weeks as the market ignored it and kept going up. It seems gravity finally caught up with price.

I don’t want to go over the many indicators we’ve already covered in the past few weeks so I’ll just briefly cover two. The first, the percentage of S&P 500 components that closed above their 50 day moving average has been not only extremely high, it has uncharacteristically stayed there for the past 30 days of trading. Today’s declines pushed it down from almost 90%.

Another specific indicator, the ISEE Sentiment index has been elevated sporadically since May 5th when it reached 225. Then on Friday (May 8th) it was 191 and on Monday 197. And more alarming, on a down day like today, when the S&P 500 and the Nasdaq ~3%, the ISEE was 179. That means even when we have a clear down trending day, retail option traders are still bullish enough to buy 179 calls for every 100 puts.

What we’ve been asking ourselves is whether this is a bear market rally or a nascent bull market. This is far more than a technical question to be answered for bragging rights. Fact is that distinguishing between the two allows us to calibrate the indicators that we look at. As I’ve mentioned before, breadth measures and sentiment act very differently during a bear market than during a new bull market.

For obvious reasons, there are precious few tools that this kind of guidance. The Coppock Curve, although not perfect, is one of them and by the end of the month we’ll have a better idea. For more information on this indicator, check out the previous link. The “line in the sand” is the 874 level for the S&P 500 index. If we can hold that by month’s end, even if we head lower, the Coppock Guide will have provided a signal.

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