Trader’s Narrative

Last week I presented a historical study of what happens when the S&P 500 is this far away from its 200 day moving average. If you missed it, click the link to check it out in full.

According to the study, when the stock market has trended enough to set off this indicator, it has trouble continuing its heady ways in the months that follow. The average 6 month return is -5%.

If you look at the data carefully, it becomes apparent that certain date ranges contain a lot of repeated instances where the S&P 500 index is 20% or more above its long term moving average. We’ve just traversed one of these periods from September 16th to the 22nd. Between those dates there were 5 consecutive days were the S&P 500 was at this threshold (or very very close).

The last time this occurred was at the end of July 1997. But the best example was of tenacity in this indicator was in late 1982, just as the great generational super bull market was launched. Although the expected consequence of such an overbought condition is for the market to hit a wall, or at least to pause, during the start of the great bull market, this was not the case. While it continuously flashed red, the stock market continued to climb higher and higher, acting very out of character.

So the question is whether what we are seeing is a repeat of that atypical market action. In other words, do bull market rules apply?

Although there is no way for me or anyone else to prove it definitively one way or another, I highly doubt that what we are witnessing is the dawn of another rare secular bull market based on one variable: valuation.

I mentioned a lot of ratios, statistics and data before but putting all those numbers aside, here is a simple chart which sums up the strange voyage we have taken, from fully priced perfection to panic induced forced liquidation and back again:

That doesn’t look like a great launch pad for the next generational bull market. Heck, even bonds are priced for perfection. At best, we are going through a cyclical bull market - otherwise known as a bear market rally.

If we step back from the day to day movements of the stock market and take a very wide perspective, we notice some overarching cycles at play. One of these is the 18 year stock market. Some, like Art Cashin in the video below, express it as a 17.6 year cycle but in reality this is not a precise determination. The 18 year cycle is more an average than an accurate, regularly repeating cycle:

Since stock prices are supposed to be random, it is odd to find such an orderly pattern. Why equity prices follow this rhythm may not be so befuddling if we consider commodity prices as their counter balance. For example, zooming in, we can see the period from 1980’s to the present for the Reuters/Jeffries CRB Index, the most popular proxy for the commodity markets:

While the equity markets went on a generational bull market from the 1980’s to their top in 2000, the commodities markets were in a painful and protracted bear market. This wasn’t just a coincidence. Over the long term, equities and commodities are on a teeter totter: when one is up, the other down; when one wins, the other loses. Of course this relationship isn’t evident until you step back from the short term fluctuations.

The rationale for this is simple. The price of physical goods are expenses for corporations as they are the raw materials to produce things. When the costs increase, profits decrease. This trend continues until it reaches an inflection point where it can not continue. Profits decrease and a retrenchment takes place. Demand decreases for raw materials and their prices fall.

Then this trend continues until investments in the acquirement and production of raw materials is ignored. Mines take billions of dollars to develop and can take decades to ramp up production. Oil reserves likewise are expensive to find and exploit. As the current supplies are depleted, the prices of physical goods rises. It continues to rise until it reaches a tipping point when investment in the sector once again is lucrative. And the wheel turns again.

I was introduced to this cycle when I read Hot Commodities by Jim Rogers. This is a great introductory book to the commodities markets by the way. I highly recommend it.

According to economist David Rosenberg, we are halfway through the current bear market. This estimate is in keeping with the 18 year cycle if we assume that the top was in early 2000. And the counter estimate is that we have the same period of time left in the commodities bull market. But something is amiss.

The CRB index crumbled 57% from its top in 2008. We haven’t seen such a decline before in a commodity bull market. Those are serious deflationary forces at play right now in the world economy. Which is why central banks are throwing everything and the kitchen sink at it to prevent it from spiraling out of control. Here is a free 60 page book from EWI about the dangers of deflation and how to position yourself both defensively and offensively to benefit.

Rosenberg continue to believe in a healthy commodity bull market but I’m not so sure. What we saw last year was not a normal bull market but a speculative bubble caused by lax regulations which allowed large institutions to run roughshod over everyone else and walk prices higher. The aftermath of bubbles is always ugly and unpredictable to some degree so I have my suspicions that the regular cycle was tampered with, in a sense, by this.

Art Cashin on the 17.6 Year Cycle:

Maybe my problem is that I try to understand things. So here I am, amid all this hue and cry about interest rates shooting to the moon in order to contain rapidly rising inflation and I find myself asking, inflation? what inflation?

The CRB commodities index broke down from its long term uptrend line last year and has been going lower since. And gold, probably the most watched gauge of inflationary expectations, has just done the same.

Last friday gold didn’t hold the $665 level which was support provided by the long term trendline (see graph). Instead it easily sliced through in a wide range bar and reached a low of $647.80.

Not the sort of price action that is congruent with an inflationary scenario, wouldn’t you think?

I’ve been wary of gold for a while now. But in any case, bonds have been taken to the back alley and beaten to a pulp. Time to buy the panic?

If there is an opportunity, it’s between now and Friday morning - when the CPI numbers will be released. You know the drill: buy the rumour, sell the news.