Trader’s Narrative

The market is full of cycles. Some are fast and others like the inter-relationship between the small capitalization and the large capitalization subset play out at a glacial pace:

The stock market seems to go through these slow, vast cycles between large caps and small caps and they usually last about 5 years. Most surprisingly, they resemble a sine wave - with some noise thrown in - which is surprisingly orderly and predictable.

But we seem to be in a rare exception right now when the market can’t make up its mind who is winning and who is losing. Since 2005 we’ve been in a holding pattern with the ratio of small caps relative to large caps around the same level as 1994.

This is around the area where small caps have given up the fight and large caps taken over. Going back 30+ years the ratio topped out higher than this level (approximately 0.80) in 1984. So based on historical precedent, we should see large caps take the stage for the next few years.

The real question though is what does it mean? I’ve turned it over but I can’t detect any edge from this slow back and forth cycle. Especially for timing the market.

Having an idea of where we are in the over all scheme of things may be helpful if you’re going to go long one and short the other but it doesn’t seem to be all that helpful when you’re simply asking if it is a good time to short or go long either market by itself.

For example, while 1991 was a trough, it corresponded to the start of a period of years where the S&P 500 did quite well. But in 1994 where the ratio topped, that was arguably also a good time to buy. And then finally, in 1999 and 2000 when the ratio was pushed down again, that was not a good time to be invested in the market going forward.

If you’re not familiar with Bullish Percent charts or how they are calculated, check out my previous post on How To Time the Market With Bullish Percent Charts. I use them to find inflection points, which is different than their creator’s intention.

The Nasdaq Bullish Percent Index reached a recent high of 51.36% and more importantly, it has hovered at or above the 50% level for 5 consecutive trading days:

Even more alarming, this is the corresponding level that we last saw in October 2007, just as the brutal bear market was about to descend into Wall St. In the past 10+ years, the Nasdaq Bullish Percent Index has had a tough time going higher than 50-60%. The only exception was in 2003 when we saw BPI pushed to 78% by the powerful new bull market.

So not only are we back to Bullish Percent levels where the bear market started, we are at levels which have historically marked tops in the equity market. The only justification for new long positions here, or continuing to hold on to existing long positions, is the expectation that we are going to see yet another powerful non-stop rocket ride as in 2003.

Anything is possible but considering everything, I think that scenario is highly improbable.

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The following is excerpted from Robert Prechter’s Independent Investor eBook. The 75-page eBook is 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.

By Robert Prechter, CMT

…The natural tendency of people to apply physics to finance explains why successful traders are so rare and why they are so immensely rewarded for their skills. There is no such thing as a “born trader” because people are born — or learn very early — to respect the laws of physics. This respect is so strong that they apply these laws even in inappropriate situations. Most people who follow the market closely act as if the market is a physical force aimed at their heads. Buying during rallies and selling during declines is akin to ducking when a rock is hurtling toward you.

Successful traders learn to do something that almost no one else can do. They sell near the emotional extreme of a rally and buy near the emotional extreme of a decline. The mental discipline that a successful trader shows in buying low and selling high is akin to that of a person who sees a rock thrown at his head and refuses to duck. He thinks, I’m betting that the rock will veer away at the last moment, of its own accord. In this endeavor, he must ignore the laws of physics to which his mind naturally defaults. In the physical world, this would be insane behavior; in finance, it makes him rich.

Unfortunately, sometimes the rock does not veer. It hits the trader in the head. All he has to rely upon is percentages. He knows from long study that most of the time, the rock coming at him will veer away, but he also must take the consequences when it doesn’t. The emotional fortitude required to stand in the way of a hurtling stone when you might get hurt is immense, and few people possess it. It is, of course, a great paradox that people who can’t perform this feat get hurt over and over in financial markets and endure a serious stoning, sometimes to death. Many great truths about life are paradoxical, and so is this one.

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.

Robert Prechter, Certified Market Technician, is the founder and CEO of Elliott Wave International author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

The better analogy in my view is to compare individual investor’s behavior with that of an animal in a herd. Through evolution, we have learned that the “safest” place to be is with the pack or the herd and venturing out on your own can get you eaten. But it is only by doing what others aren’t doing that you gain what other’s miss. As long as you simply go along with the crowd, you’ll be “safe” in the sense that you’ll share the same experience as everyone else (and be able to commiserate during tough times) but you’ll never gain anything extraordinary either.

Whatever analogy you use, the lesson is the same. We are barely more than our “lizard brains” and being able to transcend emotions which lock you into a cycle of behaviors is paramount if you want to be able to achieve above and beyond the average.

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In late November 2008, the S&P 500 index was trading at 850, when we looked at a chart of the 10 year rolling returns. The 10 year return back then was -23% - although horrendous, not one of the worst we’ve seen in history. It still made me consider that it was reason enough Why Long Term Investors Should Consider Buying:

Flash forward a few months to take into account the continued erosion of the S&P 500 and we have the updated chart above. Using the most current data, we have a rolling 10 year return of -45.67% (not including dividends).

How bad is that? There are only a few months that were worse. And they were all around the 10 year anniversary of the 1920’s top:

• 8/1/1939 -61.66%
• 9/1/1939 -59.20%
• 7/1/1939 -58.88%
• 4/1/1939 -57.16%
• 6/1/1939 -56.29%
• 5/1/1939 -56.24%
• 5/1/1940 -55.81%
• 6/1/1940 -55.07%
• 10/1/1939 -53.91%
• 7/1/1940 -52.56%
• 4/1/1940 -51.81%
• 3/1/1939 -51.28%
• 8/1/1940 -50.94%
• 2/1/1939 -50.38%
• 1/1/1939 -49.72%
• 3/1/1940 -49.25%
• 9/1/1940 -48.85%
• 2/1/1940 -47.03%

The monthly data I used went from January 1st 1910 to present (March 1st 2009) so what we are saw as a 10 year simple rolling return is in the worst 1.5% of months for almost 100 years.

Just imagine the stories you’ll tell your grandchildren about the Great Decession. And all the major players: Madoff, Bernanke, Bush, Obama, Greenspan, etc. These are truly historic times we are living through.

Some have written me and questioned the validity of the original market call back in November 25th, 2008. As way of explanation, let me say first, that unlike a loud TV personality, I don’t pretend to know what the market will do - nor am I claiming that you should in me trust (cough Cramer cough). You should base market decisions on your own due diligence. Taking into account something I write is fine, as long as you do your own thinking afterward.

In any case, I made it clear that this was intended for long term investors. Not traders. Long term investors can still make a killing even if they are off a bit. You are either going to get in early, and share in the continued decline of the market, or you’re going to get in late, and pay opportunity costs. But if your time horizon is 25+ years, you don’t really care about a few percentage points here or there, your aim is to catch the big wave.

Even if you disregard the chart above and the fact that we are going through a rare and magnificent opportunity, you have to sit up and take notice when great market timers like Barry Ritholtz, Doug Kass, Jeremy Grantham, Warren Buffett, etc. turn bullish en masse.

Back in November 2008, when the market was just days away from making that year’s lows I pointed out an ominous double top formation on the S&P 500 index.

The market managed to bounce from that support but when it was tested again last week, it wasn’t strong enough. The double top formation has unquestionably completed. The only remaining quandary is will it complete?

Before I showed a log scale chart (see above link), so here’s an arithmetically scaled chart of the double top:

If we take the neckline to be 776 on the S&P 500 (the 2002-2003 bear market low) and the top to be 1576 reached in October 2007, then a measured move would be meaningless because it would require the market to drop 800 points - something it can’t do right now. Unless we invent a way for stocks to go into negative integers.

Even half-way completing such a measured move would mean utter catastrophe for the stock market and by extension the global economy. Especially if it happens suddenly.

Before you think that is completely impossible, consider the reality that a long term Japanese investor faces:
Continue reading ‘Are We Headed Back To 1980?’