Trader’s Narrative

When you take a step back and get a very long term perspective on the stock market, you realize that an apt analogy is a dog pulling on its leash. There is an overarching trend - which is the path set by the owner - but like a distracted puppy, the market can pull in one direction for short, intense spikes.

By watching the relative distance to its moving average we can tell where we are and how probable it is that we revert back to the very long term trend. This is what I referred to when I built a case for being bullish in March 2009: Another Reason We’ve Seen the Market Low. To my shock and horror, on November 20th 2008 the S&P 500 closed almost 40% below its 200 day moving average. It had never done that in the entire history of the index!

And in keeping with every other similar spike down, 60 days later, the index had recovered. In fact, we saw the sharpest rally to match the never before seen spike low.

We’ve now come full circle and are at the other end of the extreme. Last week, the S&P 500 closed 20.27% above its 200 day moving average. To give you an idea of how rare this is, here’s a chart of the S&P 500 relative to its long term moving average from 1950 onwards (click to see the larger version open in a new window):

Not only have we never seen this measure sink so low, we’ve also never seen it recover so fast! It took only 206 trading days for the S&P 500 to go from being 39.79% below its 200 day moving average to being 20.27% above it. The only other time we saw a similarly quick lurch from the abyss to the heavens was when bell bottoms and butterfly collars were the rage.

Back then, it took the S&P 500 only 185 trading days to go from being 28.8% below its 200 day moving average (on October 3rd 1974) to being 21.6% above its moving average (on June 26th 1975). That tidbit may be fascinating to know but I’m sure you’re wondering, so what happens when we are this far above the 200 day moving average?

To answer that, I went through the daily S&P 500 data and marked the appropriate dates where we approached or crossed the 20% Maginot line. Since such instances tend to clump together, I only considered the first date and ignored the repeats during the same month.

So for example, on May 5th 1975, the S&P 500 traded at 90.08 which was 19.66% above its 200 day moving average. Then a few days later on May 9th it closed slightly higher relative to its long term moving average (20.10%). I ignored all such repeats. I then calculated the forward 1 month, 3 month and 6 month returns (excluding dividends) from the first date. Here are the results:
Continue reading ‘What Happens This Far Above The 200 Moving Average?’

Last week we looked at the levels of cash and free credits being held in institutional and retail trading accounts in the US: Mutual Fund Cash Levels & NYSE Free Credits. I briefly touched on a research report on mutual fund cash levels by Jason Goepfert, who by the way, runs a great service at SentimenTrader. However, I wrote that:

Unfortunately, Goepfert’s research report does not take into consideration inflation or deflation but simply adjusts the level of mutual fund cash levels according to the 90 day T-Bill rate. I’ve sent him a message about this so hopefully when he’s back from vacation he can update it with this new twist thrown in.

Upon his return, Jason accepted my suggestion and lost no time in whipping up a new indicator which takes into account the added variable of inflation/deflation.

To be able to understand what this new chart is saying, it is helpful to go back to the award winning research report. In it, Jason argues that before we try to use mutual fund cash levels as an indicator, we need to adjust it for the prevailing interest rate environment. For example, in the 1980’s, with interest rates in the double digits, there was ample reward for sitting in cash. Stripping out this effect, therefore, is important because otherwise it is a distortion.

Using statistical modeling, we can determine how much cash should be held by assuming a certain level of interest (90 day T-Bill rate). After that, it is easy to compare the actual cash levels to this theoretical level to determine if mutual funds are overweight or underweight cash. Looked at this way, mutual fund cash levels are neutral, telling us that managers are neither overweight or underweight cash right now.

Alright, so what happens when we also take into account the effect of inflation or in today’s case deflation? In other words, the real rate of interest?

A completely different picture emerges. This isn’t surprising because we are currently experiencing real interest rates close to +6.5% - a far cry from the nominal rate of 90 day T-bills. Here is the inflation/deflation adjusted chart of mutual fund cash levels:
Continue reading ‘Mutual Fund Cash Levels Adjusted For Inflation’

This is not meant to be alarmist message but rather to illustrate how historical bear markets have behaved and also, to balance what seems to be a far too prevalent nonchalant calm about what is going on in the markets.

Although the classic definition of a bear market is a 20% decline, there is no reason why a falling market should stop at that limit.

In fact, previous bear markets have been much more devastating. As mentioned in the most recent edition of Barron’s, out of the last 10 bull markets (from 1940 onwards), only 3 other bull markets have not erased 50% or more of the gains they provided. The average bear market has delivered a 30% decline (for the Dow).

Back in late June 2008, Paul Desmond, of Lowry’s Research was quoted in Barron’s:

“We think we’re still quite a ways from a bottom,” Desmond warns. Over the next year, he expects the Dow to fall 30% to 50% from its October ‘07 top. The market could enjoy a few short-lived rallies during that span, like the one we experienced from March through May. But each rally is apt to result in a lower high and a lower low in the market.

What would a 30% or 50% decline look like?

The S&P 500 Index (SPX) reached a top in October at 1565 and its 2002 low was 777. Which means that the bull market gained 788 points - the market doubled, in other words. But now we’ve lost ~50% of those gains.

And if we fall 50% from the October 2007 we would be slightly under where the S&P 500 Index found its bear market footing way back in early 2003. A complete round trip.

I’m not predicting that will happen - no one knows where the market will be, of course. The point is that such a scenario has happened in the past. and is far too probable than most people would imagine.

About 4 months ago I wrote about the Canadian stock markets with a dual message: the Canadian retail investor was panicking and cashing in their mutual fund. According to contrarian analysis, this is a good thing because the less knowledgeable and weaker market participants are usually wrong - especially when they react like a herd.

But I also wrote “Caution, Caution, Caution”, saying that even so, I was worried that the market looked heavy. My reasoning was based on the percentage of stocks above their moving average.

My thinking was that although the sentiment would probably put a floor on the market, things could get a bit dicey. Did they ever!

In this case, it pays to be lucky! I was right in being cautious but wrong in thinking that the market would soon rebound from any weakness. After falling, the index has been wrapped up in a tight trading range for the past two months. To be honest, it shocked me to see it so weak in the aftermath of the July sell off.

I wanted to layout my thinking to illustrate that relying on any one indicator, however sound or logical it may be, is dangerous. Timing the stock market is an extremely difficult thing to do and if you’re going to get lucky, it pays to have many tools in your toolbox.

Here’s yet another market indicator which is suggesting caution. I’ve been noticing these pop up for a while now. And although we have now broken above the problematic resistance level of 1400, there are several reasons to reign in any rampant bullishness in the short term.

Among them, sentiment as well as the High/Low Indicator that I’ve mentioned before a few times. It measures and compares the number of highs to lows in the S&P 500 index. It is a ratio of the highs to the sum of the highs and lows. So when it is a low number, we know that there are ample lows but little or no highs. And the reverse when it is a large number: many highs with few lows.

Like many others, this metric is much better at pinpointing a bottom than top. This year has already brought two crazy oversold situations in the market. The first in January and the second, mid-March. You have to remember the blue line in the above graph is a moving average, which means that we spent many days with a tonne of new 52-week lows and zero 52 week highs.

At the same time, we aren’t yet pushing the other extreme. Clearly the extraordinary situation in early 2008 has been resolved and the S&P 500 has bounced back - around +10%. And even if the High Low Index did get red-lined, it is no guarantee that the S&P 500 will top out instantly.

But the important thing I take from this metric is that we no longer have that deep oversold condition from which to catapult higher. Been there, done that. The easy money has been made in that trade. Now the longs have to keep their wits about them.