Trader’s Narrative

Guest Post by Vadim Pokhlebkin

It’s corporate earnings season again, and everywhere you turn, analysts talk about the influence of earnings on the broad stock market:

• US Stocks Surge On Data, 3Q Earnings From JPMorgan, Intel (Wall Street Journal)
• Stocks Open Down on J&J Earnings (Washington Post)
• European Stocks Surge; US Earnings Lift Mood (Wall Street Journal)

With so much emphasis on earnings, this may come as a shock: The idea of earnings driving the broad stock market is a myth.

When making a statement like that, you’d better have proof. Robert Prechter, EWI’s founder and CEO, presented some of it in his 1999 Wave Principle of Human Social Behavior:

Are stocks driven by corporate earnings? In June 1991, The Wall Street Journal reported on a study by Goldman Sachs’s Barrie Wigmore, who found that “only 35% of stock price growth [in the 1980s] can be attributed to earnings and interest rates.” Wigmore concludes that all the rest is due simply to changing social attitudes toward holding stocks. Says the Journal, “[This] may have just blown a hole through this most cherished of Wall Street convictions.”

What about simply the trend of earnings vs. the stock market? Well, since 1932, corporate profits have been down in 19 years. The Dow rose in 14 of those years. In 1973-74, the Dow fell 46% while earnings rose 47%. 12-month earnings peaked at the bear market low. Earnings do not drive stocks.

And in 2004, EWI’s monthly Elliott Wave Financial Forecast added this chart and comment:

Earnings don’t drive stock prices. We’ve said it a thousand times and showed the history that proves the point time and again. But that’s not to say earnings don’t matter. When earnings give investors a rising sense of confidence, they can be a powerful backdrop for a downturn in stock prices. This was certainly true in 2000, as the chart shows. Peak earnings coincided with the stock market’s all-time high and stayed strong right through the third quarter before finally succumbing to the bear market in stock prices. Investors who bought stocks based on strong earnings (and the trend of higher earnings) got killed.

So if earnings don’t drive the stock market’s broad trend, what does? The Elliott Wave Principle says that what shapes stock market trends is how investors collectively feel about the future. Investors’ mood — or social mood — changes before “the fundamentals” reflect that change, which is why trying to predict the markets by following the earnings reports and other “fundamentals” will often leave you puzzled. The chart above makes that clear.

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Robert Prechter, Chartered Market Technician, is the world’s foremost expert on and proponent of the deflationary scenario. Prechter 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.

According to the simple stock market timing method which relies on the 30 day rate of change of the 10 year treasury bonds, we are very oversold and should expect a rebound here.

This system is somewhat better at finding tops than bottoms, but it is a good general indicator to throw in the pot:

The rate of change (bottom panel) is really off the charts. The chart doesn’t go back that far but we haven’t had a reading this low since May 2003 when the S&P 500 was at 1000; lifting off a triple bottom and escaping from the clutches of the bear market.

It wasn’t that long ago when people were running around pulling their hair out because of a swift sell off in the bond market. As yields spiked in the 10 year and 30 year notes, a lot of attention was invested in trying to explain what this meant.

In early July I showed one simple indicator based on the 10 year Treasury Notes and how it has a very good record of finding market tops - something most indicators are loath to do.

Here is the indicator again, going back three years:

As you can see, this is able to not only find tops, but bottoms as well. Whenever the rate of change of the 10 year T-Notes drops into negative territory, we start to see a high probability of the equity market bottoming. It isn’t perfect, as you can see. It missed the October 2005 bottom (or was early depending on how you want to think about it).

The rational argument is that as bond yields fall, equities become more appealing compared to bonds. And so funds flow from bonds to stocks. Although not simple, it is both logical and fairly consistent. What else can you ask from an indicator?

Over the next few months and even till the end of the year, I’d be willing to “forecast” that we will close higher, but for the next few days and weeks, the market may be heading into some kind of a short term top or choppy trading.

I was looking over some different indicators to take the pulse of the market when I noticed that according to the ISE Sentiment there are too many calls being bought compared to puts right now.

In fact, the ratio is at levels which have in the past marked market tops. As you may recall from the last time I talked about the ISEE data, it only measures opening long customer transactions on International Securities Exchange. Which makes the data very useful, especially considering the growing volume of options traded on the ISE.

Take a look at the graph below which compares the S&P 500 to the ISEE sentiment data. As you’ll notice, when the 10 day moving average rises too much (too many calls bought to open, compared to puts) the market has a hard time powering ahead. It either swoons or enters into a sideways range.

There’s no magic to the number 10 by the way. Any short term moving average would smooth out the data and show you the same thing (more or less).

On Friday, the market was jolted down quite harshly. Although the move printed a wide range candle on index charts, it did not result in any sort of oversold readings. So the market certainly has room to the downside. And you have to remember that a bull market never makes it easy. It bucks at every chance to try and throw you off.

If we do see some general market weakness though, I’d really be wary of the soft sectors like the financials. The banks and brokers will most probably get the brunt of any serious selling since they are already very weak relative to the market.

Click to Enlarge Graph:

In early June I stumbled on a promising indicator for finding market tops. As a student of the markets I’ve desperately searched for a reliable tell for tops. But for the most part the prey is elusive.

Market bottoms are much, much easier to find than tops. The VIX index pops, the put call ratio spikes, sentiment goes haywire, and on and on. There are literally dozens and dozens of indicators that one can line up as good signs of a market bottom.

The indicator that I mentioned involves the interplay between the stock market and the bond market. As the rates in the bond market rise, the stock market usually suffers because money starts to flow out of equities and into less riskier (and higher yielding) bonds. And vice versa.

It is simply, the 30 day rate of change of the 10 year Treasury Bond yield. When it approaches 9% (or more), the stock market tends to get weak. Especially when immediately prior to the signal it has been on an uptrend.

This is what we had in early June 2007 and so far, the signal has been good. I suppose we could argue whether the June high water mark is truly a “top” or whether it is simply a pause. To really know, we need more time. Still, one can’t argue that entering at that time wasn’t a good idea since it wouldn’t have made you any money. In fact, exiting to preserve capital seems to have been rather smart.

Of the major market proxies, the Nasdaq composite is the only one that has surpassed its early June highs. The Russell 2000 Small Cap index, the Dow Jones, and the S&P 500 have all traded within a range.

But I’m still rather bullish for the intermediate to long term time frame. I’ve shared with you a few reasons for that. Most recently, the remarkable Commitment of Traders report, the short interest ratio and finally the total apathy from retail investors. The fly in the ointment continues to be the flacid financials.