Trader’s Narrative

A while back I presented a historical study which looked at the behaviour of the S&P 500 relative to its long term trend line: what happens this far above the 200 day moving average? If you haven’t yet, go check it our for full details because what follows will make much more sense.

When the Dow broke 10,000 (for the nth time) in the middle of last month, I cautioned that stocks had risen into thin air (again). The S&P 500 meandered around 1090 for a few days and then fell back.

Now, once again, looking at the same technical metric, I would be remiss to not issue another cautionary note:

As of today’s close, the S&P 500 index is 18.6% above its 200 day moving average. That is very close the 20% ceiling that seems to exert an almost magical restraint on momentum.

In the days left in the week we could potentially move up to 1120, which would expand the distance between the close and the 200 day moving average to approximately 21%. That’s really the maximum distance that it has been able to roam away from its long term trend in the past. So that’s about +2% further gain in equities from where we are.

Also, remember that tops that form at the 20% ceiling tend to cluster. So just like mid October, we may see a few days where the S&P 500 hovers around the 1120 area before either dropping as it did before or simply plateauing (to wait for the long term average to catch up).

Although this message may appear bearish in tone, it is only in the short term. If my prediction is borne out, then the S&P 500 will have made yet another higher high (and higher low) - the very definition of an uptrend and a rather beautiful chart formation.

Finally, it seems that every time I write along these lines, someone comments to remind me that the “markets can do anything”. So allow me to nip that in the bud.

Well, yes, of course the market can do anything. I’m not under the illusion that I can restrain them or to make them do my bidding. I’m simply observing a pattern of behaviour that they have exhibited in the past and projecting from that a probability. So I hope that is crystal clear.

You’ve probably already noticed this since the pattern completed in late July and early August. In case you haven’t, the Philadelphia Banking index (BKX) has carved out a fairly decent reverse head and shoulder formation:

Of course, the technical pattern in the above chart mirrors the one visible in other sectors as well as the general S&P 500 index itself. No surprise there since most stocks take their cue from the major index, rising and falling like the tide.

The one fly in the ointment is the left shoulder (see red exclamation mark on chart). Although the left shoulder is fully formed, I’d prefer to see a more symmetrical one to the right shoulder. That would have only been possible if the year end rally would have taken the Banking index a bit higher to reach the neckline. So it isn’t a picture perfect inverse head and shoulder pattern.

Back in June I mentioned that the financial sector was losing relative strength and the baton had been passed to the Semiconductor Index (SOX). Since then the banks have continued to lag the S&P 500 and the tech sector has been the engine of the stock market.

We’ve got considerable resistance ahead at the 50 level (on the BKX). But the measured move target is 74 - which takes us to the next significant support/resistance level. Needless to say, the reverse head and shoulder formation is the quintessential reversal pattern in technical analysis.

While the Baltic Dry Index is a leading economic indicator, lately, it has been also behaving as a leading indicator of the stock market.

I hinted towards this early in the year when it looked like it had put in a significant bottom and I wondered if the Baltic Dry Index would lead the stock market higher. Of course, we now know it certainly did.

The index measuring international shipping rates around the world bottomed in early December 2008 three months ahead of the stock market (green arrows):

In fact, if you compare the S&P 500 index for the past few years with the Baltic Dry Index (BDI), it would seem that shipping rates have lead the equities from 1 to 3 months in both rallies and tops (take a look at the marked points on the chart above).

Of course, the relationship is fuzzy and not a one to one, up and down, direct correlation. But in all its fuzziness, you can still make it out rather clearly. You can even see that about a month before the stock market went into a waterfall decline last year, the BDI broke down below its low and started on its head first dive.

So what is it saying now?

The BDI topped out in early June 2009 at 4291 and has since been in a downtrend. In keeping with the same approximate time lag, we would expect the stock market to top out in late August or early September. Which is right about now. We’ve been underwater since the S&P 500 index hit 1031 on August 27th, 2009. Now, I’m not suggesting that you trade just on this type of thing but it does provide an interesting context. Especially when you consider everything else which is telling longs to be cautious.

If you just joined us, we went over multiple reasons for bearishness in the past weeks sentiment overview as well as the newly inflation adjusted mutual fund cash levels indicator.

Last week we took a look at a recent research report from Morgan Stanley on the aftermath of secular bear markets. Although in that article I featured this chart comparing the Nasdaq market from its peak in 2000 to now with the infamous Dow Jones Industrial index top in 1929, it deserves another mention. You can click on the graph to see it in full size:

I’m always fascinated by the fractal nature of the stock market. But I’m not convinced this isn’t just a random coincidence. Here’s another chart from Bloomberg comparing the S&P 500 with the Nikkei:

Again, an uncanny similarity. Again and again, markets seem to follow the same script. Or rather, the individual participants act with synchronous precision to create and unravel manias.

Another interesting comparison I mentioned a while ago is this year’s spring rally in the S&P 500 with that 6 years ago: Comparing Flag Formations: Then & Now. But where we part company from the past is when we look at the magnitude of this most recent rally.

This surge has offered no real opportunities for those who hesitated at its inception and waited for a pull back. In fact, the rally from the March 2009 lows has been the sharpest we’ve had in 40+ years:

If you consider each rally chronologically, something becomes noticeable: with the exception of the 1982 example, each subsequent bull market rally has been slightly sharper than the previous one. Maybe there is a pattern there. But it is hard to statistically defend since the observable sample is so small.

Here’s the thing. Earnings have collapsed. Utterly and completely. Like a house of cards. Like never before.

And because equity prices only fell by ~50%, that means the price earnings ratio skyrocketed to the stratosphere and beyond. Just look at the chart of the S&P 500 index’s P/E ratio - it looks like it just fell through a wormhole:

Source: Chart of the Day

Honestly, my initial reaction was to ignore this latest chart. First, because we already went over this months ago when the P/E ratio was 122: How The Price Earnings Ratio Can Fool You. But also because this whole issue is truly meaningless.

But then I realized that this chart is making the rounds on the internet at a torrid pace. It is being forwarded and many other bloggers are featuring it with a bearish slant. So while it really is a distraction, perhaps there’s something of value here. Not the data set graphed but rather the reaction of people and their fixation on this useless little statistic.

If anything, the morbid fascination with the gloomy and shocking picture the above chart depicts tells us about the public mood out there. And from a contrarian point of view, this is the sort of ‘worry’ that bull markets proverbially like to climb.