Trader’s Narrative

Here’s an a long term indicator that I stumbled on that has been able to time the stock market’s generational buy points very well. It is a ratio of discretionary spending to total US consumer spending.

Click to see larger graph in new window:

Source: Bloomberg

Every time that the US Consumer rediscovers frugality and retrenches by spending less on the non-essentials, the stock market makes a major bottom.

In the early 1960’s discretionary spending as a percentage of the total budget went below 17%. We then had the roaring market powered by the “nifty fifty”.

In the early 1980’s again discretionary spending went below 17%, reaching a slightly lower level. And again, we saw the birth of the 80’s “go go” bull market that was rudely interrupted by Black Monday in October 1987.

In the early 1990’s discretionary spending once again breached 17% and once again the market made a low (in late 1990) that would go uninterrupted until the LTCM crisis in the summer of 1998 and top out in 2000 at the height of the tech bubble.

Which brings us to the most recent - and seemingly the most depressive state of the US consumer. Belt tightening is so rampant that discretionary spending is at an all time low for at least 50 years. No wonder we are constantly hearing today’s economic situation compared to the Great Depression.

But if the previous dark times are any indication, the stock market is poised for a shocking come back.

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.

No doubt, you’ve probably seen a chart of the unemployment rate recently. And you know about the surprise dip in last month’s unemployment rate.

By the way, that reduction has been roundly dismissed as a statistical mirage because more than not, it was caused by people who gave up looking for a job, rather than people actually finding a job.

If you think the level of unemployment is alarming, you’ll find the chart of the average duration of unemployment in weeks downright frightening:

Source: St. Louis Fed

The shaded bars, of course, represent instances and durations of recessions as determined by the NBER.

Since the Department of Labor started collecting data for this statistic in the late 1940’s, we haven’t seen unemployment last this long. The latest data is for July 2009 at 25.1 weeks - in other words, almost 6 months!

No wonder people are giving up looking for work. You would have to have the patience and fortitude of Job to persevere through such a harrowing episode. And remember, this is an average, so there are many who have been unemployed for much longer.

This means that the stock market recovery we’ve seen so far has not only been mostly a profitless, revenue-less one but also it is shaping up to be a jobless recovery. But then again, the stock market is famously supposed to be ahead of economic measures like unemployment.

Take the previous highest peak in the average duration of unemployment: July 1983 at 21.2 weeks. If we travel back in time to those days, it isn’t hard to imagine that we would be equally frightened at this statistic. However, thanks to hindsight we now know that by July 1983 the stock market had already bottomed and gone on to gain an astonishing 70% (for the Standard & Poor’s 500 index). So far, we’re only up about 45% since the March 2009 bottom - if it is indeed the floor.

So while the above chart may send a chill down everyone’s back about the health of the US economy, it doesn’t mean that the stock market is on borrowed time. More importantly, how can anyone look at it and still be worried about inflation?

Despite all the stimulus, the US economy is far, far away from reaching capacity and inciting inflation worries. I guess that is the narrow silver lining in this dark cloud.

Tony Oz is an accomplished trader and educator - a rare find in the trading community. He has not only demonstrated his unparalleled skill, over and over again, he has been extremely forthcoming and transparent in his methods as well.

Of his several books, “How I Make a Living Trading Stocks” is even an account of a short period of time in the post-2000 Tech bubble where he shows exactly what he traded and why in great detail. Even more amazing, during this intense bear market, he took mostly long trades. Tony’s methods are surprisingly simple. He relies on technical analysis, resistance, support as well as tape reading.

From time to time he provides general market comments but it has been a while since we last heard from him. His previous market call was in October 2008 when he caught a classic ‘falling knife’ for a quick trade. Recently, due to a family matter Tony took some time off from trading. I’m glad to hear that things have worked out well and Tony can direct his attention to the stock market once again.

Here is his most recent commentary:

The smart thing to do right now is to probably fade an extended upward swing move by identifying an intraday reversal pattern and selling the market short. If such a position is taken, it would be prudent to place a stop loss above the intraday high, this way a trader would not risk too many points. A target around S&P 920-930 should be realistic for a short position entered at 955-975.

It is always hard to call a top or a bottom no matter what the time frame a trader is looking at, so a trader should not try and do that. However, the S&P had a nice run from the 870’s to 950’s, and it may come back into the channel at some point in the near future. Consequently, going long right now may be painful if a trader’s time frame is longer than a few days. (Please note! If the market pulls back first and then it rallies the above short-sale strategy is invalid. This strategy is only valid for an “EXTENDED” upward swing, which means without a day off).

For the traders who are looking to buy a pullback from this run, a good strategy would be to use the 50% retracement rule from the low to the high.

An investor may ask, “Why is an entry here risky?” And the answer would be as so: Let’s say the S&P goes to 1020. This would be a 140+ points run from the lows we just made 7-10 days ago. A 50% retracement will take us back 70 points, which will put us back at 950, which is exactly where we are right now

Source: Tony Oz Newsletter

Tony also mentions that soon he will be updating his classic book: “How I Make a Living Trading Stocks“. This is one of the most sought after books and since it has gone out of print, the prices are astronomical. I’ve read and re-read the book many times and can attest to its value. So keep an eye out for the updated edition coming out in October 2009.

The stock market is a forward discounting mechanism so it usually bottoms much earlier than the economy. While the historic average length of recessions is about 15 months, the stock market has, on average, bottomed after only 6 months:

But notice how stock prices fall well before a recession officially starts. It isn’t that stock market troughs last less than recessions, but that they are shifted back in time.

As the chart shows, in recent times, the S&P 500 has not been as sprightly as before. Whereas before it would find its feet 6 months after the start of a recession, from 2000 to 2004 it took up to 24 months. That is a huge difference. And only time will tell if it was simply an outlier or significant shift.

If anything, this chart further reinforces the epic proportions of this current downturn. As I mentioned in the Weinstein stage analysis of the market, my expectation is for the market to weaken but to maintain its previous swing low. Then with some more backing and filling to allow the long term moving average to slow down and flatten, setting the stage for a lasting low.