This post first appeared in The Felder Report PREMIUM on 8/15/15:
Last week, one of my favorite market mavens tweeted:
For those who don’t know, Helene has been around the block. She’s seen all kinds of markets and mapped most by hand. Yes, she’s an old school technician who draws her charts out in pencil and paper. She’s done this each and every trading day for decades. Through that process I believe she has cultivated a familiarity, even a level of intimacy, with the markets that very few will ever understand. When you go through this process with the care that she does over the amount of time that she has, I think you begin to feel things that others, who don’t have nearly the same connection to the markets, simply don’t.
To this seasoned tape reader, the stock market feels like bear. I believe she is mainly referring to the stock market’s inability to rally when it should. As I wrote in last week’s chart book, it appeared as if the stock market “should” rally. Last week it was really unable to do so (outside of a major reversal Wednesday that was driven by record buyback volume on the Goldman Sachs trading desk). This could be the beginning of a shift in the overall character of a market that has trained many to buy each every dip over the past few years.
And when you begin to dig into it, there are plenty of other signals out there that suggest what we are currently witnessing is bear market behavior. I’ve mentioned it before but I think it’s hard to overstate the significance of the fact that the most cyclically sensitive sectors are leading to the downside. The brokers, energy, industrials, materials, retail, semiconductors and transportation sector ETFs all trade below their 200-day moving averages (note: the brokers and retail sector were able to regain theirs by the end of the week). In other words, they have all now shifted from uptrends to downtrends. I believe this has implications for both the stock market and the economy, as I wrote last week.
Perhaps more importantly, as Nautilus Research noted last week, Bloomberg’s IPO Index has nearly entered bear market territory. I say that this may be a more significant indicator than the reversal in the cyclical sectors mentioned above because IPOs are a terrific measure of investor risk appetite. They love IPOs at euphoric peaks and demand completely dries up at bear market lows. If this index has peaked and entered a bear market it suggests that the longer-term sentiment cycle has peaked, as well. This is how bear markets usually begin.
The recent volatility we have seen in the stock market is also something we don’t normally see outside a bear market. While the percentage moves are not quite as dramatic, the large, daily point moves in the Dow we saw last week are something we have only witnessed during the 2008 stock market crash.
The bearish action in those cyclical sectors, the peak in IPOs and the increasing volatility all fit into the broader theme of deteriorating breadth that I, along with many others, have discussed for weeks now. The bottom line is the uniformity of the trend is clearly deteriorating.
Think of it sort of like you would think about popular opinion. Let’s take gay marriage for example. At first, the majority shares a clear consensus against the idea. Over time, however, there are a few folks that begin to sow growing discontent with the consensus backed by rational arguments which appeal to both liberals (equality) and conservatives (libertarianism). Eventually, the tide turns and a new consensus is formed in favor of gay marriage.
The process of a shift from bull to bear market is very similar. A healthy uptrend is characterized by strong uniformity of trend. The market is led by a majority of stocks pushing it higher. As bearish evidence begins to pile up, more and more stocks fall off and the market begins to rely on fewer and fewer stocks to push it higher. Eventually, more stocks are declining than advancing and the overall market begins to roll over. This is how bull markets become bear markets and this sort of shift in breadth is exactly what we are seeing right now.
There are times when this sort of breadth warning can be safely ignored. However, at the end of one of the strongest 6-year runs in the history of the stock market that has taken both valuations and sentiment to historical extremes, it’s probably worth paying more attention to. Looking back at the 2007 and 2000 stock market peaks, the sort of breadth divergence we are seeing today was clearly a sign of a major trend change.
Speaking of signals of major trend changes, we now have a “death cross” in the Dow Jones Industrial Average. This just means the Dow’s 50-day moving average has crossed below its 200-day moving average. This can be a “noisy” signal. In other words, it’s not always a sign of a major top. Nor is a “golden cross” (the reverse of a “death cross,” meaning the 50 crosses back above the 200) always a sign of a major bottom. Still, these signals occur at every major turning point.
From a breadth perspective I find it fascinating to note that, even while the S&P 500 remains within a couple percent of all-time highs, roughly half of its components have completed “death crosses” of their own. This may be the clearest sign I’ve seen of distribution under the seemingly placid surface.
Just as breadth deteriorates over time as a bull market shifts to bear, sentiment deteriorates in concert with it. I recently shared the chart below of Rydex sentiment. Back in December I believe we witnessed a euphoric blowoff in investor sentiment. Rydex traders at the time were nearly twice as bullish as they were at the peak of the dotcom bubble. Sentiment has been reverting since suggesting a major shift is underway similar to the shift in sentiment we saw back during the 2000 stock market peak.
Activity in the options market right now certainly suggests sentiment has already shifted dramatically. In fact, if we were to only look at the trend in the put/call ratio without looking at the chart of today’s stock market, I believe we would have to conclude that we were already well into bear market territory. The only time we have ever seen the sort of persistent hedging activity in options was during the 2008 crash. In other words, options traders are behaving as if we have already entered a bear market.
I believe that most of this deteriorating breadth and sentiment can be attributed to deteriorating fundamentals. Both sales and earnings for the S&P 500 are now in recession, meaning they have declined for at least two, consecutive quarters. This also something we usually don’t see outside of a bear market.
Deteriorating sales and earnings usually means rising default rates in corporate bonds. Rising defaults means credit market investors demand greater protections, usually in the form of wider spreads over the risk-free rate. This is exactly what we are seeing in the credit markets right now. The current widening in spreads (inverted in the chart below) is just the sort of thing we saw after stocks had already peaked in 2000 and 2007. This adds some credence to the idea that the S&P 500’s May peak could be THE peak for this bull market.
As many have pointed out, much of the weakness in the bond market can be attributed to energy. But this doesn’t mean it should be written off as an isolated event. The markets and the economy are complex systems. Everything is interrelated. As I wrote over on the blog last week, the oil crash may turn one of the single largest buyers of equities in the world into a forced seller. This is only one example of how one single input can ripple across the whole pond and affect every other one.
The bottom line is energy is critical to many companies and economies around the world. The last two times high-yield energy interest rate spreads were this wide was during the last two bear markets. And I have yet to hear anyone make a compelling case why energy may truly be isolated or why this time is any different than those prior two occasions.
So there is plenty of evidence that a bear market may have already begun: Cyclicals have reversed their uptrends and are now leading to the downside; risk appetites in IPOs, the options market and in the bond market have already rolled over; volatility is rising; breadth is deteriorating; earnings and sales are in recession; and the bond market is already acting as if the cycle has turned. Thus it feels like a bear market because it’s acting just like one – in every way but price… for now.
If we have already entered a bear market, the question then becomes, ‘what sort of bear market should we expect?’
I’m not a huge fan of analogs, especially those based on price alone. However, Paul Tudor Jones’ greatest trade was based on using 1929 as an analog for the 1987 crash. Jim Rogers profited at the very same time using 1937 as analog for the 1987 crash. Both of these gentlemen saw the similarities in those euphoric booms and used their historical perspective to great benefit. Another gentleman, of similar investing caliber though employing a totally different style, Ray Dalio, recently shared that he sees the 1937 as a fitting analog for today’s market drawing the following comparisons:
1) Debt limits reached at bubble top, causing the economy and markets to peak (1929 & 2007)
2) Interest rates hit zero amid depression (1931 & 2008)
3) Money printing starts, kicking off a beautiful deleveraging (1933 & 2009)
4) The stock market and “risky assets” rally (1933-1936 & 2009-2014)
5) The economy improves during a cyclical recovery (1933-1936 & 2009-2014)
6) The central bank tightens, resulting in a self-reinforcing downturn (1937 & 2015)
These similarities are what makes this analog especially compelling to me. The Fed has now removed QE and, as they have been telling us for months now, intends to raise the Fed Funds rate off of the floor at any time. Considering the signs of economic weakness I’ve shared above (namely cyclical sector weakness and sales and earnings recession), it seems the risk of creating a “self-reinforcing downturn” by tightening policy is fairly high. Last week, Tim Duy wrote about the possibility of the Fed engineering a recession by tightening policy.
Robert Shiller also sees the parallels between today and 1937.
If 1937 is, in fact, a decent analog for today’s market, and based upon the chart below there’s about a 97% correlation between the two, then it might be wise to study what happened to the market back then. Tom Thornton shared the chart-version of the analog last week (over which we had a long discussion, at least by twitter standards).
Another reason I think this sort of analog is valuable today (along with the 1987 NDX analog I shared a couple weeks ago), is I believe the stock market is currently very “crash prone,” as Bill Fleckenstein has called it. I agree with Bill mainly due to the unprecedented level of herding going on in the markets right now (see “why a stock market crash may once again be inevitable” over on the blog for more). It’s something I have never seen before in my career, not even during the internet bubble.
As GMO’s Ben Inker recently wrote, there is a huge number of “price-insensitive buyers” in the market today. In this category he includes, “monetary authorities,” “developed market central banks,” “defined benefit pension plans,” “risk parity portfolios,” and “traditional mutual funds.” There he pretty much covers the institutional bases but when it comes to retail traders he left out a couple. “Index fund investors” and “quantitative trend followers” both represent “price-insensitive buyers” and have now become, by far, the two most popular strategies for individual investors.
Simply based on the anecdotal evidence I’ve seen “quantitative trend following” may be the single most popular trading strategy in the world right now. It may not have grown as big yet, but it is to the current market what “day trading” was to the dotcom bubble. The Wall Street Journal reports:
DIY’s newest frontier is algorithmic trading. Spurred on by their own curiosity and coached by hobbyist groups and online courses, thousands of day-trading tinkerers are writing up their own trading software and turning it loose on the markets… Interactive Brokers Group Inc. actively solicits at-home algorithmic traders with services to support their transactions. YouTube videos from traders and companies explaining the basics have tens of thousands of views. More than 170,000 people enrolled in a popular online course, “Computational Investing,” taught by Georgia Institute of Technology professor Tucker Balch.
Almost every trader I interact with on social media not only considers himself a trend follower, his success since 2013 has filled him with such hubris he genuinely believes trend following is the only way to make money in the markets. To him, everything else is just mumbo jumbo.
Now don’t get me wrong. I absolutely see the value in trend following and try to utilize it at times. However, what makes the incredible popularity of the method so troublesome for the markets is that it creates herding across a variety of markets like we have never seen before. Citigroup recently put out a report detailing this phenomenon. They posit that ‘markets used to be self-limiting.’ Due to the prevalence of these “price-insensitive buyers,” however, the markets have now become more heavily one-sided than they ever have before. This leaves them vulnerable to, “hitting major air pockets.”
Trend followers have different ways of determining the overall trend but they are all very similar. Some simply use the 200-day moving average. Others use crosses in the 50 and 200-day averages. Others use a 10 or 12-month moving average. Whatever is used, there is a very good likelihood that these signals will all trigger around the same time, at least within a few weeks to a month or so of each other.
If the stock market reverses trend based on any of these indicators, there is a high probability that this massive herd of “price-insensitive buyers” will all look for the exit around the same time. And there is no possible source of demand I can think of (not even corporate buyback programs which did the trick last week) that would be able to soak up this sort of supply coming to market in such a short period of time. This is how markets crash.
I believe that, based on the evidence I have presented here, there is a good possibility we are currently entering a bear market. If this is, in fact, the case, when “price-insensitive buyers” decide to abandon ship it is likely to make for a more violent decline than anyone might expect. In fact, we shouldn’t be surprised by a 1937-style episode. It’s no coincidence that Keynes first published his famous thoughts on “animal spirits” and how they lead to herding during the bull market of 1936. History rhymes. And right now the market is telling us, in a pretty clear way, that the next bear market may already be upon us.