Stoogelogo
Investing, Markets, Weekly Reports

On The Stock/Bond Conundrum

Professional investors typically look at the stock market as playing Curly to the bond market’s Moe. (I don’t know who Larry is… Currencies? Commodities?) Behavioral finance teaches us that neither of them are very rational over the short run and can, at times, get pretty zany. But the bond market is typically a bit wiser than the stock market and at times it likes to slap the stock market around when it gets wise. Maybe it’s because the bond market has things like “vigilantes” (or used to) that keep it a bit more honest. Who really knows?

Right now traders can’t stop talking about the divergence between the two. Bonds are saying the economy looks punk (as the yield curve continues to flatten) and stocks are saying everything looks hunky dory (as they surge to new highs). So who’s right? Is Moe about to do the eye poke on Curly or will Curly get the block in along with the last laugh.

I’ll just say that I don’t know; I’m not an economist and I wouldn’t trust those guys to know either. But I do have at least a clue.

First quarter GDP would suggest that the bond market has it right but, as we all know, markets are forward-looking, discounting mechanisms. So the continued weakness in yields would suggest that bonds see the Q1 contraction as more then just a blip while stocks are saying, “it’s not so bad.

And we’ve recently heard from a couple of market watchers I do trust who have come down on the side of the bond market. Stephanie Pomboy gave a terrific interview to Barron’s over the weekend:

The No. 1 thing is that investors generally have underestimated the impact that QE [quantitative easing] has had on the economy and the degree to which it has supported growth. As a consequence, they have underestimated the cost the tapering [of monthly Treasury bond purchases by the Fed] would have, and that is starting to come into focus. People will realize that the economy really has not achieved any self-sustaining momentum and that it requires continued stimulus. I liken it to a car on a flat road that has no momentum. When you take your foot off the gas, the car just stops moving. That’s essentially what the Fed is doing…. I expect to see Treasury yields trading in a range from 2% to 3%, basically how it’s been for the past several years. You want to sell at 2% and buy at 3%. I wouldn’t be surprised to see rates fall below 2%, as investor perceptions about the economy meet with reality and they realize that the Fed still has a lot of work to do.

Is it just a coincidence that the Fed began to taper in January and the economy began to contract at the very same time? Maybe. But it’s worth making a note of especially due to the fact that each time QE has ended in the past it’s led to problems that have forced the Fed into a new round of QE. Different this time?

Jeff Gundlach, another whose work I greatly admire, seems to agree with Stephanie. A couple of weeks ago he predicted we would see “one of the biggest short covering scrambles of all time” in the bond market that would send the 10-year yield below 2% and perhaps even below the 1.5% level tagged back in 2012. The recent economic slowing would have to at least continue if not accelerate for something like this to occur.

To be sure, this is THE contrarian call right now. A recent poll of 72 economists found none of them see a contraction in our future. To me, this is the sort of consensus that Bob Dylan sang about:

“Half of the people can be part right all of the time
Some of the people can be all right part of the time
But all of the people can’t be all right all of the time” [emphasis mine]
I think Abraham Lincoln said that
“I’ll let you be in my dreams if I can be in yours”
I said that.

And I wouldn’t be surprised to see Curly get slapped upside the head yet again.

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Investing, Markets

The Calm Before The Storm

It seems like volatility always dies down in the summertime as traders retreat to the Hamptons and focus more on sunscreen than stock screens. And you’re not supposed to short a dull market but…

When volatility gets as low as it has recently I take it as a sign of dangerous complacency, especially with the growing potential risks to stocks right now. Bianco research recently noted that over the past 25 years there has only been one other period where volatility has been as low as it is today: July 2007. This marked the beginning of a volatility pick up that ultimately peaked manifold higher during the height of the financial crisis.

Normally, low volatility is no reason in and of itself to become worried about stocks. In fact, low volatility is typically bullish. However, when complacency reaches an extreme like this it does suggest that investors are usually in for some sort of ‘surprise’ that sends volatility higher. And there’s a very good argument to be made that prolonged periods of low volatility actually create more extreme, pent-up volatility.

It works like this: A stock market that goes months and months without anything more than mild pullbacks lulls investors into a sense of security or confidence that stocks just don’t go down anymore. They extrapolate the recent benign price action far out into the future; they start believing things like the “great moderation” line of bullshit. This causes them to become overconfident and over-commit to stocks. When a pullback greater than just a few percent finally happens these investors are surprised by the ‘extreme volatility’ (which is really just normal volatility that has been dormant) and they reduce the undue exposure they put on when they believed volatility was dead. Add this to the normal selling that occurs during and you get a greater than average sell off. Multiply all of these effects (to account for record low vol) from the beginning and that’s how you get a crash like we saw subsequent to the record low vol mid-2007.

Now there were all sorts of other issues that compounded to create the worst financial panic in a few generations and that’s not about to happen again. But history does look like it could be rhyming in some ways right now.

Any major dude will tell you” about not just the record low vol but also that record high margin debt has finally and ominously begun to reverse. A few months ago Jeff Gundlach warned that we could expect a double digit decline once this happened. And @jlyonsfundmgmt shared a great chart the other day showing the correlation between margin debt and the peaks of the past few bubbles.

I know: Correlation ≠ causation. Still, it makes a great deal of sense to me that margin debt is greatly responsible for blowing up an equity bubble in the first place and when it peaks it’s a good sign that the bubble has run out of fuel.

And we’ve seen some canaries croaking in this coal mine over the past couple of months. Biotech stocks, MoMos and the Russell 2000 have all taken it on the chin lately even while the major indexes have hovered near their all-time highs.

As for the latter, @ukarlewitz noted late last week in his excellent “Weekly Market Summary” that, “RUT [Russell 2000] recently ended a streak of more than 360 days above its 200-dma, its longest ever. Every prior instance when a long streak in RUT ended has led to SPX also breaking its 200-dma in the weeks ahead.” That level lies >5% below its current number but there’s a good chance stocks could fall at least twice that much. Again @ukarlewitz:

At more than 5 years, the current bull market (defined as a gain uninterrupted by a drawdown of more than 20% on a closing basis) is both longer and more powerful (on an inflation-adjusted basis) than either the one from 1982-87 or 2002-07. It is, in fact, longer than every bull market in the past century except the ones ending in 1929 and 2000. In other words, this exceptionally long advance without a 10% correction is occurring at the point where virtually every bull market has already ended.

No. This doesn’t mean stocks are about to fall 20%+. But with record low vol over this span how many investors are prepared for such a scenario?

There are also divergences galore. Toddo, calls our attention to the weakness in the banks along with the small caps in contrast to the majors. Maybe more important is what the smart money is doing. We haven’t seen a divergence this large between “emotional buying” and rational buying since… you guessed it. Yep, 2007.

Another noteworthy divergence/canary can be seen in junk bonds. Risk appetites there have also begun to reverse and this is typically a prelude to equity risk appetites reversing as well. So what to junk bond investors see that equity investors don’t?

Maybe it’s that the latest episode of “reaching for yield” is about to come home to roost.

Maybe it’s the weakness in retail. TJX, HD, WFM, BBY, PETM and others have all disappointed investors over the past couple of weeks and we all know consumers make up 70% of the economy.

Maybe it’s the bursting of the bubble in profit margins.

Maybe it’s the bursting of the housing bubble in China.

Or maybe it’s just the fact that this cycle has run its course and is about to swing the other direction. Who knows?

In any case, I’d argue that the record low vol shows investors aren’t looking ahead as much as looking behind and reminiscing at how good things have been over the past five years or so. They’re expecting more of the same even though it’s mathematically impossible. But people love to believe things even when they know they’re not true. And you know what? According to the Fed, this is the very definition of a bubble.

It might not be your father’s bubble but just because we haven’t matched the p/e’s achieved during the internet bubble doesn’t mean that we aren’t ridiculously overvalued today. And it’s increasingly likely this is just the calm before the storm.

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Markets, Posts, Trading

Two Key Fibonacci Levels I’m Watching Right Now

There are two charts I’ve been watching for weeks now that I thought I would share today. Both represent critical Fibonacci levels in important indexes. For that reason they matter greatly to the broader stock market.

First is the Russell 2000 which represents small cap stocks. These little guys have just torn it up over the past few years – so much so that they are now trading at a valuation that is 26% above their late 90’s peak! A while back I labeled the breakout above $85 “the most bullish chart I’m watching right now.” Since then the index has soared nearly 40%. But now it’s running into the 1.618 Fibonacci extension within the context of a broken rising wedge (bearish) and diverging money flow and MACD (bearish):

iwm

This next chart shows the weekly performance of the Financial Sector ETF. It hasn’t performed nearly as well as the small caps over the past few years as it still has a long way to go to recover the losses it suffered during the financial crisis. it’s now running into the 61.8% Fibonacci retracement of that decline also within the context of a broken rising wedge (bearish) and divergences in RSI and MACD (bearish).

xlf

Small caps have led the broader rally over the past few years and finance now makes up a very large part of our economy so both of these charts are key “tells” in my book.

For more fun with Fibonacci see “Nature by Numbers.”

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Featured, Investing, Markets, Posts, Trading

For Everyone Who Thinks Tom DeMark’s 1929 Analog Is A Joke…

If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too;

 

Tom DeMark has been absolutely lambasted since he first proposed his 1929 analog a few months ago. It suggests stocks might be following a similar pattern today as they did back then, ultimately headed for a crash. Even many market watchers I deeply respect have turned the study into a joke on social media.

To these folks I’d just like to point them in the direction of Paul Tudor Jones II, one of the most successful hedge fund managers in history. Anyone who has read the original “Market Wizards” should be familiar with his story. It begins, “October 1987 was a devastating month for most investors as the world stock markets witnessed a collapse that rivaled 1929. That same month, the Tudor Futures Fund, managed by Paul Tudor Jones, registered an incredible 62 percent return.”

How did he do it? How did he manage to profit so handily from an event nobody saw coming? Jones answers, “our analog model to 1929 had the collapse perfectly nailed. [Paul Jones' analog model, developed by his research director, Peter Borish, super-imposed the 1980s market over the 1920s market. The two markets demonstrated a remarkable degree of correlation. This model was a key tool in Jones' stock index trading during 1987.]” The 1929 analog was the “key” that helped him predict and prepare for the crash.

Screen Shot 2014-03-13 at 7.31.03 AMphoto via “Trader” (chart title reads “The Dow in the Eighties and Twenties”)

The documentary, “Trader,” also verifies this account. It was filmed in the months leading up to the 1987 crash. There are many scenes in the film in which Jones and Borish discuss the analog and how it provides the foundation for their daily trading. “At times like this, what gives these two confidence is a theory that says the stock market moves in cycles, in patterns, and Paul and Peter subscribe to the Elliott Wave Theory which says to them what happened 49 years ago, in the late 1920s, is happening again now.” Sadly, Mr. Jones has removed the film from circulation. His reason for doing so is anyone’s guess but witnessing the ridicule that DeMark has suffered recently I can’t blame him.

Jones and DeMark are two of the men I respect most in this business. I believe that one of the main reasons behind their success is their ability to, ‘keep their heads and have faith in their own convictions when all about them are losing theirs and doubting them.’ To me, this latest 1929 analog is still valid until the Dow Industrials make a new high. Until then, I’ll take the ridicule as a contrarian sign that Tom is onto something.

UPDATE: After I shared this post with Tom via email he shared this response with me:

[blockquote2]In regard to the 1929 comparison it was taken entirely out of context and was merely a talking point. It originated from an interview with a business week reporter in early October. At that time, she was asking about the market and I forecast it would likely bottom October 7 or 8—interview was October 7 i believe—and it would rally 12.6% and a likely market top would appear. She asked if it would be a major market top and I replied anecdotally among the charts we were following at the time was a comparison between 1929 and the current market and I sent the chart to her. It showed the rally from the August 1929 low to the September 3, 1929 peak was also 12.6%. She asked if I expected the same outcome and my one sentence response which she quoted in the article and appeared beneath the gold chart– “I’m (the analog) not afraid I’m going to be wrong,” DeMark says. “I’m just saying it’s something to consider.”  See link http://www.businessweek.com/articles/2013-10-14/hedge-fund-chart-guru-tom-demark-sees-dark-days-ahead [/blockquote2]

[blockquote2]Subsequent to the article we received various congrats as the both DJIA and SPX rallied 12.6-12.7% into their respective december 31 and Janaury 14 highs. Then the market declined and unexpectedly we received interview requests from virtually around the world. The casual comparison between the two periods surprisingly had taken on a life of its own. Late Novenber and December tv interviews served to fuel the fire of this analog. Finally when I appeared on CNBC at the february bottom the topic of conversation, just as it had been throughout the decline and in interviews, was the comparison and I was very clear it was unlikely to occur and assigned 10% likelihood and this was also mentioned on Glenn Beck interview about the same time.[/blockquote2]

[blockquote2]Now you have the background of how a casual remark erupted into something more than intended. Agree with your assessment that DJIA has not yet cancelled the comparison. In fact the following report by Goldman Sachs seems to agree with you as they conducted their own research of comparable market periods and the one with the strongest correlation was actually identical to what we off-handedly referenced in an interview early last Ocotber—see below for Goldman update.[/blockquote2]

[blockquote2]BY the way, the gold forecast made in same interview and numerous times on tv late last year forecasting December 31, 2013 as the low in advance and which has been very accurate has been given little or no notice whatsoever. Strange.[/blockquote2]Here’s an excerpt from the Goldman note:

[blockquote2]Recently, Tom DeMark brought up 1929 as a possible analog for today’s market.  In discussing sentiment, I also showed how the idea of that analog was mocked in the media.  In light of the fact that the Dow Industrial did not make a new high in tandem with SPX, I feel it is appropriate to make my contribution to the discussion.[/blockquote2]

[blockquote2]Using a historical software product, I asked for the historical best match for the last 2.5 year (~500 days) of action in the Dow. Combing the Dow’s entire history, the best match was 1929 (Chart 6). The charts match up right in October of that year. The program uses a term “correlation” to judge the quality of the match. The correlation for the match is 97.5%.  I have been using this software since 1997, and a match of that quality over a period of 500 days is relatively rare.[/blockquote2]

[blockquote2]Bottom Line: My opinion is that it might be a good idea to protect yourself from a further decline in SPX.[/blockquote2]

To put the 97.5% correlation into context, in the “Trader” documentary, Peter Borish says that the 1987 correlation with the 1929 chart was roughly 92%.

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Investing, Links, Markets, Posts

Why I’m Nearly As Bearish As I Was Bullish 5 Years Ago

I’ve been pretty bearish (and wrong – or early depending on your time frame) in these pages for a few months now. This week the stock market marks it’s 5-year bull market anniversary and what an impressive run its been. Five years ago I was rip-snorting bullish (and also wrong – or early – for a few months):

scTo quote Charles Dickens, we are currently facing “the worst of times.” By any measure, this is the worst economy America has witnessed in decades. However, for prudent investors in both stocks and real estate, “it is the best of times,” as we are now faced with a once-in-a-lifetime opportunity. -Fortitude in the Face of Crisis, 3/12/09

All three time frames [daily, weekly and monthly] are now aligned with [DeMark] Buy Signals. -TD Indicators: Another Tool for the Trader’s Toolbox, 3/10/09

All in all, there are many signs that the indexes are close to forming a major market bottom. -A Bird’s Eye View of the Bull and the Bear, 3/6/09

Stocks haven’t been this cheap in over 20 years. -Cheapest Stock Market in Decades, Part Deux, 3/4/09

Reading back through this stuff I can’t help but feel like I’ve stepped through the looking glass into exactly the opposite situation, as all of these signs have now reversed making this one of the worst times to buy stocks in decades.

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Investing, Markets, Posts

Stocks Have Surged Only Because Investors Have Completely Abandoned Fundamental Investment Analysis

A little over a month ago I wrote, “One Reason I’m Worried About The Rise Of The Robo-Advisor,” arguing, “as this form of investing becomes more and more popular, the risk of mispricings (and even bubbles) in the markets grows with it because it completely abandons the basic process of analyzing value and risk.” Buying ETFs through a robo-advisor is merely making a decision to own stocks (along with a few other asset classes) without any regard for price (or value). And while this is probably the right thing to do for most investors it can lead to a situation in which investors pour money into stocks at very unattractive values and push prices even higher because there is no natural price sensitivity to curtail them (see my bacon analogy in the earlier post).

What I didn’t recognize at the time is that this is a problem that is much bigger than the small but growing world of robo-advisors. Peter Atwater writes:

[blockquote2]Today’s equity markets are dominated by the post-2000 growth in both futures contracts, particularly the e-minis, and ETFs. E-mini average daily volume in 2000 was just 67,820 contracts versus 1,510,352 last year. On the SPDR S&P 500 ETF Trust average daily volume in 2000 was under 8 million shares. Last year, the average daily volume was 122 million shares. The average NYSE trading volume, by comparison, for 2000 was 1.04 billion shares versus 2.6 billion shares in 2007 and 1.4 billion shares in 2013. The 2013 figure also includes the NYSE ARCA and NYSE MKT volumes. While none of these statistics are likely to have been much of a surprise, I think they convey how profoundly different the drivers of equity prices are today from a decade and a half ago.[/blockquote2]

The growth that we have seen in the past 14 years in these types of index products, before robo-advisors have even made a peep, is absolutely astounding. They have gone from becoming a trading tool for a handful of professionals to the outright drivers of day-to-day stock market performance. How did this happen? Josh Brown explains:

[blockquote2]In 2005, fee-based accounts directly managed by financial advisors and brokers totaled $198 billion. As of year-end 2013, that figure had soared to over $1.29 trillion – more than a sextupling in under a decade. It is safe to say that, while some of these fee-based accounts are managed actively (brokers picking stocks, selling options and whatnot), the vast majority are not… Vanguard, State Street and iShares are to this era of investing as Janus, Fidelity and online day-trading were to the 1990′s. In fact, Vanguard’s share of all fund assets – now approaching 20% or $2.3 trillion – is the vexillum behind which the entire do-less movement marches. What this means for the very character of the stock market and the way it behaves is very important. It means that, almost no matter what happens, each week advisors of every stripe have money to put to work and they’re increasingly agnostic about the news of the day.[/blockquote2]

They are also agnostic about investment value. Whether stocks are under- or over-valued makes no difference to them. They put the numbers into their asset allocation software and put the money to work regardless. Fundamental investment analysis never enters the equation. And when you meet diminishing supply (due to stock buybacks and acquisitions) with insatiable and price-blind demand you get the stock market we’ve witnessed over the past few years – a rip-snorting bull that pushes prices to extreme levels.

When I wrote the earlier article I was more worried about these affects of robo-advisors in the future. Now, in light of these new facts, it looks like my worries have already become reality.

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Investing, Markets, Posts

The Running Of The “FrankenBulls”

A good number of traders have suggested that quantitative easing (the Fed program of buying bonds) is essentially steroids for risk assets. It’s hard to argue otherwise. When the most powerful financial force in the world is buying to the tune of $1 trillion per year it’s hard not to follow suit and risk appetites have clearly soared since the Fed began the programs roughly five years ago.

Over the weekend, the folks at Decision Point (now part of the fantastic StockCharts.com site) reviewed the current sentiment situation over at the Rydex family of funds which offer a variety of bullish and bearish leveraged stock market funds. Traders there are clearly “extremely bullish”:

rydex

Longer-term, Doug Short just updated his chart depicting the net free credit in investor accounts. Unlike sentiment polls which tells us what investors are telling us about the market, this is terrific gauge of what investors are actually doing with their money:

NYSE-investor-credit-SPX-since-1980

We just set a new record for negative credit balances. What this means is investors have never before utilized this much net margin debt (cash minus debt in their accounts). The next largest deficit was at the height of the internet bubble and we now how that trade worked out for them.

The bottom line is investors have now become super-bullish – or, if you buy the idea that the Fed has inspired this epic risk-taking, we should probably call them “Frankenbulls.” Just like those crazy Belgians who have genetically engineered a new breed of “Frankencows” the Fed has engineered an entire class of “Frankenbulls” addicted to leveraged investments in stocks. And at some point it will come back to haunt them.

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