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The Trend Is Now Your Frenemy, Part Deux

A month ago the major indexes broke down below their uptrend lines. They have since gained back all of their losses and then some. But that doesn’t mean everything’s peachy again.

In fact, I believe there’s a good chance that last month’s correction was only the beginning of a resurgence in volatility and very possibly could evolve into a major topping process for the stock market.

I’ve spent a lot of digital ink here discussing how overvalued I believe the market is currently. Mr. Buffett’s favorite yardstick, total market cap to GNP, shows the market to be currently trading at a level that is nearly twice its long-term average valuation. In other words, stocks would need to fall nearly 50% just to return to an average level, let alone an undervalued one.

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Sentiment is also stretched about as far as it has ever been. Investors could hardly be more bullish than they are today, based simply on the percent of household financial assets allocated to stocks. In the simplest terms, this means that potential demand for stocks is not nearly as great as potential supply (see Philosophical Economics’s terrific post on the supply demand dynamic in stocks).

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While these two measures are very highly correlated to future 10-years returns in the stock market, they have very little utility in trying to time a market peak or even a correction. That’s why we have to consider the overall trend. Fundamentals and sentiment won’t tell us when the trend may be coming to an end. Only the market can tell us that.

And the market is sending plenty of signals that this may be happing right now.

The simplest way to analyze a trend is to see if prices trade above or below a simple 200-day moving average (approximate to the 10-month moving average) and/or draw a long-term trend line. (Meb Faber recently wrote an interesting piece on just how important the 200-dma is to hedge fund titan Paul Tudor Jones). And this is what we looked at in the last post in this series.

But we can also get a good feel for the overall health of a trend by looking at what is commonly called its “internals.” This is just a fancy way of referring to things like the percent of stocks trading above their respective 200-day moving averages, the cumulative advance/decline line and the number of new 52-week highs or lows being made.

Essentially, these are all ways to look at how the components of an index are performing relative to the overall index. A healthy trend is driven by a majority of the index’s components. Likewise, an unhealthy or weakening one is driven by fewer and fewer components. (Lowry’s has done some fantastic research on this phenomenon you can read here).

Right now all of these measures are suggesting that the current long-term uptrend is waning in strength. Let’s take a look first at the NYSE Composite:

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This index is actually one of the few that has failed to make new highs during the ramp over the past few weeks. Still, it’s plain to see that the cumulative advance-decline line (top black line), the percent of stocks trading above their 200-dmas (middle black line) and the pattern of new highs-new lows (bottom black bars) are all diverging from the new highs being made by the major indexes. The last time all three of these internal indicators diverged this way was in October of 2007, just prior to the bear market that coincided with the financial crisis.

The Nasdaq Composite looks very similar:

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The main difference here is that the three indicators diverged not just in 2007 but also in 2011 prior to the selloff precipitated by the European sovereign debt crisis. Overall, I think it’s safe to say the current uptrend is not as healthy as the bulls would like to see. And both of these composite indexes are important components of the S&P 500 index so don’t think it’s immune.

Still, it’s true that prices for both of these indexes have regained their 200-day moving averages and multi-year uptrend lines. Ultimately, this tells me that the overall uptrend is still in tact. But these internal diverging indicators suggest that it may be nearing its end as more and more of the underlying components have, in fact, given up their own uptrends.

What’s more, considering the extreme levels of overvaluation and bullish sentiment, the next cycle lower, when it does finally turn, may be more than just your average market correction.

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Can Gold Regain Its Gleam?

Over the past few months I’ve been looking at gold and particularly the gold mining stocks for signs of a bottom. To be clear, I don’t own either… yet.

But here’s why I’m intrigued by the opportunity:

  1. Central banks are competing to devalue their currencies. The longer this goes on the more likely gold will benefit.
  2. Gold miners are extremely cheap relative to gold.
  3. This might just be the most hated asset class in the world right now.

The reasons I haven’t taken a position yet are:

  1. If we are, in fact, currently experiencing a global deflation this is not good for gold (or oil, copper, etc.).
  2. The trend is super-fugly.

So basically, I’m waiting for the chart to confirm or deny the above. As it stands, the long-term uptrend broke last month:

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So unless we see a major reversal soon (or at least some sort of attempt to form a bottom) I’ll have to assume deflation trumps money printing. However, if gold can manage to find a bottom it could end up being a helluva trade. Stay tuned.

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Stocks Shoot The Moon

Here’s an interesting chart I put together today that coalesces a few posts I’ve done over the past few months:

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It plots the S&P 500 ETF (red and black bars), which recently hit a new, all-time high, alongside:

  1. Junk bond risk appetites – blue line (see: “Obscene Risk Hidden In Plain Sight“)
  2. The inverse volatility ETF – red line (see: “Crowded Trade Du Jour: Short Volatility“)
  3. Consumer discretionary ETF vs. Consumer staples ETF – green line (see: “TFR: Stocks, Gold & China” – technically this was a newsletter, not a post – subscribe here)

Clearly none of these indicators have kept pace during the rally over the past few weeks. Have stocks overshot the mark or will these indicators now play catch up? Or maybe they just don’t matter anymore. Who knows?

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Overcrowded Trade Du Jour: Short Volatility

Periods of low volatility are to investors what a sweet lullaby sung by whispering nanny is to an overtired baby. It relaxes them, gets them to put their worries aside and believe that everything is going to be okay. Great for babies. Not so great for investors.

Because Mr. Market is a sadistic nanny, usually lulling investors into a sense of calm and security right at the worst time.

The few years that led up to the financial crisis were the last great period of low volatility investors witnessed. Clearly, the overwhelming sense of calm in the market (lack of fear), even through the first half of 2007, was unrealistic. You may remember that all of the gains earned during those years were quickly given back and then some during the financial crisis.

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But investors were simply doing what they do best: projecting the results of the recent past way out into the future. They were lulled into believing that volatility was no longer cyclical and that the goldilocks economy meant that it was smooth sailing as far as the eye could see.

Alas, we learned shortly thereafter that volatility AND the economy AND the credit markets were, in fact, still subject to cycles.

“Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.” -Howard Marks

I bring this up today because volatility has once again witnessed a period of sustained depression and investors have once again been lulled into a sense of extreme complacency (if that’s even a thing).

ETFs that track the inverse performance of the VIX have become hugely popular this year. They have now attracted nearly $2 billion in assets, $800 million of that coming just in the month of September. In effect, these are bets that the current period of low volatility will last for the foreseeable future – that’s the only way they will make any money.

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Chart via FT.com

The problem is that the VIX currently stands at about 15. It’s lowest point in the past few decades is around 10. From the beginning of the year to early July when the VIX neared that 10-ish level these ETFs saw about a 35% gain (on about a 35% decline in the underlying index). Nice! Right?

Wrong. During the brief, not-even-10% correction we witnessed last month these ETFs declined nearly 50%!! Imagine what would happen if we actually saw a 20% decline… or more. These funds would be obliterated.

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I was recently listening to Tony Robbins on the Tim Ferris podcast and he shared an insight about one thing the world’s greatest investors have in common: they look for fantastic risk/reward setups. They look to risk a penny to make 25 cents. To me this looks just the opposite. It’s like risking 50 cents to make pennies. Good luck with that.

Further reading:

“Now that everyone’s a volatility seller…” – FT Alphaville

“Record short VIX notes sounding alarm to Deutsche Bank” – Bloomberg

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Wagging The Dog

Regular readers know I like to try to combine fundamentals with technicals and sentiment to form a holistic investment/trading thesis. Right now I believe that these three factors are lined up on the bears’ side in the case of small cap stocks, which have led the broader indices of late – the proverbial tail wagging dog.

First, to say valuations are stretched in the case of small cap stocks doesn’t quite tell the whole story. In fact, they may have never been more stretched than they are today. (I’d love to see a CAPE ratio for the Russell 2000 if anyone’s got that data.)

The trailing price-to-earnings ratio currently looks fairly absurd:

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Chart via WSJ.com

I would assume that the astronomical level of the p/e is due to the fact that a large number of companies have losses rather than earnings. But even if you look at price-to-revenues the stocks look extremely overvalued. WSJ reports:

As of Sept. 30, for example, stocks in the Russell 2000 traded at 1.5 times their revenue of the previous 12 months, a measure known as the price/sales ratio. That is just a hair below the highest valuation seen going back to 1994, the earliest year for which data is available. Such levels were last seen during the stock bubble of the late 1990s, according to Russell Indexes.

The index would have to fall another 15% just to return to the average price/sales ratio of the past 20 years.

A price/sales ratio of 1.5 times in the Russell 2000 doesn’t happen often, says Lori Calvasina, a U.S. equity strategist at Credit Suisse Group CSGN.VX +0.08% who specializes in small and midcap stocks. “But whenever we’ve been there, the Russell 2000 has literally never been up 12 months later, and the average decline is about 16%,” she says.

So it’s hard to make the case that small caps aren’t currently overpriced and technically, they look vulnerable on a couple of time frames.

Back when the ETF broke out above the 82.5 level at the end of 2012 I called this chart the most bullish chart I could find. I’ve been watching ever since, adding the 1.618 Fibonacci extension which has proved to be significant resistance since early spring:

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What’s most glaring about this chart is the recent selloff has seen the uptrend line that dates back to the 2009 low break. The ETF is now testing the underside of the trend line along with its 20-week moving average. So this correction is more than the typical brief pullbacks we’ve seen over the past two years.

Comparing it to the 2010 and 2011 corrections, then might give us a bit better idea of what to expect from this selloff. Notice both of those pullbacks saw the ETF make lower lows with divergences in RSI, volume and MACD histograms. Should the current selloff follow this pattern we should see a lower low made over the next few weeks.

The daily chart confirms this view. RSI (at the top of the chart) is showing another divergence/non-confirmation with the latest high made on Thursday. The index has failed to overcome its 61.8% retracement along with the other major indexes. Finally, volatility looks to have broken out and the pullback is just a test of the breakout level, suggesting we could see another surge in volatility soon. Unlike the other indexes, this relative high for the Russell comes in the context of a clear pattern of lower highs and lower lows, the definition of a downtrend:

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All of this makes a retest of last week’s lows very likely, in my opinion. It may be putting the cart before the horse, but I believe the big question after this next pullback will be whether this all amounts to a larger topping pattern for index.

Last month the index closed more than 1% below its 10-month moving average which amounts to a long-term sell signal for trend followers. Should it be unable to regain that level by at least 1% over the next few months, the most bullish time of year for the markets, I think it will be safe to assume the Russell will be faced with a new bear market lasting anywhere from roughly twelve to twenty-four months.

In fact, should the complex head and shoulders pattern in the chart above play out it would see the index decline to around the 950 area, a 21% decline which meets the definition of a bear market. But as I said, let’s see what happens over the next couple of weeks first.

Finally, sentiment toward the sector has surged. StockTwits traders are absolutely rip-snorting bullish on the Russell 2000 futures contract right now – even more bullish than they were a month ago when the major indexes were hitting all-time highs:

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Chart via StockTwits

The bottom line is these stocks are overvalued, overbought and over-owned right now. What’s more, they have led the broader indexes over the past couple of months and I believe they could very well represent a significant “canary in the coal mine” investors should pay close attention to.

See also: “The Dominant Risk For Wall Street” May Be Manifesting In Small Caps and What Does “Reduce Risk” Mean To You?

Disclosure: I currently own inverse Russell 2000 ETFs (what amount to short positions) for myself and for clients.

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Why?

I’ve been thinking about blogging and social media. Why do we do it?

There are all kinds of answers for all kinds of different folks and I’m sure they each apply to me in some degree.

Some are looking to be heard (in other words, to be listened to – aren’t we all?). Some are looking for their 15 minutes of fame. Some want to come down on one side or another of a specific issue and be right, damn it!

I’m guilty of all of these things, as I said, to some degree, but none of them are the main reasons I do this.

First and foremost, I blog and tweet and such because it helps me flesh out my own ideas. A lot of the time I’m just thinking out loud and typing it. There’s something about writing things down AND in a public way where you can get feedback that just helps expedite or make the thinking process more efficient. I can’t explain it but it works.

Second, it helps to put things out there where they can’t be retracted in order to hold myself more accountable. When something’s not put out there permanently it’s really easy to either totally forget about it or to change the way we remember it over time. A blog post or a tweet brings it right back into the present and makes it impossible to misremember or deny.

Finally, one of the best feelings I can get in my business is helping someone learn something that makes a dramatic impact in their lives – even if it comes from my own horrible mistake! It’s why I do this here and on social media and why I teach a class at the local community college. It’s just very rewarding.

But at the end of the day, this whole thing, the blog, social media and even my class is really just for me. It helps me be a better thinker and a better investor – so I’ll keep doing it.

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The Worst Trade Of My Life

“The only thing to do when a person is wrong is to be right, by ceasing to be wrong. Cut your losses quickly, without hesitation. Don’t waste time.” -Jesse Livermore

This morning I closed out the worst trade of my life. Corinthian Colleges stock price is up about 100% this week on news that its creditors aren’t going to immediately force them into bankruptcy. But that doesn’t even come close to making up for the losses I’ve suffered over the past three years.

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It began back in 2011 when I first started buying the stock. At the time, it looked cheap because the for-profit industry was facing two major challenges that hurt Corinthian even more than most of its competitors. First, the industry was heading into what appeared to me to be a cyclical downturn as the economy began to improve and those who were out of work became less interested in learning new skills or burnishing their resumes. Second, the federal government was unhappy with the industry’s business practices and started devising and implementing more regulatory restraints for the companies.

What I totally miscalculated was that it’s probably a secular decline, not a cyclical one, for the industry. AND the government was fully prepared to put a company like Corinthian out of business. To make things worse, the stock price tried to tell me this for three years and I just wouldn’t listen.

“The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade.” -Paul Tudor Jones

Guilty as charged, Paul. What I’ve learned – the hard way – from all of this: What the best traders and investors in the world perhaps do best is admit when they’re wrong and take a loss quickly.

Warren Buffett’s recent Tesco trade is a great example of this. A few weeks ago it was revealed that the company, the largest grocery store operator in the UK, is now being investigated for accounting fraud. Buffett began dumping his shares almost immediately, roughly a quarter-million of them, in fact, calling the investment a, “huge mistake.”

Buffett’s speed and decisiveness in cutting this loss should be an inspiration to investors. In fact, I believe that even if you don’t have the greatest possible investment or trading process to begin with (just a decent one), if you have a terrific plan for selling that involves cutting losses quickly and ruthlessly, you can generate alpha (outperformance) solely that way (by losing less when markets fall). That’s how critical it is.

Moreover, it doesn’t need to be based solely on fundamental developments as Buffett’s sale seems to be. The trend in Corinthian over the past three years was plain as day. In fact, while I owned it, it rarely spent any time at all above its 200-day moving average. Outside of late 2011, early 2012 it didn’t really ever make any higher highs and higher lows. The trend over the past two years was almost screaming, “this stock is a loser! Get out while you can!!”

The bottom line is this: We all will make mistakes in the markets. What separates the best from the rest is how they deal with them and then how they learn from them and adapt their methods going forward. This was the worst trade of my life. I’ll never forget it because, although it had to literally beat me over the head, this lesson has now been lodged firmly in my brain.

So if you learn anything at all from Jesse Livermore, Paul Tudor Jones, Warren Buffett or from my painful mistake, I hope it’s this: Recognize when you’ve made a mistake and sell immediately. And pay attention to the trend. If it doesn’t validate your thesis, move on to your next idea.

“There is no better test of a man’s integrity than his behavior when he is wrong.” ―Marvin Williams

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