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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):

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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).

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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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Charts, Posts

Stocks Aren’t Out Of The Woods Just Yet

Last week Art Cashin mentioned the possibility of the S&P 500 forming a “formidable” head and shoulders top pattern. Only by pushing to new highs can the index avoid fulfilling the pattern and despite the recent string of positive trading days the index has yet to do so.

And I’m seeing the pattern form in a few other indexes and stocks, as well. The cleanest pattern is probably that in the Dow Transportation Average:

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The Russell 2000 is another vulnerable index:

scThere are also a few bellwether stocks that are susceptible to the pattern right now:

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There are others but these are the ones I thought most notable. Pay attention to how all this dandruff works itself out. I’ve rarely seen it this pervasive.

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Investing, Markets

George Soros’ Big Bearish Bet

The man who ‘broke the bank of England’ has taken aim at the US stock market. From Marketwatch:

Within Friday’s 13F filings news was the revelation that the firm, founded by legendary investor George Soros, increased a put position on the S&P 500 ETF SPY by a whopping 154% in the fourth quarter, compared with the third. (A put or short position basically gives the owner the right to sell a security at a set price for a limited time, and in making such a bet, an investor generally believes the security is going to decline.) The value of that holding, the biggest position in the fund, has risen to $1.3 billion from around $470 million. It now makes up a 11.13% chunk of all reported holdings.

It’s not clear whether Soros is using the put options as a hedge or a bet on an outright decline in stocks. My guess is it’s probably a combination of both.

He did write an op-ed recently about his worries over China:

The major uncertainty facing the world today is not the euro but the future direction of China. The growth model responsible for its rapid rise has run out of steam… There are some eerie resemblances with the financial conditions that prevailed in the US in the years preceding the crash of 2008.

Should China experience a bust along the lines of what our country went through five years ago it would have major implications for the world economy. And we’re beginning to see signs of the massive debt cycle in China turn south.

I linked this story in my Friday post. It details the growing problem with defaulted “trust products” in the China and it is precisely the type of catalyst that could kick off a larger crisis.

Last month, China’s banking sector dodged a potential catastrophe when a mystery group stepped in at the 11th hour to pay investors in the now-infamous “Credit Equals Gold #1, a defaulted $495-million trust product. Barely two weeks have passed and now another trust product has failed to pay back investors. This product—known as “Songhua River #77 Shanxi Opulent Blessing Project”—is unlikely to cause more than a minor scare. But episodes like Credit Equals Gold and Opulent Blessing Project are just the beginning, says Mike Werner, senior analyst at Bernstein Research, in a note today. One reason is that more than 43% of the 10.9 trillion yuan ($1.8 trillion) worth of outstanding trust products come due in 2014… Rising rates will make it hard for bankrupt companies to find the cash to pay back investors, he says.

Of course all of this is just speculation on my part. Soros obviously has his own reasons for putting the trade on. But the clues are all pointing in the same direction.

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Charts

Fibonacci, Fractals & Fear-Mongering

Wednesday I tweeted an interview with Art Cashin in which he discusses the “formidable” head and shoulders pattern setting up in the Dow. He also mentions how it correlates to the “scary” 1929 chart being passed around trading desks right now (see “Don’t Dismiss The Possibility Of A Stock Market Crash“).

As you can see in the chart below the index has rallied right up to the underside of its 50-day moving average and could be setting up the right shoulder of a head and shoulders top:

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On a shorter time frame, it’s clear to see that despite the recent strength the Dow has failed to overcome its 61.8% Fibonacci retracement level. In addition, prices are making a new high today even though MACD has already crossed down setting up a divergence:

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This is the moment of truth. If the 1929 analogue is to remain valid prices need to reverse right here right now. To be clear, Tom DeMark, when he first introduced the analogue, made it clear it was for “entertainment purposes” only. I don’t believe he is “fear-mongering” at all – neither do I intend to do so. Fibonacci and fractal analysis is something I find truly fascinating and this is a real time example of how it applies to the markets.

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The Great Crash
Investing

Don’t Dismiss The Possibility Of A Stock Market Crash

This analogue (discovered by Tom Demark) between the 1929 Dow Jones Industrial Average and today’s index has been around for months. It hasn’t gone away because the current market keeps fitting itself to the pattern:

MW-BU310_scary__20140210132547_MGvia Marketwatch

Before you dismiss it as mumbo jumbo consider a couple of things:

Option skewness (indicating the probability of a crash) recently hit its highest level ever recorded:

wmc131230avia John Hussman

And the massive growth of margin debt and leveraged ETFs over the past few years poses a systemic risk to the stock market that has also never before been witnessed:

NYSE-investor-credit-SPX-since-1980via dshort.com

mw 02-05-2014via Distressed Volatility

Now I didn’t post this to scare you. I just think it’s worthwhile to consider these things because they do happen from time to time and when they do it’s best to be prepared – to have a game plan.

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