Extreme risk in equities

We now have a syndrome that has rarely been followed by significant market gains, and almost always followed by a decline:

  1. Overvalued: Shiller PE above 18 (it’s 23)
  2. Overbullish: High “bullishness” and low “bearishness” readings in DSI, NAAIM, Investors Intelligence, VIX, etc
  3. Overbought: SPX near upper Bollinger bands (daily, weekly & monthly), over 50% above 4-year low, over 7% above 52-week running ave.
  4. Rising yields: Treasury bonds have recently declined, 10-year yields above level of 6 months ago.
  5. Developing choppiness: A smooth rise of less than 1% per day for several weeks, followed by several days of increased market volatility and sideways price action.
  6. Declining RSI: Indicates momentum is lost.

http://grabilla.com/03206-b41abbf3-34cb-423a-921b-9e550f272c8b.png

The first four of these points are the work of John Hussman* (though I may cite here different sentiment indicators or signs of an overbought market than he does). The last two are my own, and serve to identify a top with greater precision, as Hussman’s syndrome, while an excellent intermediate-term indicator, can be sustained for several weeks as the market continues to rise. When the last two are present, stocks rarely make further headway before declining, though they may churn sideways for weeks.

* Here is Hussman’s uber-bearish syndrome in his own words, with his own chart showing points in history when this has occurred:

  1. S&P 500 Index overvalued, with the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) greater than 18. The present multiple is actually 22.6.
  2. S&P 500 Index overbought, with the index more than 7% above its 52-week smoothing, at least 50% above its 4-year low, and within 3% of its upper Bollinger bands (2 standard deviations above the 20-period moving average) at daily, weekly, and monthly resolutions. Presently, the S&P 500 is either at or slightly through each of those bands.
  3. Investor sentiment overbullish (Investors Intelligence), with the 2-week average of advisory bulls greater than 52% and bearishness below 28%. The most recent weekly figures were 54.3% vs. 22.3%. The sentiment figures we use for 1929 are imputed using the extent and volatility of prior market movements, which explains a significant amount of variation in investor sentiment over time.
  4. Yields rising, with the 10-year Treasury yield higher than 6 months earlier.

The blue bars in the chart below identify historical points since 1970 corresponding to these conditions.

Vast majority of traders now bearish, equities short-term oversold

The easy money for the shorts has been made. This doesn’t mean that the market is likely to rally, just that we have now enjoyed the portion of the decline that our intermediate-term sell signal in late September and early October all but guaranteed. This in no way rules out further declines immediately ahead, possibly severe. It is just that traders could easily find safer entry points for short-to-intermediate-term short sales, or worse exits.

Stocks remain at historically high valuations, economic headwinds are mounting, and bullish sentiment has been dominant for years, so we are likely at the start of a significant turn.

yahoo SPX 1 year

Market again overbought on overbullish sentiment

The global economy is clearly on the downswing, with the US likely having entered a recession this summer (watch for revisions in GDP and employment data in the coming months). However, as in Sept-Oct 2007, the equity market has bounced from a brief oversold interlude to a new high.

Here is the NAAIM survey. This is a relatively new dataset, but it has proved high-correlated with proven sentiment indicators like DSI and Rydex fund activity). The survey is updated each Thursday with data from Wednesday.

NAAIM Sentiment Survey, 19 Sept 2012

Sentiment has been elevated for a month, which is sufficient for a significant decline, though the likelihood of a setback and the expected magnitude thereof grows with each week that it remains elevated. This, coupled with sideways price action for few weeks (we don’t have this yet) and a declining trend in daily RSI (possibly developing) would virtually lock in the case for an intermediate-term top.

S&P500 daily chart, Yahoo Finance

EDIT: To clarify, this is not a screaming short-term sell yet, since the market has had a habit of creaping slightly higher over a few weeks from conditions like this. However, things can reverse at any time, and it is highly likely that any further gains will be quickly erased once the turn comes.

The macro picture of deteriorating economic data bolsters the case that a bull market top is near, so if this is an intermediate-term top it could prove to be the final top prior to a bear market. This cyclical bull is now 3.5 years old. This is long in comparison to the cyclical bulls of the 1910s and 1970s secular bear markets (18-36 months was typical), but short in comparison to the last cyclical bull (spring 2003 – fall 2007, 4.5 years).

Topping pattern developing, stay tuned

We finally have a weakening trend on the daily RSI (see RSI on bottom of chart). This is a prerequisite for anyone considering taking a short position, especially with leverage.

It would be typical for some type of quick plunge to develop soon, perhap on the order of 5-8% in SPX, maybe 100 points (1000 Dow points). It would also be typical for stocks to recover from such a plunge and test the highs again, as in spring 2011 or Summer-Fall 2007. In May 2010, this process was compressed in the “Flash Crash,” which was followed quickly by a decline of around 20%.

However, the weekly trend is still up, though finally in overbought territory. Perhaps this begins to turn over the next few weeks as the market chops sideways.

Further strengthening the bear case is sentiment, which has now been elevated for at least two months (I recommend sentimenttrader.com at $30/month for all you can eat indicators). Sentiment is a powerful indicator, but actual price tops lag tops in sentiment by several weeks to months, as prices tend to levitate and chop sideways for a while on weakening RSI prior to major declines. Bottoms have a much closer time relationship to sentiment (extreme bearishness among traders is usually quickly followed by rallies).

The best free sentiment resource that I am aware of is the NAAIM Survey of Manager Sentiment. As you can see in the chart below, sustained bullish sentiment is required in order to register a valid sell signal, as the crowd is often right for a while. The relatively short period of bullishness here is another sign that any decline that develops soon could be short-lived.

I should also mention that John Hussman has noted that the market has exhibited his syndrome of overbought, overvalued, overbullish on rising yields, for several weeks now. This set of conditions coincides with many of the very worst times to be long stocks, and has almost no false positives. Advances made during such periods are soon given up, often in severe declines.

The following set of conditions is one way to capture the basic “overvalued, overbought, overbullish, rising-yields” syndrome:

1) S&P 500 more than 8% above its 52 week (exponential) average
2) S&P 500 more than 50% above its 4-year low
3) Shiller P/E greater than 18
4) 10-year Treasury yield higher than 6 months earlier
5) Advisory bullishness > 47%, with bearishness < 27% (Investor’s Intelligence)

[These are observationally equivalent to criteria I noted in the July 16, 2007 comment, A Who's Who of Awful Times to Invest. The Shiller P/E is used in place of the price/peak earnings ratio (as the latter can be corrupted when prior peak earnings reflect unusually elevated profit margins). Also, it's sufficient for the market to have advanced substantially from its 4-year low, regardless of whether that advance represents a 4-year high. I've added elevated bullish sentiment with a 20 point spread to capture the "overbullish" part of the syndrome, which doesn't change the set of warnings, but narrows the number of weeks at each peak to the most extreme observations].

The historical instances corresponding to these conditions are as follows:

December 1972 – January 1973 (followed by a 48% collapse over the next 21 months)

August – September 1987 (followed by a 34% plunge over the following 3 months)

July 1998 (followed abruptly by an 18% loss over the following 3 months)

July 1999 (followed by a 12% market loss over the next 3 months)

January 2000 (followed by a spike 10% loss over the next 6 weeks)

March 2000 (followed by a spike loss of 12% over 3 weeks, and a 49% loss into 2002)

July 2007 (followed by a 57% market plunge over the following 21 months)

January 2010 (followed by a 7% “air pocket” loss over the next 4 weeks)

April 2010 (followed by a 17% market loss over the following 3 months)

December 2010

 

This chart from Hussman has data through March 3, but the latest blue band is now about a month wider:

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This is clearly time to exit stocks or hedge all market risk. The upside is limited relative to the downside.

Rumors of dollar’s death greatly exaggerated

Sentiment is still very anti-dollar (though not as extreme as last February-April), but the index is no lower than a few months ago, nor even a few years ago. Despite all of the dollar-crash and hyperinflation hysteria in recent years, early 2008 still marks the bottom.

MACD and RSI also seem to back up the case that the next big move is more likely up than down:

3 year daily chart:

stockcharts.com

5-year weekly chart:

bigcharts.com

10-year monthly:

futures.tradingcharts.com

The 10-year chart says it all: the dollar has already crashed, and as is typical in the financial markets, few noticed or attempted to take action until the move was already over.

Hussman: Market risk is extreme

John Hussman is the rare mutual fund manager who uses technicals and hedging to minimize risk and maximize returns during a full bull-bear cycle. He hedged up in 2000 and 2007 to preserve his fund’s equity during the ensuing bear markets, and is again tightly-hedged in preparation for another downturn.

His weekly market comment is a must-read (if you just read this and Mish’s blog regularly, you’re all set). He uses a set of indicators to identify periods during which risk is elevated based on historical statistical analysis. They are: 1) stock market investor sentiment, 2) Case-Shiller PE ratio, 3) Treasury yield trends, and 4) price action (to indicate whether stocks are overbought or oversold using moving averages).

He concludes each market comment (in which he puts on his academic cap to discuss market statistics, Fed policy, etc in geeky detail), with a quick summary of where his funds are positioned according to the prevailing risk profile. When he starts his conclusion like this, you better not be long stocks:

Market Climate

As of last week, the Market Climate for equities was characterized by an unusually extreme profile of overvalued, overbought, overbullish, rising-yield conditions. Both Strategic Growth and Strategic International Equity remain tightly hedged here.

Here is a chart showing where these market conditions have existed in the past:

Thoughts on P3 and the secular bear

Hi guys.

Sorry for being so quiet on the blog lately. I’ve been busy trying to take my mining site out of beta among other things, and not following the day-to-day action much.

In response to comments about Elliott Wave and EWI, I actually don’t read EWI anymore except for Prechter’s monthly essays. I don’t see that the short-term stuff offers much of an edge over just following basic technical and sentiment indicators. Trying to force the market into fitting a specific pattern has just not been a good way to go, but the intermediate-term technical indicators have been doing quite well.

For instance, put:call, vix and weakening RSI have nailed the tops in November, January and March-April. The last was just screaming SELL as loud as the market ever does, and we got the follow through we deserved.

Short-term oversold conditions in late May and July were marked by the VIX and weakening selling as indicated by RSI.  Constantly anticipating a hard 1930-style P3 is just a bad way to play. Of course you don’t want to be caught long without protection at any point in this environment, credit crunch and depression that it is, but there is a tremendous degree of speculative enthusiasm and stubborn optimism among traders that is making this a long slog down.

Of course I think this is a secular bear market that won’t end until there is real value restored in stocks and real estate, which means solid after-tax yields high enough to compensate scared investors for the risk of further capital losses. But there is no reason why we have to get there in 3-4 years — this could go more like ’66-’82 in the US or post-’89 in Japan.

That said, we have not had full-on recognition of the extent of the economic problems within the financial community, with most analysts and economists clinging to the hope of Keynesianism. Trading horizons are so short-term among the big players that these considerations hardly matter. The technicals are all that drive the machines and guys like Paul Jones, Cohen, etc.

This is a deflation though, no doubt at all. Credit is contracting hard, and prices of everything not directly traded as futures or set by the government are falling. This includes private sector wages, groceries, capital goods, etc. In this environment we do not have the same set-up as for the rolling sideways market of ’66-’82 (only in nominal terms was that a sideways market – in real terms it was a 75% loss). The ’30s and Japan are still the corollaries to watch.

Also remember that the public sector has gotten itself into huge trouble, which is just starting to take effect with austerity measures in Europe and pending bankruptcies in US municipalities. US states are also broke and will have to finally deal with their union problems. Shrinking government worker salaries, if not payrolls, will put further pressure on demand for goods and leave banks with more bad loans. None of this is inflationary. Remember, in the ’70s private debt was low and growing, and companies were increasing their revenues and profits so that by ’82 Dow 1000 was a bargain. Now we’re in a generational de-leveraging, frugality-restoring mode, Kondratieff winter for lack of a better term.

The last couple of years should give deflationists confidence that we’re able to correctly assess the situation. Where is that dollar crash? What about $200 oil? What, in 2010 China still owns trillions in treasuries? Bernanke has tripled the US base money supply but a dozen eggs is still $1.50 and the long bond yields 4%? Obama spent how much, and unemployment is 17% ?

We make it way too hard on ourselves trying to get every squiggle right. Stocks and real estate are expensive and cash is still the way to go. Gold is still increasing in purchasing power. This is not bizarro world, it’s so far just a very big dead cat bounce after a 60% crash. US stocks are about where they were 12 months ago, and other markets are much lower, so clearly momentum is broken and bears should be confident so long as they’re not over-levered.

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PS- In response to Roger, upon first glance VXX looks like a fine vehicle for trading volatility. It seems to have tracked the VIX without much error since launch. Of course VIX futures and long-term OTM puts are also fine for going long vol.

VIX & Put:Call starting to make puts attractive again

A fair degree of complacency has snuck back into markets over the last month.  We don’t have a strong sell signal in stocks yet, but if April marked the high in US and European markets and economic indicators are turning down again, this could be a good spot to start building short positions again:

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Here’s the equity put:call vs the 20 day moving average, back to one standard deviation under its mean. Dipping lower would require the kind of extreme complacency that we’ve only seen twice in the last decade, so I wouldn’t count on it:

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The dollar has also corrected its overbought condition (and is actually very oversold), which is key for a resumption of the deflation trade:

One year later, a real head and shoulders?

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Solid deflation trade on today: bonds, yen, dollar up and everything else down. This is hard selling, so it looks like we’re completing the top of the great dead cat bounce of ’09-’10. Once stocks and commodities break May’s lows, they could fall very quickly towards the levels of winter ’09.

Here’s crude oil, continuous contract futures. This is a beautiful short right now. How quickly the phrase “demand destruction” disappeared from discourse, along with all the other reasons why $35 was a perfectly reasonable price for oil.