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Loaded for bear

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Graphite here.

Although it’s easy for this kind of contrarianism to turn into unhelpful navel gazing, on Friday the level of despondency seemed to hit a new high (or is it low?) on the bear blogs. Posts and message boards are chock full of buzz about perpetual asset inflation powered by the Fed’s magical money machine and an ample supply of that tricky thing called “liquidity.” Visions of the 1990s and 2000s are offered as proof that the market can disconnect itself from any fundamental or technical backdrop and power to endless new highs. The January highs are trotted out as “points of no return” for the bears, as though the market is guaranteed to launch higher if it manages to cross that threshold. And with the market seeming to shrug off every negative news item from sovereign defaults to bank failures to continued hemorrhaging of jobs in the U.S., traders are unable to conceive of a “trigger” that could send stocks lower.

Meanwhile, take a step back and look at the technical picture the market is presenting at the moment. After a several-week buying frenzy in stocks, we have new highs in the high-beta Nasdaq and Russell indices, unconfirmed (so far) by the Dow and S&P. Friday’s 5:1 NYSE a/d ratio was cause for concern, but hardly a match for the 35:1 down day seen in the February selloff. The 17 handle on the VIX shows complacency in the option market. Bonds and the dollar remain very well bid, despite the imminent end to Fed purchases and the best efforts of politicians to dismiss the euro’s and pound’s woes as the unnecessary manipulation of nefarious speculators. After a period of sideways movement the currency DSI sentiment has backed off somewhat from its recent extremes. Sterling in particular seems to have taken over whipping boy duties from the euro for the moment, and may have just finished a failed breakout from a channel on the 1-month chart. I have entered a short position with a stop above the upper channel line:

Interactive Brokers

Source: Interactive Brokers

If it tops here, crude oil will have put in a right shoulder on a ponderous 6-month H&S formation. A close today below 81.79 in the April contract would also create a bearish outside reversal bar (not shown):

Interactive Brokers

Source: Interactive Brokers

Over the weekend Marketwatch ran a segment prominently touting “The Year of the Bull,” complete with an upward sloping line starting from March 1, 2009.

If immediate new highs are in store for the major indices I would expect them to be muted at best, following Friday’s buying frenzy and the outpouring of bullish sentiment and resignation from the bears. If all the indices turn and fail right here I would think we will put in a stronger, swifter leg to the downside than we saw in January. And with entries in various markets offering tight, well-defined stops at multi-week highs, risk/reward favors the battered bears for now.

The power of technical analysis. (repost from 3.3.10)

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(First published 3.3.10, 1:27PM EST)

I’ve noticed lately how well the 60-min RSI (relative strength index — a measure of oomph in price movement) has been doing, so today I decided to quantify it. The result is simply spectacular, even with a mechanical buy/sell decision that always had you in the market either long or short.

Here is a 60-day chart of the Dow, by 60-min bar. The circles are negative RSI crosses (red arrows on the bottom) and the boxes are positive crosses (green arrows). The numbers are the Dow points one might achieve by riding Dow futures from the previous signal using the signals alone, with no stop-losses. Additional signals do not add to the position, and the trade is reversed on the next opposing signal.

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I tried to be conservative with those point totals (not buying or selling top or bottom tick), and some of those moves may have been missed due to opening gaps (where the price has already moved so far by the time of the opening bell), but you get the idea. It comes out to 1425 Dow points, even having been short for the whole 500 point drop in late January, which a stop-loss could have prevented. A single mini-dow futures contract, symbol YM, requires a margin of $6825 and is worth $5 per Dow point.

Now, this is hardly a perfect reflection of actual trading, but just mechanically trading a simple signal is infinitely superior to trying to outguess the crowd based on mumbo-jumbo like the Greek situation, Barney Frank, Obama this or that, oil prices, GDP, consumer data, or any other nonsense.

Now, I don’t have to tell explain any further why I think the market will probably fall by early next week.

Some more Dow history

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Continuing the top series…

Be sure to look at the lines on these charts, including RSI trends. If you gave Paul Tudor Jones nothing but graph paper and a ruler and he would still be a star. With price and RSI, you have all you need technique-wise. The rest is all emotional.

Prophet.net

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Here’s something I find interesting. A line connecting the bottom ticks in the 1974 and 1978 crashes precisely arrested the 1987 crash.

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The crash of ’08 solidly busted it:

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Skeptical that these old trendlines matter? Look at the support line connecting the depression lows of July 1932 (40) and May 1942 (92). It served as support an addional five times, and when it was finally breached in 1969 at 920 the market crashed that very week and entered a decade-long bear market.

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One more oldie is still very much in play, the line connecting the secular bear market lows of 1932 and 1974. Today it runs today through roughly Dow 5600:

Yen to test the highs?

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Don’t sell short the Yen just yet. It is wedging up to the highs and still seems to find a bid when stocks fall. I noticed this large wedge on the USD.JPY 5-year:

Interactive Brokers

A breakout of that wedge will be bearish for Yen, and a nice spot to think about shorting. For now, I’m letting it run, since the Yen is still the only thing stronger than the dollar in deflation. Note, however, that each subsequent move down in dollar/yen is shallower and choppier than the last, hinting at a pending reversal.

Here’s another way to look at it. There’s still an unbroken longstanding support line in Yen/Dollar, but the rise in 2009 was choppier and at a shallower angle than previous rallies. You can also see in weekly RSI that the trend is tiring:

Add mortgages to the debt bubble (with junk bonds, munis, sovereign debt…)

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Mortgages are still cheap, if you can get them. The spread over 30-year T-bonds has fallen to record lows, at just 0.2%.

St. Louis Fed

This spread is unsustainable and will be corrected by falling bond yields (rising prices) and/or rising mortgage rates. It is possible that mortgage rates fall still lower, but the spread must widen to deliver a decent risk premium (the same is true for corporate bonds). I actually would not discount the odds of yet lower mortgage rates if Treasuries rally hard, since we are going through deflation (best defined as a contraction of money and credit) and the real yield is a good deal higher than the nominal.

Lookat CPI minus food and energy (it is mainly higher oil and gas prices over the last 12 months that are holding it up):

David Rosenberg calls mortgages a bubble:

Once again, this Houdini recovery has involved a situation where mortgage rates have plunged and yet Treasury bond yields have been rising — 30-year fixed rate mortgages have fallen to 4.93% and are sitting are record-tight spreads over long Treasury bonds (see Chart 6). Historically, the average spread is 150bps and this differential is now 20bps. This is remarkable and our concern is that investors who may be exposed to mortgages are at serious risk because there is a considerable chance that these rates will be moving higher over the intermediate term — notwithstanding continued support from Uncle Sam’s pocketbook.

Investors must be reminded time and again that mortgages are callable, Treasuries are not; and we are now in a situation where net of fees, which average 70bps, anyone buying mortgage paper today is receiving a rate that is less than what the borrower is paying, How nutty is that? Remember — despite all the ridiculous comparisons to the Weimar Republic, the long bond is THE risk-free benchmark interest rate in the U.S. and with State taxes going up, Treasuries are an even further bargain because of their tax status.

Houses are still way too expensive in the US, as indicated by inventories, income multiples and rental yields, but if they fall to historically cheap levels in the coming years while mortgage rates stay low, they could be a fantastic investment. This is especially true if we later go through a period of high inflation, so that real mortgage payments drop (fixed-rate only of course) while rents and incomes rise.

This goes to show the importance of keeping hold of your cash during deflation, because there will be historic opportunities in almost every asset class.

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More here from David Rosenberg (free account required).

PPS – Here’s an update on the long Treasury note, short junk bond play. As you can see, we are still in a very nice spot to put on the trade:

Newton’s AAPL

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Sir Isaac actually dabbled in the stock market during the South Seas bubble — when it started to get crazy, he got out, but then near the very top he succumbed to the mania and bought in again, only to lose his shirt*. Apparently, he forgot his own rule.

Prophet.net

*Reportedly 20,000 pounds, back when the pound was such a mass of 0.925 silver.

What does a top look like?

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Some charts from historical tops in the Dow, starting with 1901:

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The giant gap down above did not happen in a day. The government forced the closure of the NYSE on July 27 (after a crash when the closure was foreseen), and it was not reopened until Dec 14. The Great War started in the interim.

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In May 1940, where you can see a crash above, the Low Countries fell to Germany and Northern France was occupied. However, charts alone were all you needed to be bearish.

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