Tag Archives: SPX

Hussman: Market risk is extreme

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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:

Max caution alert: exit or hedge all market risk

Posted on
34

This is one of those times where markets are stretched to the limit and any further upside will be minimal in relation to the extreme risk entailed. Sentiment has been dollar-bearish and risk-bullish for so long that a violent reversal is all but guaranteed. This is not to say that the absolute top is in, but that at the very least, another episode like last April-June is coming up.

Watch for a sharp sell-off in stocks, commodities and the EUR-CAD-AUD complex. Even gold and silver are vulnerable, especially silver. We could be near a secular top in silver, where the recent superspike has all but gauranteed an unhappy ending to what has been a fantastic technical and fundamental play for the last decade. Gold is much more reasonably valued and should continue to outperform risk assets because the monetary authorities are so reckless, but there is just too much froth in silver to hope for even that.

The rally since early 2009 has been not just another dead cat bounce in the bear market from 2007 (like I thought it would be), but another full-blown reflation and risk binge like the 2003-2007 cyclical bull. The secular bear since 2000 is still here, and valuations and technicals suggest that another cyclical bear phase is imminent. There is no telling how long it will take or how it will play out, but the only prudent move at times like this is to take all market risk off the table. Bears still standing should think about going fully short. Anyone holding stocks should sell or get fully hedged. History shows that the expected 10-year return on stocks from conditions like this is under 3.5%, and such a positive figure is often only acheived after a major drawdown and rebound. See John Hussman’s excellent research on the topic of expected returns from various valuation levels: http://hussmanfunds.com/weeklyMarketComment.html

Want to know what a secular bear looks like? Check out 1966-1982: a series of crashes and rallies that resulted in a 75% inflation-adjusted loss. In the absense of 70s-style inflation, this time the nominal loss should be closer to the real loss. Think Japan 1989-who knows?

The headlines this time around should have less to do with US housing, though that bear is still raging. We’re likely to hear much more about European sovereign debt, where haircuts and defaults need to happen, and Canadian, Australian and Chinese real estate. When the China construction bubble pops it will remove a major fundamental pillar from the commodities market.

There is no safe haven but cash, and cash is all the better since everyone has feared it for so long. If I had to build a bulletproof portfolio that I was not allowed to touch for five years, it would be something like this: 20% gold bullion, 25% US T-bills, 25% US 10-year notes, 25% Swiss Francs (as much as I hate to buy francs at $1.13) and 5% deep out-of-the-money 2013 SPX puts (automatic cash settlement).

There will be a great value opportunity in stocks before long (the tell will be dividend yields over 5% on blue chips). It’s just a matter of having the cash when it comes, so that you aren’t like the guy who said in 1932 that he’d be buying if he hadn’t lost everything in the crash.

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PS – For those of you who think QE3,4,5,6 will save the markets, I’ll counter that it doesn’t matter, not on any time frame that counts. Risk appetite and private credit are what matter the most, and the Fed can’t print that. At 3AM, spiking the punchbowl doesn’t work anymore.

Or I can put it this way: the Fed has increased the monetary base from 850 billion to 2500 billion since 2007. Have your bank balance, salary and monthly bills increased 200%? If not, why should stock and commodity prices? Not even Lloyd Blankfein is 200% richer than four years ago.

Major dollar rally coming soon, to a trading screen near you.

Posted on
6

Sorry for my long hiatus from blogging. I’ve been trading very little over the last six months, demoralized and righly so due to chronically awful trade execution and overreaching. I have a highly valid reversal strategy, but it is not a trend strategy, and I need to keep my bearish macro views out of the equation (though I suspect that they would be better suited to the next 2 years that the last 2 – but I need to forget about that and keep such discussions academic, for risk of corrupting a perfectly good trading model).

I’ve done some soul-searching and review of my trading history and this blog, and come to the conclusion that I should not abandon this pursuit but instead work to remedy my fatal flaws. A review of my history shows that I am able to identify turns in markets with a very high degree of probability. The fatal flaws are not analytical, but as is usually the case, emotional and procedural. This blog actually has a very good record of both initiating positions and closing or reversing them. As a trader, I would have done well to follow its advice, but I would often revert back to my bear bias, and way too soon, as when I shorted risk last March-April, booked huge profits and went long (including buying bottom tick in EUR and CHF) in June, only to reverse and go short again in July on bias alone without my proven criteria for a valid set-up.

My basic methodology as it has evolved here since August 2008 when this blog began, is to use sentiment and technical data to identify oversold and overbought conditions that are long in the tooth and due for clearing reversals.

The classic set-up is like this:

  • DSI sentiment has plateaued or bottomed at an extreme (<20% or >80% for at least 5 weeks, the longer the better – this can go on for 6 months at the outside, more commonly 4-12 weeks if we are talking <20% or >80% readings).
  • A major move comensurate with that sentiment has occurred (the market is trading at highs or lows), which to the mass of traders seems totatally justified by fundamentals.
  • Price action shows weakening momentum. This is indicated by a diverging trend in oomph indicators MACD and RSI. This usually means that the rate of change is slowing and that each new little push is slower and on lower volume, even as new extremes in price are reached.
  • A loose stop-loss level can be identified (a level that should it be broken decisively, would indicate that the prevailing trend still has legs). This is a mult-week strategy, so stops should use daily or even weekly levels — no use for 5 minute charts here.
  • Markets are highly coordinated in recent years. E.g., if the dollar is looking like it is going to rally, don’t be long stocks or commodities or short bonds.
  • Adjust stops downward to breakeven after the reversal, and tighten stops to a gain as DSI data reaches 40-60% middle ground.
  • Tighten stops much more or close positions after DSI data approaches the opposite extreme (e.g., if you shorted SPX when DSI bulls were 90%, prepare to close and consider the trade finished once DSI reaches 25%).
  • This is not a trend system! Repeat, this is not a trend system! Trade reversals only, as those have the highest probability. Once the oversold/overbought condition is cleared, the probability of the market continuing in your direction is vastly lower, and does not justify the risk (no matter your opinion of the longer-term situation or fundamentals). This last point was my fatal flaw.
So, we have a classic long-dollar set-up developing right now. I give it strong odds that we experience a major dollar rally within 2 months, with all of the de-leveraging that entails in other markets. This is not the place to put on a heavy position if you are not willing to accept big drawdowns, since this market could easily trend for a while yet, with the stock markets holding up as well.
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source: futures.tradingcharts.com
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Note that this trade is confirmed by the opposite in the stock market. Plateau in DSI and other sentiment indicators at a high level of bullishness for several weeks. This condition will be cleared to the downside as the dollar breaks upward. Copper, oil, etc will also correct hard down, and the anti-dollar currency pack (CAD, GBP, EUR, AUD and probably CHF) will fall as well. Not sure about JPY – it often trades up with the dollar during these little episodes of risk unwinding.
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As always, the timing is the most uncertain factor here, but the longer the dollar sentiment stays low, the less risk there is in this trade and the stronger the resulting rally will be. I can’t say whether this will come next week or in early June, but we are at the point where traders should be nervous about short-dollar, long-risk positions, because that trade is running on momentum alone and meets the requisites for sudden reversal.
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The archetypal set-up was long-dollar in fall 2009, after dismal trader sentiment since early June 09. The set-up was in place by late August, but the dollar continued to drift down through November, helped along by small clearing rallies and brief upticks in sentiment. Because average sentiment was low for an extraordinarily long time (6 months), we had a very powerful rally, from 74 to 88, over the following 6 months. This time, sentiment has been low for two months so far, certainly enough for a good rally, but not necessarily for the same killer trade. On the other hand it is somewhat better because the readings are more extreme.
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The clearing episodes are the wall of worry or the slope of hope that keep the trend going.  A smoothy trending market with a flattening slope is more dangerous for followers and better for reversal traders. So far we have such a market, but if it gets choppy, with little sell-offs in stocks and small dollar rallies, it can last longer, and if the clearing events are big enough, it would cancel this trade. There will be others.

One year later, a real head and shoulders?

Posted on
6

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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.

Relief rally coming?

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We’ve got a clear divergence on RSI now, as each impulse lower over this week has been weaker than the last. This is a sign to tighten up stops or close shorts. You could make a decent case for a quick long trade here with a stop just under the lows, but on a wider time frame market risk is still very high.

Here’s a chart of SPX futures:

TD Ameritrade

Toppy action in dollar index, another rally in stocks coming?

Posted on
5

The dollar index is showing waning strength on advances, and its rally is very long in the tooth. There could be worse times to take a short position on DX. At least there is a clear and close stop price at the highs.

Here’s the 2-hour bar, then the 5-min:

TD Ameritrade

Here’s what ES looks like to me this evening (5-min chart). There’s an upward divergence in RSI, indicating waning oomph on the sell-offs:

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I took a long position in CHF and ES (SPX futures) after the close of regular trading today, and I’ve shorted some Treasuries and yen, but I’m still short oil, palladium (added to my position today), copper, silver, gold also added more today) and copper. I’m agnostic about the intermediate-term direction of the risk/inflation trade and just trading what I see: commodities look broken, but stocks still have rebound potential, as do the euro, franc and pound.

This chop and weak rally action in stocks precludes neither a big new rally nor a fall into the abyss. Big rallies like August-October 2007 or Feb-April 2010 have started slowly with chop like this and kept the bears confident. The timeframe for such a rally is limited, however, and if we don’t take off in another week or so momentum will peter out and we can start to roll over. This is what happened in late spring 1930 after the first hard leg down from the top of that post-crash rally.

ES update (edited for clarity): stock futures still strong, but watch RSI for signs of weakness

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1

We don’t really have waning strength yet on the hourly scale in SPX futures, but I can see the possibility. If this current rally leg (from Friday afternoon’s low around 1083) fails to break 1107 (Friday’s high) or does so on weaker RSI than the last rally, it will be a hint that the entire move up from 1036 is coming to an end. A fresh wave of selling will be even more probable if hourly RSI makes a lower low after a lower high.

Watch for weakening rallies and strengthening sell-offs to telegraph impending declines, even if prices are holding up (to be clear, we don’t have such weakening yet — I’m just watching for it). Prices often do stay elevated right up until a nasty break, like we saw from mid-April to early May (see chart below, ES 2-hour bar). You can also see the strengthening rallies and weakening declines since the bottom last week (the bottom was less strong than the preceding wave down, which is a classic buy signal).

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Here’s the ES hourly. Still showing strength, but it would be bearish if this current wave does not get at least as powerful as the last.

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And 15-min bar… this one shows weakness, but it’s too early in the wave to be sure.

All charts from TD Ameritrade

Today is a trading day for most of the world (and US futures are trading, though on a cut schedule), so don’t think that prices will wait for 9:30 EST Tuesday to make any important moves.

Remember, we have a rather neutral set of conditions on the daily chart, but the Elliott Wave crowd is looking for a hard third wave down anytime, and last week’s action could serve as a perfectly functional 2nd wave. If there is a third wave coming, it will be more powerful than the decline from 1220 to 1040, possibily taking us under 900 very quickly. Judging by May 6, the market has signaled that it is capable of such a move, and relentless declines are common following bear market rallies. Also in favor of such a move are the continued dollar and yen strength, anemic rallies of the euro, chf and pound, and the fact that the commodity complex is looking broken.

If you can’t tell, I am ambivalent about stocks now and positioned appropriately flat at the moment. These are not good junctures to trade, since the signals are so mixed.

Week in review and intermediate-term thoughts

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Today I’m going to lay out what I’m watching for clues about the intermediate-term prospects. The action of the last 4 weeks has been more suggestive of a reversal than any we’ve had since the March 2009 lows. However, even if a top is in hand and we are finally at our spring 1930 moment, I’m not willing to throw caution to the wind and discount the possibility of another few weeks of rally.

Let’s start with the 5-day average equity:put call ratio, which has nailed so many intermediate-term tops, not least of which this last, which it suggested would be followed by a serious decline:

Indexindicators.com

The put:call ratio could use a bit more of a reset, which could be achieved by just a few more days of calmer or rising markets. Nothing major required here, just a pause.

This break has shaken up a few traders, but judging from interviews this week, the majority remain fairly sanguine about a continued bull phase and consider this a healthy correction, much as they did the first declines off SPX 1550 in late 2007 and early 2008. Also, the past year has established a very clear pattern of modest declines followed by new highs on extreme bullishness. Traders and their machines may be programmed to buy this dip, but with the recent technical damage (we busted the last low for the first time in the whole rally and experienced a mini-crash) I’d expect any rally to be relatively shallow.

There is a pattern of reduced oomph on each subsequent rally phase, which you can see in the diminishing slopes of each rally. You can also see the weakening of the larger trend in the angles between subsequent lows.  (Click to enlarge the image.)

TD Ameritrade

I’ve drawn those ovals on RSI to show a technique I have for picking bottoms. It gets most intermediate term bottoms, and perhaps more importantly, it has a low false-positive rate. A rally becomes likely when you get a double bottom in RSI. This works on any scale you chose, from 1-minute to daily or higher. The likelihood of a rally increases if the second bottom on RSI is higher than the first. This is common because the middle wave of a decline is usually more intense than the final wave.

Now, this current juncture has such a double bottom signal, though the second RSI bottom is not higher than the first. It is also trickier because the first was formed by the latest black Thursday, May 6. I’m not sure how such an event should factor in, but it throws off our analysis somewhat. Perhaps the May 6 event should be discounted (it was really just 1 hour of trading that produced the reading) so that we can’t actually count this RSI bottom as a 2nd.

In terms of time, we’re just over 4 weeks into the decline, which is approaching the average for an intermediate-term decline over the last 3 years (the last one was very short at 3 weeks, and others have lasted up to 8 weeks).

Also of consideration is the extreme complacency that we are correcting. Look again at CPCE in the first chart above. From what I can tell, it set a record for complacency going back to at least the year 1999. This suggests we may have more decline ahead before an extended relief rally. Sentiment has turned negative, but not overwhealmingly so, and it has only been negative for a couple of weeks, so this is not a contraint to a further decline.

One more consideration is the 1930 parallel. Once stocks broke that April after their rally from the crash of ’29, they failed to rally hard for years. The decline was steady all the way down to the bottom in July ’32. In this analalogue, we would have another week or so of choppy and weak rally, followed by the bottom falling out, an outcome that would elegantly resolve our situation. The dip-buyers pile in, but the oomph is gone, momentum weakens and RSI turns down, then BAM, we’re back to SPX 750 this summer.

Prophet charts

I am approaching this situation by being neutral on stocks at the moment. I am holding a core position in December 2011 and 2012 SPY puts and some calls I’m short on IYR and GDX, though I sold a portion of the puts on Tuesday morning and and the rest are hedged with a short in VIX futures (I do this because spreads on options make them costly to trade in and out of). Essentially, I’m flat on equities.

I closed a ton of shorts from last Thursday to Tuesday morning, and went long SPX, ASX and Nikkei futures (and long CHF, EUR, GBP and short JPY and VIX) early this week when I saw divergences in the VIX, currencies and commodities (ie, stock indexes made a new low that was not confirmed with new extremes elsewhere, a buy signal) as well as a glaring RSI divergence on the hourly scale. Those “long risk” positions I closed for profits on Thursday and Friday, since we’ve already corrected the extreme short-term oversold condition and are in neutral territory. Equity-wise, I ended the week where I was on Tuesday morning, since the drop in volitility hurt my puts as much as my various longs made me money. Vol is a bitch that way — sometimes you time prices right, but it’s not enough.

Speaking of the VIX, I think it could settle down for a few weeks, though to a higher level than in April, before the next decline pushes it up again. I think it will remain elevated (as from Oct 2007 onwards) for many more months or a couple of years:

Prophet charts

In the commodity space I’m even more convinced that a major top is at hand, since some trendline breaks have been decisive (platinum, palladium, oil) and the declines have been so violent all around. Commodities tend not to rally as hard as stocks once the trend changes to down, so I entered shorts on oil, silver, gold, palladium and copper near their highs late in the week. The precious metals are looking particularly suspect to me here, and I still think my July 2008 double top analogue is in play.

The euro, Swiss franc and British pound are still looking very weak. Sentiment has been in the dumps for four months now, which is a set-up for a spectacular rally, but judging from their heaviness this week as stocks and commodities and CAD and AUD rallied, I think they may slide to one more low before that rally.