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.

Credit markets iced over. Put your head between your knees.

This is still a Goldilocks economy?

Many standard fear gauges remain near their most elevated levels of the bust so far. From highly emotional conditions like these, we should expect a big move in equity prices. The question is whether the next emotion is relief or all-out panic.

If the fundamentals were not so horrible and stock prices not so high (with earnings falling off a cliff, real PEs are in the stratosphere and dividend yields are pathetic), this would be a promising time to go long, at least for a trade. As is, that would be Russian Roulette, because it would be hard to imagine a market more primed to absolutely crash than this one.

With open talk of a depression from the Secretary of the Treasury, and the President comparing the financial system to a “house of cards,” the Dow Jones Industrial Average registers the same opinion about the economy as it did in mid-2006, when talk of Goldilocks was in the air. Something has to give.

This is the Dow from summer 1982 to the present. We are still at the crest of the tidal wave:

Click image for larger view. Source: Yahoo! Finance.

Last week (Sept 15th-19th) a huge amount of steam was let out out of the market, first from the bears, and then from the bulls. By Friday afternoon, traders expressed physical and emotional exhaustion, and volume dried up. It was an eerie feeling.

That week started off in a fright, with new lows on the Dow, T-bills under 0.1% and a VIX over 40. In a lesser bear market, Thursday’s bailout announcement should have marked a substantial bottom (by no means the bottom, but at least the basis for a tradeable rally).

However, the 1000 point, three-hour rally from 2:30PM on Thursday to 11:00AM on Friday hardly set up the basis for a sustained rise, since where else could stocks go but down after such a move? The very violence of it showed how much fear was out there by Thursday morning. We were truly looking into the abyss, that netherworld below 10,000.

After the short-squeeze ran out of steam, prices dribbled down from Friday afternoon to this Wednesday on low volume and volatility, before a little follow-up rally Thursday and Friday relieved the very-near-term oversold condition.  The Dow rests this weekend at 11,143, awaiting what will surely be a wise edict from the philosophers in our legislature. 11,143 is a number neither too ugly sounding nor too pollyannaish, square in the middle, with plenty of room on either side (at least for the near-term).

10-day view here (double lines mark the days):

Click image for larger view. Source: Bigcharts.com

Fear is still highly elevated, no doubt stoked among the general public by the scare tactics and demeanor of Messrs. Bernanke and Paulson. Over the last week, even people who did not support Ron Paul for president have begun to acknowledge the magnitude of the problem. The question is, what are they going to to about it, and when?

To see where Mr. Market’s next move is coming from, follow his rates, not his stocks.

The credit market isn’t waiting for anyone, public nor Paulson. As far as banks are concerned, it’s already TEOTWAWKI, and that is important because changes in credit markets precede changes in equity markets. Two summers ago, while Goldilocks was still enjoying her porridge, bond traders were looking out the window and deciding to pay a premium for long-term debt over short-term (an inverted yield curve is almost always followed 12-18 months later by a recession).

Short-term Treasury yields of course are extremely compressed. 3-month T-bill yield here:

Click image for larger view. Source: Yahoo! Finance

Here is the TED spread, the difference between LIBOR (the rate that banks outside the US Fed system lend one another overnight) and 90 day Treasuries. A wide spread indicates reluctance to lend, i.e., a lack of trust between banks.

Click image for larger view. Source: Bloomberg

Here’s another scary picture from the credit markets, the discount rate spread, the difference in yield between AA and A2/P2 rated commercial paper (short-term corporate debt such as trade receivables). This is why non-Treasury money market funds are so risky (and why Paulson wants to bail them out):

Click image for larger view. Source: Federal Reserve

Fear bloodhounds should also be trained on the Chicago Board of Exchange Volatility Index, a measure of expected volatility in the S&P 500, as indicated by near-term options prices. From summer 2006 to summer 2007, the VIX dipped under 10 at times, truly the calm before the storm, registering the very apex of the decades of unfounded optimism and imprudence that brought about this mess. During the dot-com bust, it nudged over 40 on occasion, a number that was breached intraday in the pre-bailout depths of last Thursday. Two-year view here:

Click image for larger view. Source: Yahoo! Finance

This bear is scared to hell of Goldilocks. It’s too dangerous out there to even short with the confidence that you can get paid if you are right. Where will the money come from?

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