Technical Talk: Upside breakout for S&P?

Sunday, August 5th, 2012

The comments below were provided by Kevin Lane of Fusion IQ.

As seen in the chart below the S&P 500 Index (SPX 1390.99 �‘1.90%) held its 100-day moving average yesterday (green line) near 1,350 and today is bouncing on ECB news and better-than-expected-non-farm payrolls – does anyone smell election year mark-ups? That said, the Index is still setting higher lows since its June low, which is bullish; however it has also been capped near the 1,385 area (red line) for a while now. The Index continues to remain locked in a range, with resistance at 1,385, and near-term support at 1,350. [PduP: The closing level on Friday was 1,391.] Whichever way it breaks, momentum will surely follow. More meaningful support lies near the 1,330 – 1,325 band (purple-shaded lines and arrows) as this was the area where the S&P 500 double-bottomed recently. This is the area that is most critical in regard to keeping the market together.

There are conflicting data that could support a breakout (i.e. more consistent levels of news highs, low long exposure levels and low levels of bullish sentiment) or a breakdown (i.e. weak action in cyclicals and transports, especially truckers). However, if forced to choose, we are leaning towards an upside breakout. That said, we won’t be ashamed to pull the rip cord if key supports are broken as this would take the breakout call off the table. After all, being wrong once in a while is inevitable, however, ignoring an oncoming truck (i.e. a break of support) assuming you can swerve around it, is never a smart strategy!

This game is about knowing when to press forward, when to sit tight and watch, when to retreat and, most important, knowing when to change strategies if need be!

Source: Source: Kevin Lane, Fusion IQ, August 3, 2012.

Tags: Amp, Arrows, Bullish Sentiment, Consistent Levels, Cyclicals, Election Year, Exposure Levels, Iq, Lows, Mark Ups, Meaningful Support, Momentum, Non Farm Payrolls, Red Line, Rip Cord, Smart Strategy, Spx, Transports, Truckers, Ups
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The Odds Are Against You

Monday, July 9th, 2012

by Guy Lerner, The Technical Take

I define the price cycle as the path prices take from low to high and back to low again.  To help determine where I am in that cycle I use investor sentiment.  Typically, extremes in bearish sentiment often define cycle low points leading to bullish gains, and extremes in bullish sentiment often define cycle high points leading to a loss of price momentum at best and more commonly, a retracement in price of the price move from low to high.  This is the price cycle — “wash, rinse, repeat”.

The most recent bullish price cycle hit a low on October 7, 2011 and it did not peak out until April 20, 2012.  Since April 20, 2012, the market (i.e., SP500) has sold off a little bit and has bounced little bit, but prices are still below the sell point.  We are at that point in the price cycle where the bullish gains have been made and price momentum has been lost.  We have yet to hit an extreme in bearish sentiment that would define a low point in the price cycle, and as I have stated for months now , the only way we can get there is to have lower prices.   To understand what I am talking about, I will quantify these price dynamics.

So let’s create a study that looks at the part of the price cycle where upward price momentum has already slowed and prices have yet to hit a low point.  In essence, what I am doing is looking at the part of the price cycle when prices are above the 200 day moving average and momentum has fallen out of the trend.  For the study then, our buy signal occurs when the upward price thrust of the price cycle has ended and prices are above the 40 week moving average.  Our sell signal is either new extremes in bearish sentiment (i.e., the bottom of the price cycle) or prices have closed below the 40 week moving average.  What I want to know is what happens to price in the period  after momentum of the upward thrust of the price cycles wanes to the next buy signal.  This would replicate the current conditions in the market.  The study is based upon the SP500 data starting in 1991.

Figure 1 shows the equity curve for this strategy, and it is not pretty.  So once momentum of the initial price thrust is over, buying the market just because price is above its 40 week moving average is a poor idea.

Figure 1. Equity Curve

Figure 2 shows the maximum adverse excursion (MAE) graph.  The MAE graph shows every trade from a particular strategy, and it is a measure of how much a trade moves adverse to its entry position.  MAE is a measure of investor angst.  For example, take the one trade inside the blue box.  This trade had an MAE or draw down of 6% before being closed out for a 1% loss.  We know it was a losing trade because the caret is red.  Now look at the 13 red carets to the right of the orange line.  This tells us that 13 out 38 total trades had an MAE greater 5%.  In other words, if you buy at the top or when everyone else is bullish or when the upward initial price thrust has diminished, it is likely that you will experience an excessive draw down.

Figure 2. MAE Graph

There are several take away points here.  Buying just because prices are above the 200 day moving average is a bad play.  Momentum needs to be present.  One way to have momentum develop is to have investors out of the market wanting in; these are the investors on the sidelines willing to pay up for prices. The best way to put investors on the sidelines is to have lower prices.  Unfortunately, the problem with the current market is that it has not done a good job of putting investors on the sidelines as the persistent belief in the “Bernanke put” has put a floor under this market.  Unfortunately, this dynamic is also responsible for the current listless price action.  Furthermore, buying the market when prices are well above the 200 day moving average, which is usually when the pundits and TV analysts are signalling the all clear, is probably a poor idea most of the time.

From this perspective, the data from this study is consistent with the notion that we are in a range bound market at best or in a process where we need to see lower prices before heading meaningfully higher.  The odds of success would be in your favor if you are buyer when others are bearish.

Tags: Bearish Sentiment, Bullish Sentiment, Curren, Extremes, Guy Lerner, Investor Sentiment, Little Bit, Moving Average, Odds, Path, Price Cycle, Price Cycles, Price Dynamics, Price Momentum, Price Move, Retracement, Trend, Upward Thrust, Wash Rinse
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Treasuries Currently Overbought: Relative Performance of Stocks vs. Bonds

Thursday, June 7th, 2012

by Tiho Brkan, The Short Side of Long

Topics Covered

• Global economic data worsening towards a recession
• Treasury Bond sentiment is extremely optimistic

Overview

The selling pressure has stopped. It seems that the S&P 500, Crude Oil and Gold are now recovering somewhat. Sentiment reached extreme negative levels on all of these asset classes over the last couple of weeks. 30 Yr Long Bond has paused its vertical rise on top of extreme bullish sentiment, while the US Dollar posted a reversal also due to extremely bullish sentiment. It seems we are entering a period of mean reversion but the bottom line still remains the same: investors have been selling risk due to possibility of a disorderly default in Eurozone, triggered by Greece as the first domino. At the same time, Asia and especially China is slowing down meaningfully. Nothing has been done, announced or hinted by authorities yet and risk off trades are very crowded.

Economic Data

Last week was one of the worst ever data release weeks for the US economy. Out of 21 releases throughout the week only 1 was better than expected, 2 came in at their estimates and a staggering 18 releases (including the important employment figures) all came in below economist expectations. I am pretty sure that the authorises, politicians and central bankers around the world are watching this with a magnifying lens right now. The question is what will they do next and will it even matter?

The overall Developed Markets Citigroup Economic Surprise Index has completely collapsed in recent weeks, so it should not be surprising at all that Bonds have outperformed Stocks again in the first half of 2012. While majority of analysts, economists and investors continue to put all of their faith towards the Federal Reserves ability to re-stimulate the economy through further QE, contrary to that I personally think it will not have too much of an effect, apart from a short to medium term sugar high rally without any new highs. In other words – a bear market rally!

Economic data is negatively surprising economists, not just in the US, but all over the world including the darling favourite of the investment world – Emerging Markets. As we can see in the chart above, the Emerging Market Citigroup Economic Surprise Index has completely collapsed for the first time since 2008 and with it GEM equities plus the global economic barometer – Dr Copper. This leads me to believe that not all is well in Asia and especially China.

While I believe all risk assets are currently oversold and due for a rebound, if the weakness continues again in repaid fashion, it will most likely lead me to a conclusion that we are entering a global recession. Chinese equity market, the Shanghai Composite, is still struggling to break upward. While this is a very bad sign, I am still willing to give it a bit more time to prove itself, as it struggles with a cluster of resistance points around 2,400 to 2,450 level. However, a proper breakdown will most likely signal a hard landing scenario for the Chinese economy. The crisis started in the US in 2007 and spread to the EU, but if we move towards a Chinese hard landing scenario, the final economic crash will most likely occur in Asia, where the boom has created over capacities in all economies from Indonesia to Korea and Australia.

Equity Markets
Nothing new to report.

Bond Markets
The second part of an article is a slight conundrum to the first part above. Here I focus on overbought Bond prices and extremely bullish sentiment that accompanies this assets. Therefore, one major problem when discussing a possibility of a recession, from a contrarian point of view, is that majority of market participants are already overweight Bonds as a fear trade. So the question is, if things get worse, will these safe havens go even higher?

Focusing on the current outlook, be it German Bunds or US Treasuries, prices have gone almost vertical in recent weeks and yields have dropped to 200 year plus record lows. While the uptrend is still intact for the 30 Yr Long Bond and the bull market is still posting new highs, currently the Daily Sentiment Index is showing readings of 97% bulls as of Friday last week. These types of readings usually do not offer too much further gains and most likely signal that we could at least suffer a correction / pullback from current levels.

This view is also confirmed by the Mark Hulbert service of tracking Bond newsletter exposure recommendations. Consider that at present, Bond newsletters are recommending 40% plus long exposure towards this asset class. This a very dramatic switch from March 2012, where these same “gurus” were recommending 40% net short exposure (and got it completely wrong). Historically, readings of 40% plus on each side have been very extreme and usually signalled that Bond prices reversed in some type of a counter trend rally.

Personally, I do not own any bonds in my fund, because I think they are a major major major major bubble! To led money to the US government at 1.5% over the next ten years is a total robbery when adjusted for true inflation figures, in my opinion. Therefore, I am waiting to short these assets, together with the Japanese Yen, at some time in the future.

Having said that, that does not mean prices cannot go higher from these levels, as overvalued bubbles can turn into manias and totally insane buying frenzies. Remember Nasdaq in 1999? Therefore, I am still reluctant to call a final top on the Treasury bull market, until the final EU crisis resolution and some type of a major default occurs to create a capitulation.
Currency Markets
Nothing new to report.

Commodity Markets
Nothing new to report.

Credit Markets
Nothing new to report.

Recommandations

• Summary: my further action depends on political and central bank intervention. During market panics, authorises also panic. It is not until they start to panic, that they actually do something about current problems, which usually take form of some type of reflation policy. However, weak action will make me reduce my longs substantially and rebalance my portfolio towards net short exposure. Italy and Spain are once again moving towards the edge of the cliff, which is a real worry while Asia is now in a meaningful slowdown.
• I still own SPY Calls purchased in middle of May, and today I purchased some more Calls on the SPY ETF. I do not own any other equity positions in my portfolio.
• I also still own SLV Calls purchased in middle of May, and I also added to that by buying some more SLV ETF positions today (only a small trade). I am also still holding onto that core Silver position from late December 2011 bottom at $26.
• I bought a very small position in Agricultural commodities through RJA ETF today. I’m expecting the Agricultural bull market to resume eventually (best fundamentals of any asset class right now). But, I haven’t done anything major just yet.
• Other assets on my watch list for some shorter term bullish rebound trades include Australian Dollar (FXA), Russian / Brazilian equities (RSX & EWZ) and Continuous Commodity Index (GCC).
• It is too early to talk about shorting anything yet, as I am waiting for a market rebound first.

Tags: agricultural, Asset Classes, Brazil, Bullish Sentiment, China, Citigroup, Crude Oil, Economic Data, Economists, Employment Figures, energy, ETF, ETFs, Eurozone, Federal Reserves, Gold, Magnifying Lens, Mean Reversion, New Highs, Qe, Recession, Relative Performance, Stocks Bonds, Tiho, Time Asia, Treasuries, Treasury Bond, Vertical Rise
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Individual Investors Laughing All the Way to the Bank (Bespoke)

Friday, May 11th, 2012

by Bespoke Investment Group

Individual investors are often ridiculed as being the last to get into the market and the last to get out.  However, looking at trends in bullish sentiment suggests that individual investors may not be the dopes that many institutional investors often classify them as.  In this week’s survey of bullish sentiment from the American Association of Individual Investors (AAII), bullish sentiment dropped from 35.4% down to 25.4%.  This puts bullish sentiment at the lowest level since September.

Looking at the chart below shows that bullish sentiment on the part of individual investors has been declining since February or about six weeks before the S&P 500 reached its peak.  If this was just a one-time event, we could probably chalk up the decline in bullish sentiment ahead of the market peak as a coincidence.  The reality, however, is that last year we saw the exact same pattern as bullish sentiment also declined ahead of the big drop in equities.  The fact that individual investors have shown such good timing twice in a row now suggests that they deserve more credit than many have been giving them credit for.  Perhaps they could even lend a hand to the Chief Investment Office of JP Morgan (JPM).

Tags: Ahead, American Association Of Individual Investors, Amp, Bullish Sentiment, Chart Below Shows, Chief Investment, Coincidence, Decline, Dopes, Institutional Investors, Investment Group, Investment Office, Jp Morgan, Jpm, Laughing All The Way, Laughing All The Way To The Bank, Market Peak, Nbsp, Six Weeks, Time Event
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Unbalanced Risk (Hussman)

Monday, May 7th, 2012

In recent weeks, I’ve noted that our estimate of the prospective market return/risk profile has shifted to the most negative 1% of instances we’ve observed in the historical data. Most of the time, a given set of market conditions is associated with some mix of positive and negative outcomes, so we focus on the average of those outcomes in the expectation that doing so will produce good results over the complete market cycle even if we are incorrect in specific instances. With regard to current conditions, there is an absence of redeeming instances where things worked out well, coupled with an abundance of starkly negative market outcomes that have accompanied similar conditions. This uniformity of bad outcomes is why I keep using the word “warning” lately. The market’s prospective return/risk tradeoff here is highly unbalanced toward the risk side.

This isn’t just a matter of advisory bullishness being high in one week or another, or even valuations being rich, or just economic risks appearing high. Rather, what concerns us most is the syndrome of evidence: the fact that we observe so many red flags at the same time – rich valuations, overbullish sentiment, heavy institutional saturation in “risk-on” trades, near-panic levels of insider selling, a burst of new stock issuance, overbought conditions (focusing on intermediate-term horizons), a two-tiered market that couples speculation in a handful of momentum stocks with broadly deteriorating market internals, a variety of historically hostile syndromes (see An Angry Army of Aunt Minnies), and increasing likelihood of oncoming recession.

Various observers will undoubtedly take issue with each of these measures. One can look at the Investors Intelligence bullish sentiment figure, which has eased back to 43% from over 50% in early April, but ignore that bearish sentiment is down to 20.4%, less than half of the bullish sentiment figure, and the lowest level since just before the 2011 market rout. One can look the market’s price-to-forward-operating earnings multiple, which seems to be in an acceptable range, but ignore the stratospheric profit margins baked into earnings estimates. One can take issue with our recession concerns, choosing one rule-of-thumb or another that has gone “quiet” out of the broad ensemble of measures that we’ve presented over time, but ignore everything else we’ve written on the subject.

For example, our Recession Warning Composite is “quiet” here, as it usually becomes active only after a market loss of about 10-15%, yet still generally well before a recession is obvious to all (as was true both in late-2000 and late-2007). Strictly defined, the composite would require the manufacturing PMI to decline by a fraction of a point, year-over-year payroll growth to slow another 0.08%, and credit spreads to widen by about 0.25% here. The composite is generally a useful and early signal of recession, and it’s clear that the signal last August was either false or more likely just deferred by monetary interventions. Still, we’ve always advised against focusing on any single indicator, and there’s certainly no lack of additional evidence that I’ve presented on the subject of recession risk in recent months, so that shareholders can see the same things that I’m looking at. The value of research is that it constantly gives you better tools. Our research in areas like ensemble methods and noise reduction (including what we developed through our work in autism genetics) contributes firepower to that arsenal, and we try to approach economic and market issues with everything we’ve got.

Investors wishing to wait for a fresh negative signal from our Recession Warning Composite can do so, but should again recognize that it typically goes negative only after the market has lost some significant ground already. More often than not, stock market weakness continues well beyond those signals, but it’s not a “market timing” tool and isn’t intended for that purpose. It’s worth noting that aside from the S&P 500 – which has benefited from monetary-driven risk-on speculation, the other components of that composite are still fluctuating within a hair of their respective trigger points. Meanwhile, however, it isn’t helpful to ignore that we’ve never seen the components of economic activity as uniformly weak as they are today on a year-over-year basis except in association with recession (e.g. real final sales, real personal income, real personal consumption, employment growth, etc).

Just an analytical sidenote while we’re on the subject: when evaluating economic risk, it isn’t enough to show that some indicator has a high correlation with GDP growth. You also have to test that the indicator leads that growth rather than lags it. Otherwise it’s not a suitable way to identify a turn. We’ve seen a lot of charts lately that fail to make that distinction.

The chart below updates our estimate of the most leading “unobserved” component based on a broad ensemble of  economic data (see the note on extracting economic signals in Do I Feel Lucky? for more on this approach). Back in March, we already saw a clear downturn in the extracted signal, which tends to lead coincident economic measures by several months. This signal shows no sign of improvement, while the observed data is now characteristically rolling over.

Interestingly, the most leading component that we infer in U.S. data looks a great deal like what we are already observing globally, particularly in Europe. The path traced out by the Eurozone PMI however, does suggest that we should take any upward bump in first quarter GDP figures in the Eurozone with a grain of salt, being largely “old news” from a predictive standpoint.

As for U.S. data, the broad aggregate continues to come in weaker than expected, with a recent downturn in a broad basket of national and regional economic surveys, and of course, a disappointing April unemployment report (avoiding a negative print, however, which I suspect will come in the May report). From our standpoint, this stream of data is largely as expected, with gradual deterioration likely to accelerate as we move into mid-year. While the stock market enjoyed a brief surge of speculation following a modest positive surprise in the manufacturing Purchasing Managers Index for April, this was an outlier in the context of fairly relentless downward surprises both domestically and all across Europe. Note the concerted downturn in the overall indices, backlogs and new orders in the latest U.S. readings. Again, we would expect this deterioration to accelerate as we move into mid-year.

While I remain concerned about the high risk of a “blindside recession,” the broad consensus of economists and Wall Street analysts remains confidently optimistic. So recession risk is admittedly a “fringe” view – though a fringe view backed by the data. Still, it’s notable that many of our concerns are joined by observers with respectable records and no hesitation about taking fringe views, including Lakshman Achuthan at the Economic Cycle Research Institute and Martin Feldstein at the National Bureau of Economic Research.

It’s no secret that when Alan Greenspan stepped down from the Federal Reserve, I had hoped that Martin Feldstein would be chosen as Fed Chairman, instead of appointing Ben Bernanke to that role. In early 2008 (see Round Two – Home Price Erosion), while Bernanke was still downplaying mortgage risks, and the economy was already quietly in a recession that began nearly 6 months earlier, Feldstein was openly warning about housing and economic risks. He continued to advocate for proactive policies to blunt the oncoming damage, and criticized Bernanke’s willingness to hit CTRL+P, saying “They’ve used up half their balance sheet setting up credit lines to take on questionable credits from the banks and the securities firms.” Since then, the Fed has remained on exactly the same course, only with bigger numbers. This has encouraged needless speculation and sporadic bursts of pent-up demand, but has done nothing to address the underlying debt issues or the continued need for broad restructuring of bad credit both domestically and globally.

Notably, Feldstein is not just any Harvard economist, but is a member of the business cycle dating committee of the National Bureau of Economic Research (the official body that dates U.S. recessions), the president emeritus of the NBER, and the former head of the Council of Economic Advisors. In an interview last week on CNBC, Feldstein provided a good summary of present conditions:

“We are not doing very well. The economy is just coming along at a snail’s pace. The first quarter numbers that we just got last week were not very good at all. The GDP number was 2.2%. That was a disappointment, but you know, it was all automobiles. 1.6 out of the 2.2 was motor vehicle production. So, people were catching up after not being able to buy them the year before. So, this is a very weak economy… I think the real danger is that this is a bubble in the stock market created by low long-term interest rates that the Fed has engineered. The danger is, like all bubbles, it bursts at some point. Remember, Ben Bernanke told us in the summer of 2010 that he was going to do QE2 and then ultimately they did Operation Twist. The purpose of that was to make long-term bonds less attractive so that investors would buy into the stock market. That would raise wealth and higher wealth would lead to more consumption. It helped in the fourth quarter of 2010 and maybe that is what is helping to drive consumption during the first quarter of this year. But the danger is you get a market that is not with the reality of what is happening in the economy, which is, as I said a moment ago, is really not very good at all.”

In short, there is no question that at least on the surface, there is a lot of contradictory data available to support differing views about market valuation and economic prospects. However, once we make distinctions that have clearly been relevant in the historical data – normalizing earnings, recognizing the difference between leading, coincident and lagging indicators, weighting indicators based on their relationship to outcomes they purport to measure – much of the noise drops away, and we infer clearly negative risk for both stocks and the economy.

All of these conditions will change, and it’s certain that our return/risk estimates will not remain in such an extreme condition for very long. Maybe our present concerns won’t amount to as much downside as we expect. But if investors were to choose a point to test the hypothesis that this time will be different and risk will be well-rewarded, I hardly think a worse moment could be found.

Unbalanced Risk

Last week, Michael Wilson of Morgan Stanley noted (via ZeroHedge), “Make no mistake, institutional investors are all in.” Confirming our own observations about the elevated betas of the largest mutual funds, Wilson reported that the monthly rolling beta of mutual funds (their sensitivity to market fluctuations) now exceeds 1.10 and is the highest since the previous record, just before the wicked market plunge in 2011. Meanwhile, examining the sectors in which institutions hold their largest “overweight” relative to the S&P 500, institutions are more  concentrated in high-beta sectors than at any time since the start of Morgan Stanley’s data, and long-short funds are also near their most leveraged long positions in history. Of course, mutual fund cash levels also remain at record low levels.

Still, one feature of the iron law of equilibrium is that if institutions are heavily overweight high-risk sectors, other classes of investors must be underweight. The question is then which class of investors is most likely to shift positions. In my view, the two classes of “risk-off” investors are individual investors and value-driven, risk-conscious investors like us. On the individual side, we observe depressed home equity, plunging levels of labor force participation (except for workers over the age of 65, where labor force participation is hitting new highs), weakening employment growth, expiring unemployment compensation, repressively low interest rates on savings, and a coming fiscal drag. These investors already perceive sufficient risk in their overall portfolio of investment assets, home equity, and human capital that we doubt they will suddenly decide to take a flier in high-beta stocks to see if they can speculate themselves into financial security.

For our part, despite our 2009-early 2010 suspension of risk-taking on the hedging side (see Notes on Risk Management for a broad review of that period), the fact is that our stock selections have significantly outperformed the major indices over time, without the need to drink the Kool-Aid by buying low-quality garbage stocks or chasing the overvalued speculative momentum darlings of the moment. We have no plans to take high-beta stocks off the hands of existing holders at even richer valuations and even lower expected returns than they already have.

To some degree, those who are willing to establish very high beta portfolios may be doing it because they are speculating with “Muppets” money, with little of their own skin in the game. In any event, those assets are “all in,” and as a result, my impression is that institutions are likely to have unusual difficulty shifting out of their high-beta positions if the need arises. Investors who want high risk already own it, and the ones who don’t are likely to have far lower reservation prices and far higher required returns than are presently available to compensate for that risk.

Valuations are also a problem. While we continue to hear that the market is “cheap on forward operating earnings”, analysts who worship at the altar of forward operating earnings seem to overlook two factors, in my view. First, profit margins are more than 50% above historical norms, and profits to GDP are nearly 70% above historical norms. There is a strong accounting relationship between those profit shares and the combined savings of households and government (see Too Little to Lock In). To rely on permanently high profit margins, one must rely on the permanence of unsustainably large fiscal deficits and unusually low savings rates.

Our concern about operating earnings is not just that earnings are likely to dip in a recession, but that these elevated earnings are being used as the entire basis for stock valuation. That is, expected operating earnings are essentially being treated as a “sufficient statistic” for the whole long-term stream of cash flows that investors can expect. Failing to adjust for the cyclicality of profit margins isn’t just a transitory issue of “oh, well then we might have next year’s earnings estimates a bit high.” No, failing to adjust for the cyclicality of profit margins means that the entire estimate of fair value is off by something on the order of 50-70% from where it would be on the basis of normalized margins (somewhere in the range of 850-950 on the S&P 500).

This leads to the second factor that analysts seem to ignore. Specifically, major market downturns are not driven by a simple downturn in earnings over a year or two, but instead invariably reflect a change in the valuation of the entire long-term stream of cash flows (either because expected long-term cash flows are revised, or because investors require greater long-term prospective returns). We often hear analysts talk as if the change in the S&P 500 should simply track the change in earnings over the same period. But the historical correlation between the two – for example, the year-over-year change in earnings versus the year-over-year change in the S&P 500 – is close to zero. Major stock price fluctuations nearly always reflect a shift in expected long-term cash flows or in required long-term prospective returns.

To illustrate this, suppose you have a company that is expected to earn $2 per share next year, pays half of earnings out as dividends, and grows at 5% annually each year, ad infinitum. In order to expect a 10% return from this stock over the long-term, you would pay $20 a share today (essentially giving you 5% from expected price growth and 5% from dividend yield). In order to expect a 6% return on this stock, you would pay $100 [5% growth + 1% yield: P = D/(k-g)]. Now let’s wipe out all of the earnings and dividends in the coming year, but leave the long-term flows unchanged. If you do the math, you’ll find that in each case, the value of the stock drops by only about 90 cents. The only way you’ll get a huge change in the price of the stock is if you’ve misjudged the whole stream of long-term cash flows (which is what I believe analysts are doing by failing to adjust for profit margins and using a single year of earnings as the whole basis for valuation), or if you change the long-term prospective return that the stock is priced to achieve.

My view on this is simple – if you’ve overestimated the long-term stream of cash flows by failing to adjust for elevated profit margins, if the prospective return on stocks is unusually low even on the basis of normalized earnings (as it is today), and if you’ve set your portfolio up in a crowded trade that takes record-high beta exposure to market fluctuations (as many institutions have now done), you just might be in for some trouble.

Market Climate

As of last week, our estimates of prospective return/risk in the stock market remained in the most negative 1% of historical observations. That overall assessment reflects a variety of horizons from 2 weeks to as much as 18 months (on a longer horizon that purely reflects valuations, we estimate 5-year S&P 500 total returns of roughly zero, and 10-year prospective returns at about 4.7% after last week’s market decline). All of this can comfortably be dismissed as the ranting of a perma-bear by those who disregard our record through 2009, disagree with my insistence in 2009 to stress-test every method against Depression-era data, and doubt that we will remove our hedges in more favorable conditions (as we did in 2003, and which our ensemble methods would have supported in much of 2009-early 2010). For those who are not so easily dismissive, I appreciate your trust. Very simply, I remain concerned about a blindside recession, significant market losses, and overconfidence in the ability of the Fed to create anything but temporary psychological lifts in the face of real structural economic problems.

Strategic Growth and Strategic International remain fully hedged, Strategic Dividend Value is hedged at 50% of the value of its stockholdings (its most defensive stance), and Strategic Total Return continues to carry a duration of about 2.8 years, precious metals shares amounting to about 12% of net assets, and a few percent of assets in utilities and foreign currency shares.

Tags: Aunt Minnies, Bearish Sentiment, Bullish Sentiment, Current Conditions, Economic Risks, Hussman, Investors Intelligence, Market Internals, Market Outcomes, Momentum Stocks, Negative Outcomes, Panic Levels, Red Flags, Risk Profile, Rout One, Saturation, Stock Issuance, Tradeoff, Using The Word, Valuations
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This Time is Different ….This is Not What You Think

Thursday, May 3rd, 2012

by Guy Lerner, The Technical Take

The very erudite Dr. John Hussman is as good as a market researcher as there is, and he defines a set of market conditions that when they come together generally leads to poor equity performance.  One of Hussman’s syndromes is the “overbought, over-bullish, overvalued, and rising yields syndrome.”

My own research would agree this assessment.  The markets tend not to do well when yields are rising and when investor sentiment is overly bullish.  These constructs have formed the basis of some of my most basic and robust trading models, and this combination of excessive investor bullishness and rising yields is at the core of my “Will Robinson” signal.  Will Robinson was the young boy on the 1960′s TV show, “Lost in Space”, and when he was in danger, his robot friend would exclaim, “Danger, Will Robinson, danger!”  So when I see this constellations of market findings, it is usually danger ahead for the equity markets.

So what does this have to do with the current market environment?  From this perspective very little as I currently don’t find these conditions in the current market environment.  Over the past couple of weeks, bullish sentiment (and market “over -boughtness”) has been unwinding slowly, and as my bond trading is positive (i.e., lower yields), I am not expecting yield pressures to be a factor.  Valuations, as measured by the Shiller 10 year P/E ratio or cyclical adjusted PE ratio, remains lofty, yet truth be told, valuations are a poor market timing tool anyways.

But while Hussman is “right” about the “overbought, over-bullish, overvalued, and rising yields syndrome” and market weakness, the opposite set of conditions is probably a market positive.  The current market environment shows more bulls than bears (but necessarily extreme) and falling yield pressures.  Historically, this combination of factors has been associated with some of the more memorable price runs in recent market history.  For example from March, 1995 to February, 1996 under similar conditions, the SP500 gained approximately 30%.  There was a repeat from May, 1997 to May, 1998 when the SP500 gained 34%.  This set of conditions were also seen at the 2003 market bottom, and the late 2006 through 2007 blow off market top.  Needless to say, it does take bulls to make a bull market, and by the way, it does help to have falling interest rates.  So maybe this is why investors are currently all lathered up.

But I would contend that you need to be careful for what you wish for as something has happened to the relationship between bonds and stocks over the past 2 years.  In 2010 and 2011, falling bond yields have not been beneficial to equities.  Rather, falling bond yields, as measured by bullish signals from our bond model, have been a sign of economic weakness, and have led to crushing (i.e., poor) returns in the equity markets.  When bond yields were falling and when investors were more bullish than bearish, the SP500 had two draw downs exceeding nearly 15%.  From the 1970′s to the late 1990′s it was rare (< 5% occurrence on 70 unique instances) for such market conditions to even have a draw down greater than 6%.

I suspect investors remember those good old days from the 1990′s when the Federal Reserve had the luxury to put the pedal to the metal and keep rates low despite extreme investor enthusiasm and market overvaluations.  They don’t have that luxury now, and the only reason for the Fed to continue act in such a fashion is economic weakness.  Our bond model is currently positive suggesting lower yields.  While investors want to hark back to the “good old days”, I don’t think that is the correct interpretation.  I believe this signal suggests economic weakness as it did in 2010 and 2011.  This time is different as lower bond yields won’t see a blast off in equity prices.

Copyright © The Technical Take

Tags: Bond Trading, Bullish Sentiment, Constellations, Constructs, Current Market, Danger Will Robinson, Dr John, Guy Lerner, Investor Sentiment, John Hussman, Lost In Space, Market Environment, Market Researcher, Market Timing, Market Weakness, Pe Ratio, Robot Friend, S Tv, Syndromes, Timing Tool, Valuations
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Dow 15,000: Is this an Outlier Call or Consensus?

Friday, February 17th, 2012

Sources:
Feb. 13, 2012 – (Bloomberg) — Jeremy Siegel, professor of finance at the University of Pennsylvania’s Wharton School, talks about the outlook for U.S. stocks, and his call for the Dow to reach 15,000 by the end of this year, and possibly even 17,000 over at least the next two years, with Trish Regan on Bloomberg Television’s “Street Smart.”

http://www.bloomberg.com/video/86292500/

Mon 13 Feb 13 – Is it too soon to call for a Dow 15,000 based on an article in Barron’s over the weekend? Jim Paulsen, Wells Capital Management shares his thoughts. | 04:06 PM ET

http://video.cnbc.com/gallery/?video=3000073016

Feb. 13, 2012 – Bob Doll, of BlackRock, discusses the likelihood that the Dow will hit 15,000 in 2012.

http://video.cnbc.com/gallery/?video=3000072922

Doug Kass says bullish sentiment is just to prevalent period. And he points to the following:
- Surveys showing a substantial rise in bulls and decline in bears over the last couple weeks
- Hedge funds have increased net long exposure
- Individual investors are putting money into domestic equity funds
- Famed bear Nouriel Roubini is optimist on the market
All told, that would suggest the next big move should be lower.

http://www.cnbc.com/id/46342627

Tags: Barron, Blackrock, Bloomberg Television, Bob Doll, Bullish Sentiment, Cnbc, Couple Weeks, Domestic Equity Funds, Doug Kass, Hedge Funds, Individual Investors, Jeremy Siegel, Likelihood, Nouriel Roubini, Optimist, Substantial Rise, Trish Regan, University Of Pennsylvania, Wells Capital Management, Wharton School
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Dissecting Today’s Bull Market (Koesterich)

Tuesday, January 31st, 2012

In recent weeks, the European Central Bank and the Fed have announced new monetary stimulus and appear ready to act to prop up the global economy.

In response, some investors have apparently rediscovered their appetite for risk. Since November 29^th lows, global stocks are up roughly 9% and emerging market equities have gained about 12%. And during the past eight weeks, high yield bonds have risen roughly 5%.

In fact, this week some market watchers have declared that we’re in the midst of a bull market. For example, the WSJ’s MarketBeat blog, noting that bullish sentiment is on the rise, says “Welcome to the New Bull Market,” or at least welcome to a continuation of the bull market it says started in March 2009.

It’s important, however, to put the current “bull market” in context. There’s a big difference between various types of bull markets. In secular bull markets (like the one we experienced from 1982 to 2000), stock prices rise over a long period of time thanks to ongoing improving fundamentals. Cyclical bull markets, on the other hand, can occur within both secular bull and secular bear markets, but tend to be shorter in duration.

In my opinion, we aren’t in – and aren’t entering — a new secular bull market. Instead, we’re still stuck in a long-term secular bear market that began in 2000. It’s not as if the problems that haunted investors last November — a European crisis, a political divide in Washington, slow growth in developed markets and a potential banking crisis in China — have gone away.

Equity performance from 2003 to 2007, however, shows us that there can be relatively long rallies in secular bear markets. I believe the rally we’re experiencing now is actually a cyclical bull market that could easily go on for the remainder of 2012, assuming the European crisis doesn’t take a turn for the worse and we don’t experience other unforeseen market shocks.

Distinguishing between secular and cyclical bull and bear markets is so important because of their different investment implications. In secular bull markets, investors can rely on a traditional buy-and-hold strategy. In secular bear markets and accompanying cyclical bull markets, however, having a more tactical approach (i.e. a timeframe of five years or less) can help investors take advantage of market peaks and valleys and potentially avoid having investments merely move sideways.

So what’s a tactical investing idea for the current cyclical bull market? Well, let’s look at the investment implications of the Fed’s announcement this week. First, it suggests that nominal rates and real rates will stay low for a long time. This further buttresses the case for gold. Second, if US interest rates are going to be anchored at zero for an extended period, people are going to need to take some risk — in one form or another — to generate a decent return.

Source: Bloomberg

Past performance does not guarantee future results.

Gold and other precious metal prices may be highly volatile. The production and sale of precious metals by governments, central banks or other larger holders can be affected by various economic, financial, social and political factors, which may be unpredictable and may have a significant impact on the supply and prices of precious metals.

Tags: Banking Crisis, Bear Markets, Bull Markets, Bullish Sentiment, Continuation, Emerging Market, Global Economy, Global Stocks, High Yield Bonds, Last November, Lows, Market Shocks, Midst, Rallies, Secular Bear Market, Secular Bull Market, Stimulus, Stock Prices, Time Thanks, Wsj
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Investor Sentiment: Are Investors Rushing Towards the Edge of a Cliff?

Monday, January 9th, 2012

The article below is a guest contribution by Guy Lerner, writer of the Technical Take blog.

Last week, I stated that “higher prices should be supported by increasing number of bulls, and this would be a signal that a sustainable rally, that everyone so desperately wants, is unfolding.” So this past week, the SP500 gained about 1.6% and bullishness increased dramatically both in the Rydex data set and with the “dumb money” indicator. Yet, despite these positive developments to recruit more investors into the bullish camp, much work needs to be done. Volume is the probably the biggest issue, and the lack of volume means lack of investor conviction. So while there are more bulls, they are chasing prices higher with one hand already on the eject button. My data still suggests a mixed sentiment picture, and at this stage of the rally (relative to the time elapsed from the October lows), prices and bullish sentiment should have been much greater. The fact that the bulls have yet to take the reigns of this market suggests caution. These are still not the makings of a sustainable rally. This still looks like investors are rushing to the edge of a cliff as opposed to the promise land and nirvana of a bull market.

The “Dumb Money” indicator (see figure 1) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. This indicator shows neutral sentiment.

Figure 1. “Dumb Money”/ weekly

Figure 2 is a weekly chart of the SP500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “Our key sentiment readings all flashed Neutral signals as transactional volume across the market was low due to the holidays and trading windows closing at many companies as Q4’11 ended. Volume will be seasonally low for the next three weeks as insiders are pushed to the sidelines with their companies preparing earnings announcements.”

Figure 2. InsiderScore “Entire Market” value/ weekly

Figure 3 is a weekly chart of the SP500. The indicator in the lower panel measures all the assets in the Rydex bullish oriented equity funds divided by the sum of assets in the bullish oriented equity funds plus the assets in the bearish oriented equity funds. When the indicator is green, the value is low and there is fear in the market; this is where market bottoms are forged. When the indicator is red, there is complacency in the market. There are too many bulls and this is when market advances stall. Currently, the value of the indicator is 61.49%. Values less than 50% are associated with market bottoms. Values greater than 58% are associated with market tops.

Figure 3. Rydex Total Bull v. Total Bear/ weekly

Let me also remind readers that we are offering a one-month free trial to our Daily Sentiment Report, which focuses on daily market sentiment and the Rydex asset data. This is excellent data based upon real assets and not opinions.

Source: Guy Lerner, Technical Take, January 7, 2012.

Tags: American Association Of Individual Investors, Bullish Sentiment, Bulls, Caution, Conviction, Dumb Money, Extremes, Figure 1, Guy Lerner, Investor Sentiment, Lows, Market 1, Marketvane, Nirvana, Promise Land, Put Call Ratio, Q4, S&P500, Signals, Sustainable Rally
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Investor Sentiment: Another Case of Selling Low and Buying High?

Wednesday, November 16th, 2011

The article below is a guest contribution by Guy Lerner, writer of the Technical Take blog.

In aggregate, investor sentiment is neutral. The “dumb money” and Rydex market timer continue to get more bullish after missing out on the bulk of the gains in October. Company insiders are not showing any great clarity as well. Nonetheless, investors want in to this market, and this can be seen by the dips being so shallow. But curiously, prices haven’t gone anywhere in two weeks. The time to be in the market and accepting market risk was back in September. At best prices are range bound (as reflected by the neutral investor sentiment) and the market is just digesting the October gains. At worst, this is just another bear market rally. Is this just another case of investors selling low and buying high? That story has yet to be written, but I suspect we will find out over the next month.

The “Dumb Money” indicator (see figure 1) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. This indicator shows neutral sentiment.

Figure 1. “Dumb Money”/ weekly

Figure 2 is a weekly chart of the SP500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “There were some encouraging and discouraging signals from insiders last week. On the one hand, the number of buyers rose 78% week-over-week and the ratio of sellers to buyers narrowed from nearly 3-to-1 a week earlier to closer to 2-to-1. On the other hand, the number of sellers was the highest since the week ended May 31st. The Technology sector was the main negative driver as sentiment by one measure – our Industry Score – moved to its worst level in a year. No sector displayed bullish sentiment, although the Healthcare sector was showing some positive signs.”

Figure 2. InsiderScore “Entire Market” value/ weekly

Figure 3 is a weekly chart of the SP500. The indicator in the lower panel measures all the assets in the Rydex bullish oriented equity funds divided by the sum of assets in the bullish oriented equity funds plus the assets in the bearish oriented equity funds. When the indicatoris green, the value is low and there is fear in the market; this is where market bottoms are forged. When the indicator is red, there is complacency in the market. There are too many bulls and this is when market advances stall. Currently, the value of the indicator is 62.81%. Values less than 50% are associated with market bottoms. Values greater than 58% are associated with market tops.

Figure 3. Rydex Total Bull v. Total Bear/ weekly

Let me also remind readers that we are offering a one-month free trial to our Daily Sentiment Report, which focuses on daily market sentiment and the Rydex asset data. This is excellent data based upon real assets and not opinions.

Source: Guy Lerner, Technical Take, November 13, 2011.

Tags: American Association Of Individual Investors, Bear Market, Bullish Sentiment, Company Insiders, Dips, Dumb Money, Extremes, Figure 1, Guy Lerner, Healthcare Sector, Investor Sentiment, Market 1, Market Rally, Market Risk, Market Timer, Marketvane, Posi, Put Call Ratio, S&P500, Technology Sector
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