This weekend I attempted to tackle the four strongest criticisms against my short thesis published last week, 5 Reasons Why I am Shorting The Market:
- Sentiment - Irrational pessimism?
- Valuations - Undervalued? Or, perhaps overvalued?
- Timing - Why here, now?
- You can't fight the Fed
A week and a half ago I made what some believe to be a rather bold move, I began positioning short in a raging bull market. I had my reasons, which I believed to be convincing. My position was relatively small at the time.
That following weekend I decided to give this negative outlook further consideration; one seldom makes money shorting a bull market. Upon reflection, I added to my short position Monday morning. Still a relatively small position, the bearish evidence - in my opinion - outweighed the bullish. Below are the five reasons put forth last week:
- Negative Divergences: World equity markets, US equity markets, bonds, copper and industrial commodities, silver to gold ratio.
- Economic Analysis: Non-farm payrolls, labor force participation rate
- Sector Analysis: Increasingly defensive and risk off: housing, staples, financials, health care, energy, consumer discretionaries.
- Cycle Analysis: Seasonal, presidential, secular, and Kondratieff
- Technical Analysis: Momentum, price action, and negative divergences
I decided to use this past weekend to explore the strongest criticisms against my article, and potentially provide evidence that counters my thesis. While I believe the former objective was accomplished, as of the time I submit this article, I have failed at the latter. I am eager to receive any and all constructive criticism and feedback.
1. Irrational Pessimism? - Sentiment
As I find myself staring at what I believe to be overwhelmingly bearish data, I recently focused on one aspect that for the most part is a bullish indicator - sentiment. Typically, extreme bullishness is an indication of a market top, while extreme bearishness is indicative of a bottom (sentiment has historically been a contrarian indicator).
When so much evidence points one way, but sentiment the other, I began to ask if perhaps it is different this time. Has the memory of 2008 and 2001 resonated in people's heads enough to caution them from further excessive equity exposure? In the Internet and social media world of ours, have people come to the realization that stocks don't in fact always go up? Or by scaling back on equity purchases, are people being irrationally pessimistic about future stock market prospects?
On Thursday I was amused by a posting by another trader. He had typed in a few search queries into Google (GOOG) and received the following suggestions:
I don't know how Google's suggestions work, but surely the suggestions are not by chance. He and I both received the same results, and I imagine these results are indicative of what people either search for or end up clicking on. In any case, this evidence seems to support the belief that a high level of pessimism exists towards the stock market.
That same night I was presented with further information that began to validate this theory. As I study for my level 3 CMT exam, I have recently been reading Robert Shiller's 2005 edition of "Irrational Exuberance." On Thursday I began the final chapter of his book. Three pages into chapter 12 (p.209) I stumbled across this paragraph:
"But it seems that we should pay attention to another possible future scenario, of increasingly negative market sentiment stalling the stock market even if earnings do continue to grow well. There is considerable risk that in 2010, or even 2015, the stock market will be lower still in real, inflation-corrected terms, than it was in 2005. This can happen as part of a negative feedback loop, as part of a gradual response to poor returns on stock gradually reduces investor demand for stocks and hence reduces their prices relative to fundamentals. People may gradually get increasingly "fed up" with stocks." - p.209
Sure, this may be rebuked as being a rather abstract or theoretical suggestion. But given that the author's book in 1999 warned of an impending top in equities, and that his 2005 edition further warned of a bubble in real estate, I find this suggestion tough to dismiss. Perhaps the suggestion of irrational pessimism is warranted? Surely it is irrational to not purchase equities if earnings are growing?
While somewhat satisfied, my contentment with this explanation was further justified the next day. A trader I follow posted a blog noting the following:
"As you may know by now, sentiment continues to be highly skeptical of this hated rally. Nonetheless, that is simply part and parcel of a maturing secular bear market. Low volume rallies, high volume sell-offs, selective leadership, they were all characteristics of the late-1970s during the 1966-1982 secular bear, not to mention the latter years of the 1929-1944 secular bear. Investors lost confidence in the market as a general proposition, regardless of cyclical rallies. So, perhaps reaching the greed phase this time around is not in the cards in order for the market to top?"
Shiller offered an explanation, and this trader justified it with empirical evidence. While the combination of these findings is still not conclusive, or definitively indicative of a market top, it begs the question:
Irrational exuberance has defined past stock market tops. Is it possible that irrational pessimism will define the next one? Will sentiment no longer be a contrarian indicator?
A close friend of mine is an institutional equities trader in Toronto. He has noted that, particularly in the last year, trade order flow has completely dried up; people simply don't seem to be interested in the market, despite the fact that (US) equities continue to make nominal new highs, and earnings continue to grow.
Another friend of mine, this one from Newcastle (UK), has a friend who works for an English bank. This friend actually lies about his career as a banker in order to avoid the negative stigma attached to bankers. Does that seem rational?
Perhaps the insiders are one step ahead of us? Below is the Barron's Insider Transactions Ratio. While its current low tick would be in the bullish region, there certainly have been more bearish indications recently, and I would imagine a moving average of the readings would be more bearish than bullish.
2. Timing - Why Here, Now?
Timing is very technical in nature, and accordingly this section will focus on technical analysis. The few charts below represent a supplement to arguments put forth last week, which I believe to be substantial.
The Ted Spread is an indicator of perceived credit risk, and measures the difference between interest rates on interbank loans and T-bills. The below chart illustrates four periods in which this spread has crossed above (from below) its 150 day simple moving average (SMA), the fourth of which occurred last week. The black line below represents the S&P 500 (SPY), and crossings of the 150 day SMA are connected by the vertical blue lines.
*I would like to thank John Karle here
Small caps often lead the market, and the recent market action has been no different. The Russel 2000 (IWM) was down over 3% last week; the worst performer amongst the major US indices. On a 3-box reversal point and figure chart a sell signal was recently generated with a price objective of $84.44.
On a 1-box reversal IWM is teetering on the verge of a fulcrum sell signal that would correspond with a break of a significant trend line, with price currently under two short term SMAs. I will note that the sell signal has not been achieved yet, but merely is close. If/when the signal is generated, it points to a price target of $78.26.
We are at a very distinctive triple top in the S&P 500. While one can note that we are at new nominal highs (the horizontal resistance line slopes slightly upwards), new nominal highs were also experienced, but not sustained, in 2007. A triple top can be a powerful resistance area, especially one that is established over such an extended period of time. Until breached significantly in both time and price, I would be hesitant to call the end of the secular bear market.
One can note that last week was the first time SPY had a close below the 40 day SMA. As noted in my previous article, this breach has marked the beginning of the last two corrections.
On a shorter term analysis one can note that many bearish candlestick patterns have formed recently. For example on SPY one can see a bearish engulfing pattern (1), an advance block / stalled pattern (my first signal to finally act) (2), a breakaway gap between a doji and a bearish belt hold (3), and bearish separating lines (4) in the last month. Four conclusive sell signals at historic highs - in less than one month - in addition to all the other evidence, is pretty convincing in my opinion.
Other topping patterns are also evident in other indices. The IWM daily has three black crows, while the Transports (IYT) weekly has produced a tower top. Those unfamiliar with technical analysis may be scratching their heads about the nomenclature, some may even ridicule it. The important consideration is that all the mentioned patterns effectively display scenarios in which selling pressure exceeds buying, and are typically predictive of a change in trend.
Last week I noted that home builders (XHB) had led the rally since the end of 2011, but have appeared to be losing momentum recently. I noted the Dow Jones Home Construction Index in my article last week, and that the 20 week SMA had held as support, but could be prone to a near term breach. Such a break would be indicative of fading momentum. Last week that support was breached. I will note however that the RSI, despite breaking its support level as well, is firmly within the bull range.
I mentioned the divergence in industrial metals, notably copper, last week. While I noted the incredible divergence, it wasn't until this past Friday when an analyst mentioned that copper was in a bear market did this really hit home. Copper is in a bear market, while US equities are in a raging bull. Since the peak in copper there has been an almost 50% difference in absolute returns between the two.
All technical indicators have been flashing sell signals for some time now, and while it may be oversold after last week's move, it is definitively in bear market territory. The breakdown in the head and shoulders pattern in March was a very clear sell signal.
I will note however that upon further study I realized that copper and equities diverged from 1995 to 2000. While definitely a consideration, many intermarket relationships changed around 1998 in what can be considered a regime change towards a new deflationary period. Accordingly, I give more credence to its relationship over the last decade than the one prior.
Historically, valuations are not extended. P/Es are at what many consider to be average levels. But like anything else, a P/E needs to be taken into context. Yes, P/Es are far lower than they were at the recent major market peaks. But those are the peaks of secular bull markets. Today we are in a secular bear. If one takes a look at the chart below, you can see that in past secular bear markets P/Es have gone quite a bit lower, suggesting that we are actually currently "overvalued" rather than undervalued. Click on the chart to enlarge it and you will note that P/Es were under 8 in the 1920s and 1980s.
I imagine people will be quick to dismiss this finding; surely in today's world such low valuations are not possible?
To counter this suggestion I begin by presenting a well-established fact - technology often leads the market. Apple (AAPL) was once considered to have a "cheap" P/E at 15. I often comment on Apple as it is widely followed. I'll be clear; I have no opinion on the stock at this point. The chart has been, and continues to be, overwhelmingly bearish, but I am not making any predictions as to its future direction. The point I would like to make - that I tried to establish in an article two weeks ago - is that its P/E, and others, can go lower than commonly believed, lower than what many believe to be rational.
How many people would have ever predicted Apple's P/E would go below 9? Think about that for a while; to many people, that would have seemed unimaginable not less than one year ago today. If Apple can be priced at a P/E of 8.9, why can't the rest of the market? Is this such a crazy suggestion?
At this point it is rather interesting to return to the Google suggestions experiment presented earlier, this time with Apple. Apparently Apple has been "cheap" and a "buy" for some time.
Some say Apple's P/E is due to manipulation, hedge fund liquidations ... the list of reasons is endless. Well what happens wen hany of those same "causes" are inflicted upon the rest of the market? We know that technology often leads the market. Would it not be prudent to consider that this may be a sign of things to come?
The Apple bulls will continue to debate how cheap it is with a P/E of 8.9, and that it simply has to go up. Whether Apple warrants such a low P/E is obviously debatable. However we must recognize that people argued it was still relatively cheap when priced at $700, $600, $500, and are now doing so at $400. Is this same scenario not possible for other stocks, or the equity market in general?
4. You Can't Fight The Fed
One of the most cited criticisms of my short thesis is that the market simply cannot go down until the Fed tightens its monetary policy and removes the proverbial punch bowl that has thus far supported the market. This is a tough argument to fight. If the Fed were to announce new quantitative easing of a magnitude not experienced to date, there is a high probability that my short thesis could be proven wrong. That being said, investing based solely on this presumption seems somewhat irrational in my opinion. A similar argument was made in the late 1990s in the form of the "Greenspan Put." Ultimately that argument proved useful, until it didn't.
In the past week gold (GLD), oil (USO), copper (JJC), and many other commodities tied to the economy continued to sell off. That doesn't seem inflationary to me. Until signs of inflation are seen - commodities appreciate, bonds depreciate, etc - I have a tough time putting too much faith into the argument that the Fed can indefinitely inflate the economy out of its debt and structural problems.
Ultimately my analysis is the product of three influences: the CMT program, the CFA program, and my experience in the markets since 2008. Due to my limited exposure, I am likely subject to many biases, both cognitive and emotional: conservatism, confirmation, control, availability, anchoring, overconfidence, framing, are a few that come to mind. Also note that I am a level 3 candidate in both the CMT and CFA programs. I have yet to be chartered, or pass the final examinations.
Last week's article was widely viewed; some 35,000 people to date have read it. In light of the fact that this too may be widely disseminated, I would like to note that many of these relationships are new to me, and that I am far from considering myself an expert. While I have been performing technical analysis since 2008, I have only recently discovered intermarket analysis. I don't advise that anyone make investment decisions based solely off of my work. My objective is to provide perspective, and hopefully receive thoughtful feedback that furthers everyone's understandings. I will also note that I likely will not have time to follow up with future articles in the next month or so as I have to focus on my studies.
It is also prudent to consider that a lot of this analysis is based on past secular bear markets. There are only two in which I am able to draw considerable insight from, and two is by no means a large sample size.
The terrorist attack in Boston undoubtedly further perpetuated the selloff that began last Sunday night. The IWM, already down 1.5% prior, closed the day at the lows, down 2.3%. Tuesday saw an impressive rally, albeit on low volume, and the IWM closed up 1.5% from the day before. It is difficult to quantify the effect of this horrible event, and even more difficult to quantify the possibility and effect of future terrorist attacks.
Irrational Pessimism? - Final Thoughts
I propose people consider the following: is an environment of irrational exuberance a requirement for a major market top, or could perhaps an environment of seemingly irrational pessimism, coupled with a deteriorating economy, also produce a top? Are my arguments irrational and/or illogical, stretched, or are they perhaps dwarfed in size and scope by those that counter mine? Time will provide the best answer to this, but I am quite eager to hear people's thoughts.
You may have noted that despite all the bearish evidence, I have refrained from calling for any sort of top in the market. My outlook is based on the current available relationships and indicators as I see them. The available data, economic, and technical relationships can change on a daily basis. Further, I give great credence to the well-known investing cliché that "markets can remain irrational a lot longer than you and I can remain solvent" purported by John Maynard Keynes. Markets have traded void of fundamentals for extended periods at many points in history, and there is no reason to believe that this time must be an exception. That being said, I am by no means ruling out the very real possibility of a top being formed. But I see no value in predicting a top, despite the evidence, until further price deterioration is experienced.
After last week's price action, I believe a correction has begun. As to the extent of the correction, one can only speculate. And even if a correction has indeed begun, that doesn't rule out the possibility of higher prices - potentially even new highs - first. Major, even minor market tops do not occur overnight, and typically the first to predict them do no better than the last to join them.
Volume will be something to watch, and is considered a necessary component to confirm strength in an advance by many. Both Tuesday's and Friday's bounces were on lower relative volume, and this should raise caution to those clinging to the bull's horns.
Volatility spiked significantly last week. The concept of volatility clustering has been well documented in time series analysis; it suggests that high volatility tends to be followed by high volatility. That being said, the two most recent spikes in volatility (December and February) were short lived, and the market actually put in short term bottoms. This evidence conflicts with my short thesis.
Of the many arguments I presented last week, many stemmed around divergences. There have been comments that all the divergences only warn of potential changes in the trend, that they have existed for some time, and that they are not definitive or conclusive. These suggestions are all completely accurate. The question here remains, do you consider the warnings, or do you ignore them?
Some of my arguments may require further time and analysis to develop and explore. This article is my best attempt given my current time constraints.
Some of my analyses - such as a potential environment of irrational pessimism - are abstract, potentially even vague. Others, such as the technical analysis provided, can be considered as being rather precise. My objective is to put forth sound thoughts and ideas, backed by research, that provide perspective, and potentially even challenge conventional beliefs.
Perhaps I am aggressive in shorting the market, but in trading - as in anything in life - the reward you receive is a function of the risk taken. I believe that due to the mounting evidence one is exposed to more risk being long than short. I do not advocate that people join me in my short position, but rather consider the evidence being put forth, and seek the advice of someone more experienced than I prior to making any investment decisions.
I would like to note that a component of the research presented in these two articles has been based around the work of John Murphy and Robert Shiller. I do not know their current views of the market, but I do know that they both predicted the technology and real estate bubbles. This speaks nothing of my abilities; I merely would like to suggest that my work is based on sound foundations.
Where possible I have included a degree of historical, longer term analysis. In light of my historical references, I figured I will conclude with yet another investing cliché, one that I think warrants consideration at this juncture.
"History doesn't repeat itself, but it often rhymes" - Mark Twain
Additional disclosure: I am short IWM, SPY. I also have short and long positions in other individual securities not mentioned in this article. My time frame is typically short term in nature, from minutes to months. I closed out roughly 70% of my short exposure on Thursday (April 18) afternoon. I am however still short, and will consider selling into any further strength. As the longer term trend still remains up, I will take profits if/when the opportunity presents itself, and I will likely refrain from significant short exposure until longer term trend lines are broken. My short exposure has been mainly through put options as they are historically cheap and limit my downside risk in the case that my outlook in wrong.