There is a meaningful possibility growing that equities around the world could stage a sharp rally within the next week or so. I say this for several reasons.
First, volume is light, and appears heavily influenced by traders and, frankly, computers. A meaningful proportion of individual traders and computers alike are programmed to trade based on statistical patterns and relationships, and with these two forces apparently dominating the markets of late, the rules they follow may explain much of what we see in the overall marketplace.
Second, a commonly used trading pattern that flashes “bull market” is when short-term trading momentum dominates longer-term investment momentum. Traders use several methods to measure this occurrence. For example, traders will watch to see if the 20 week simple moving average can cross above the 40 week simple moving average. If so, past history suggests a likelihood of a new bullish market trend, and traders will react accordingly.
Point in fact, in the early part of July, the 20 week simple moving average on many US and non-US equities indexes crossed above the 40 week simple moving average. On cue, the next week equities markets around the globe staged massive rallies.
One explanation is that reported corporate earnings appeared stronger than expected, but to a purely statistics-driven trading model, earnings don’t matter. It’s hard to say how much of this month’s rally reflects earnest investments by those of us who care about earnings and earnings prospects and the like, and how much reflects a knee jerk reaction by a pack of computers and computer-like individual traders.
The low volume and curiously technical nature of this latest rally suggests participation by traders and computerized trading programs likely played at least some role.
So that said, it’s worth assuming that the market will continue to be influenced by these factors – at least until that assumption proves incorrect. Which brings me to the next point of this article, which is that a second widely used technical indicator is poised to signal a new bullish trend in equities. The 50 day exponential moving average on many US indexes is closing in rapidly on the 200 day exponential moving average.
This pattern is particularly evident with Vanguard’s Total Market Vipers (NYSEARCA:VTI), and the iShares Russell 2000 ETF (NYSEARCA:IWM). We see comparable developments abroad, as evidenced by the SPDR S&P World Ex-US ETF (NYSEARCA:GWL). In fact, certain ETFs, both domestic and international, have already seen their 50 day and 200 day exponential moving averages cross – for instance, iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) and PowerShares QQQ Trust (QQQQ).
While EEM and QQQQ are often leading indicators, but are by no means indicative of the overall equities market, unlike VTI and GWL which reflect the broadest cross section of equities.
And so what if the 50 day exponential moving averages on issues like VTI and GWL cross their 200 day exponential moving averages (which may or may not happen - we're really oversold at this point)?
Well, based on what’s happened this month in the aftermath of the 20 week and 40 week simple moving averages cross-over, it is not at all beyond the realm of possibility that we could see a comparable rally if the 50 day and 200 day exponential moving averages cross over.
Computers and traders are programmed to do what worked the last time, until it stops working.
True enough, this time around, we don’t have favorable earnings news to fuel the rally (should it even materialize), but there is another far more potent fuel out there: fear of missing the train as it leaves the station. If a rally in equities continues to unfold (which, I wish to emphasize is a big “if”), we may be able to ascribe it to panic buying, more than investing type behavior.
Here's where it gets really interesting - do computers panic? If computers act like they are in a buying panic, does it really even matter?
Regardless, technical trading signals are the reality of the market at this moment, and the reality of the market being what it is, investors should pay heed. Not only to the gains that may come in short order if all the technical signals go green, but also to the eventual comeuppance that must follow when trends get far too ahead of fundamentals.
That said, one thing we can probably all agree on is that “inevitable comeuppances” can arrive years late.
Disclosures: The author holds long positions in VTI, QQQQ, and EEM.