Markets: Reversion to the Mean or a Really Mean Reversion?

Will The Market Crash?

During the recent “Rally Without a Cause” there have been bull-&-bear commentators arguing why the equities rally is or is not justified. I will not rehash the worn out arguments yet again. Let’s make the best possible arguments in favor of the bulls to see if these justifications stand the test of logic (a little less MAD MONEY and a little more Aristotle).

Bull-FALLACY 1: Market’s Are Higher Because The Economy Is (Or Well Soon) Recover

FACT: The economy will recover due to one of the following factors:

1. Consumer spending picks up (about 60-70% of the economy), and/or

2. Corporate spending picks up (think of the Y2K, “Dot Com” spending build-up), and/or

3. U.S. exports pick up

ISSUE: But how can the economy recover if:

1. Consumers are financially wiped out and deleveraging, and/or

2. Corporate spending does not seem likely to pick up (replenishing depleted inventory levels does not a recovery make. FYI, the "good" earnings season we just had was economically doctored up, and well documented by many commentators), and/or

3. Even if U.S. exports do increase…it’s not plausible to argue that U.S. exports will pick up so much so as to compensate for declining consumer & corporate spending

Not convinced? Many commentators have presented well thought out, objective and thoroughly researched arguments why the economic pain is not over, and the recovery is not around the corner. I will not rehash other’s observations…there are many good commentators, among them Karl Denninger.

Bull-FALLACY 2: The Economy Right Now Doesn’t Matter, Markets Are Higher Because Of Successful Government Intervention

FACT: Government spending can compensate for contractions in a mild and short recession, by buying enough time for the economy to rebound…

ISSUE: …But we’re neither in a mild nor in a short recession. We are in a credit induced recession with continuing deleveraging and government-propped up firms, which have postponed difficult-&-painful economic restructuring. The only people who believe that government spending can-&-will stimulate an economy are the North Koreans, the Cubans, and the Green shooters. The sky is not falling, the world is not going to come to an end; but we’re not out of the woods yet…not by a long shot. More economic and financial agony may be ahead of us.

Bull-FALLACY 3: Markets Are Higher Because They Were Oversold In March

FACT: Assuming that markets were in fact oversold in March that does not necessarily mean current prices are justified. Markets could have been at extremes both then and now.

ISSUE: March lows were caused by economic worse-case scenario being “priced into” stocks along with a lack of liquidity due to market-sentiment. Both “information” (fact) and “noise” (sentiment, rumors) influenced prices in March….much like today’s prices are influenced by information (economy is not falling off the cliff) and noise (think CNBC pundits).

Bull-FALLACY 4: "Contrarian Call" By Bulls: Rally Should Continue Because Of Pervasive Perma-Bear Sentiment.

FACT: Contrarian strategy is, in fact, a great investment strategy to follow.

ISSUE: The markets are up 50% from the March lows, and there is pervasive bearish sentiment? If investors are predominantly bearish, then who is bidding prices up FIFTY PERCENT in the worst recession since WWII? Savvy contrarians realize that just because prices have gone down does NOT mean it’s a good time to buy. Sometimes prices go down for a reason.

Bull-FALLACY 5: Markets Higher Because Of The Lower Dollar, Change In Risk Appetite, Etc.

FACT: Change in sentiment or asset rotation has historically provided the best entry-points for swing/trend trading because “the trend is your friend”.

ISSUE: It’s entirely possible that: (1) demand for the dollar has gone down (the dollar is declining), and (2) demand for riskier equities has NOT gone up. These are not logically or financially contradictory positions. In fact, this rally has been characterized by low volume and record insider selling, not the hallmarks of a change in sentiment nor in asset rotation (going out of safe haven dollar and into equities).

CONCLUSION

Bulls have held some contradictory positions: (1) the economy right-now does and does not matter; (2) despite markets being up 50% this is a great contrarian time to buy because there are bears-bears-everywhere; (3) there’s a change in sentiment that’s fueling a shift into riskier equities…despite a generally low-volume rally with heavy insider-selling. The bullish case does not seem to hold up to logical scrutiny.

Ask yourself this simple question: Are the "real" insiders (Goldman Sachs (GS), JP Morgan (JPM)) buying or selling (never mind what they're telling the investment public via their analysts)? If they were buying, would they let the word leak-out to the public who would then bid against them?

Follow the elephant tracks. The trend is your friend, but in major bearish-trend there will be counter-trends like we’ve witnessed and these counter-trends are not your friend…merely a profitable trading opportunity for the quick-&-nimble traders. The more prices deviate from the norm due to “noise”, the more devastating the subsequent correction (statistical fact of Reversion to the Mean…or a “Really Mean Reversion”).

Disclosure: Long TZA.

Comments

[redbaron:]

I have been in small cap stocks heavily all the way in this rally, and I have beat the Dow & S&P by about two-fold since January 1 of this year. I have posted nearly all the way here on SAS, and have been shouted down by the sort of logic above all the way. This has been, so far, the best year I have ever had in 45 years of investing, and you are going to have a hard time convincing me this is not a bull market. Sure, it will correct at some point, but the stocks I invest in were definitely over-sold, and are still bouncing back.

I took some money off the table a couple of months ago,and the stocks I sold continued right on up without me, so I got back in and have not been sorry. I have some cash in reserve, but this advance seens relentless to me. Why not enjoy the ride?

Sep 14 05:02 PM

[Dave Wrixon:]

Soon it will be meaningless whether it is going up or down, because ultimately it is all measured in Dollars and nobody will have a clue what they are worth, if anything. And as for anybody making a profit, yes sure some sharks will be making a killing, but it won't get declared in the accounts of the major corporations, as accounting for anything will be just about impossible.

Sep 14 05:17 PM

[Tony Petroski:]

Very nice work play in the article.

I read the conclusion but it didn't conclude.

Bearish but why? The bulls are running on vapor? What are the elephant tracks telling us?

Sep 14 05:37 PM

[Tony Petroski:]

Excuse me, great "word play." Especially from a non-native writer.

Sep 14 05:38 PM

[dracula99:]

Why if only one argument is correct? What if the market was really oversold in March. What if the health plan passes and people like it, what if a few companies start hiring and people slowly start to buy again, then momentum starts to build and we reach 11,000 on the DOW by years' end? Why can't that happen? Do you really believe that the planet has less resources or less consumers?

Sep 14 05:56 PM

[conceptwizard:]

The planet has the same resources and less money available to the consumer. Housing equity down trillions, portfolio values down trillions, indebtedness at 126%. employment vaporizing, baby boomers spending less by 40%. Baltic dry Index deteriorating, container ships on stanbty in record numbers.
This does not have the ring for a Consumer galloping to spend money. The fact is the consumer is wiped out.

Then the dollar is debasing wiping out the increase in stock market value as it buys less.

The biggest Swiss wealth management firm that controls 27% of offshore assets advising a sell of all US stock postions.

Insider sell trading at a record high.

There are indicators here bear or bull that are facts. For those who rode the wave, its a good time to watch the sunset.



On Sep 14 05:56 PM dracula99 wrote:

> Why if only one argument is correct? What if the market was really
> oversold in March. What if the health plan passes and people like
> it, what if a few companies start hiring and people slowly start
> to buy again, then momentum starts to build and we reach 11,000 on
> the DOW by years' end? Why can't that happen? Do you really believe
> that the planet has less resources or less consumers?

Sep 14 06:20 PM

[buddhabill:]

I agree 100% with the points you make, and I am convinced that some level of correction will occur some time relatively soon. I'm just trying to figure out the best way to play it. You are long the Russell 3x short: what is your opinion on an option spread play on the IWM Russell 2k index fund?

You can get a 2:1 on an at-the-money play Oct (i.e. 62 - 58) put spread, and almost 6:1 betting on a 10% drop with a 57-54 spread, with decent trading volume.

I'd appreciate your input...

Sep 14 06:44 PM

[bigbaboon57:]

I agree with the article EXCEPT for the comment regarding the weak dollar. The weakening dollar is the ONLY reason that stocks are going up (and can continue going up so long as the dollar continues to be debased). Of course, stocks are only going up in current dollar terms, not in real terms.

Sep 14 07:38 PM

[Smiddywesson:]

Bullish argument, Part II

You want to know why the rally can continue? Given the terrible fundamentals, there's no reason for this rally to have occurred in the first place. Stocks weren't worth their March lows either. Since fundamentals didn't continue the drop in March, I'm not very receptive to a fundamental argument why the rally should end now. Yes, I know the jobs numbers stink, and without jobs in an economy that depends on 70% of its GNP coming from consumer spending, this economy is going nowhere. But I'm not arguing the rally can continue because this market is sound, I'm arguing it can continue because it has absolutely nothing to do with market fundamentals.

This rally is a casino, nothing more. The market is driven by big money fund managers who are desperate to put up some positive numbers before a second losing year in a row shuts them down. They are willing to gamble everything in a bear market because they want to survive, and their clients are out of patience. It's a safe bet for these fund managers, because either they win and save their funds, or they don't win, but they would have lost their clients anyway if they didn't try.

All I hear on the web is doom and gloom. Look at your web site today, it's downright morose. The contrarian in me tells me that we haven't topped just yet. Look at the markets' reaction to the horrible market data coming out. We struck China a body blow for the United Steel Workers (tires) and the UAW (cars), and now they have all but declared a trade war, BUT THE MARKETS WENT UP! When bad news is discounted, it is not the behavior of a market ready to come to its senses

You might say that the level of insider sellers shows something is amiss. No, really? Didn't we just agree that the fundamentals are horrible? How is more evidence of bad things going to change investor sentiment when they were bad throughout the rally? They'll just ignore the insiders like they've ignored everything else. On the other hand, maybe the insiders are selling because they need the money. Maybe they are in hock just as much as everybody else, or maybe they are gambling on the rally too.

There is a lot of liquidity being pumped into the marketplace. Unfortunately, nobody is willing to spend it. The companies are cutting costs and the individuals are worried about debt and jobs. The extra money has to go somewhere so it ends up in stocks and commodities. It happened during the Depression. How would you feel if you sat out a 300% rally? Vindicated because you were right? There are precedents for huge rallies. You know where you find them? Right after huge drops like we just experienced.

The thin volume of this rally is a trap for the bears. If the rally is going to end, where are all the sellers going to come from? They are already out of the game. There's an enormous amount of money sitting on the sidelines. Most of this money is held by small retail investors. Their retirements were hurt real bad when they went to cash. Now, they are under a unbearable strain knowing that they are the cause of their missing the rally. Every day, Joe Sidelines has to face his coworkers, a bunch of idiots who usually don't know squat about the market, but who are bragging about making money while Joe thinks about how he is going to have to work into his 70s. How long do you think people like this can hold out? If they reenter, they will be long because they can't go short in a 401k or long is all they know. There is a tremendous amount of investors ready to join the tug of war on the buy side even though the game is being played on the edge of a cliff.

I grant the fundamentals are as menacing as they can get, but that's not the issue (yet).

Smiddywesson

Sep 14 08:40 PM

[logicalman:]

agree totally and have been basically saying the same thing since the beginning of 09!!!


On Sep 14 05:02 PM redbaron wrote:

> I have been in small cap stocks heavily all the way in this rally,
> and I have beat the Dow & S&P by about two-fold since January
> 1 of this year. I have posted nearly all the way here on SAS, and
> have been shouted down by the sort of logic above all the way. This
> has been, so far, the best year I have ever had in 45 years of investing,
> and you are going to have a hard time convincing me this is not a
> bull market. Sure, it will correct at some point, but the stocks
> I invest in were definitely over-sold, and are still bouncing back.
>
>
> I took some money off the table a couple of months ago,and the stocks
> I sold continued right on up without me, so I got back in and have
> not been sorry. I have some cash in reserve, but this advance seens
> relentless to me. Why not enjoy the ride?

Sep 14 08:42 PM

[Smiddywesson:]

Exactly. If the market offers you huge moves in one direction, take them. If they move against all logic, take them. The fallacy is believing that you know where this steaming heap of dung is going to go. With these long sweeping moves, you don't have to predict, just react.

I'm not trying to be critical of the author, because his analysis of the fundamentals makes sense. It's analysis as usual that I have a problem with right now because it doesn't work. It's like trying to use your 3 HP electric bass motor to push your boat in a hurricane. Sure, it usually works, but not today bubba.

Markets do respond to the economy, except when they respond to themselves.

Sep 14 09:40 PM

[E Nuff Sed:]

Jessie Livermore said it best ""I didn't ask the tape why when I was 14, and I don't ask today, at 40. Your business with the tape is now – not tomorrow. The reason can wait." (Reminiscences of a Stock Operator, Edwin Lefèvre.)

Sep 14 09:47 PM

[E Nuff Sed:]

You missed a few big points,
1. First ever coordinated global stimulus.
2. BRIC story is not only intact but stronger than ever.
3. The USD has/is going down, all commodities and income producing assets have/will go up.
4. Interest rates are at rock bottom and they are not going any where for at least another year.
5. Cash is trash for reason no. 3 & 4.
6. We are still down 33.3% from Oct 10, 2007.
7. Panic is being replaced with Anger and Envy with Greed lurking around the corner.

How long have you been long TZA?

Sep 14 10:00 PM

[Guillaume:]

Yes!
I'll go along with these 7 points (any of these points weight more than the poor bull-fallacy argumentation up there).

Too many people - pro ot not - missed this rally. everyday they prey for the market to go down, write articles like this one up, try to convince the rest of the world they should not be long and making money, and their anger grows as the market keeps performing. it's painful, they resist it, up to when they will capitulate, it is only a matter of time & pain magnitude.

Let's let the teachers teach, and in the meantime, enjoy the ride...



On Sep 14 10:00 PM E Nuff Sed wrote:

> You missed a few big points,
> 1. First ever coordinated global stimulus.
> 2. BRIC story is not only intact but stronger than ever.
> 3. The USD has/is going down, all commodities and income producing
> assets have/will go up.
> 4. Interest rates are at rock bottom and they are not going any where
> for at least another year.
> 5. Cash is trash for reason no. 3 & 4.
> 6. We are still down 33.3% from Oct 10, 2007.
> 7. Panic is being replaced with Anger and Envy with Greed lurking
> around the corner.
>
> How long have you been long TZA?

Sep 15 12:14 AM

[dracula99:]

Doom and Gloom once again. Just so you know I am a socialist, so i berlieve the stock market should be abolished completely and people should strive to make their respective countries better. Wall street should be demolished because it syphons off a big chunck of people's money. Having said that I have made an obscene amount f money in the last 6 months by NOT listening to people like you. I don't care how many thumbs down signs I get, but this nation wide GAMBLING GAME must end.

Sep 15 08:33 AM

[Smiddywesson:]

So many smart people out there, thanks for a great blog.

I have one more thing to add. The G-20 has practically said they will put the pedal to the metal in the near term. In this country, the same people who got us into this mess with low interest rates are now in complete control of the politicians. They refuse to recognize that low interest rates and easy credit are the problem. Their reputations and legacy involve solving the problem with more of what caused the problem in the first place. As long as they are boxed in a corner and unable to admit the truth, and that will be as long as they are in office, the dollar will continue to fall. Their elected lackeys, who think they run the country, cannot now admit that they wasted trillions of dollars following a flawed game plan, so they can't change either.

So all the scoundrels, Republican and Democrat, political appointee and renown economist, are together TRAPPED ON THE LOSING SIDE OF THIS TRADE. If the market drops, they will have to pump more liquidity into the market to prop it up. If a big company fails, they will have to bail it out. Otherwise they would have to admit they were wrong. The big money knows this. The rally will continue. Watch the sweat break out on Mr. B's bald head if we drop more than 10%. He'll have to reach for the drugs. We have their egotistical skins nailed to a board.

Whether or not there is a small correction to the down side. The rally will continue until the suckers join in and create an opportunity on the short side.

Sep 15 09:08 AM

[optionsgirl:]

Tracy, everything you said is true. It makes a lot of sense to hedge your long positions for "the day when all the suckers join in and create an opportunity on the short side". Use stops and puts or sell calls --whatever works, but we've got to keep our eyes on the trend to recognize a real reversal. I thought we were going to see one about 3 weeks ago, but it didn't happen.

Sep 15 10:26 AM

[Guillaume:]

Me as well, I had the same feeling: Late August, I thought the correction was coming, so I lightened up my long, but again this market failed to drop after trying over a few days.
I am long again, comforted by the solid support we saw when the market tried to go down and failed.
The strength of the rebound suggests that many Bears and Flats took the opportunity to come-in, too happy to be given a chance.

After this failed sell-off, the market's risk appetite is higher. No-one can fight it for the moment.

On Sep 15 10:26 AM optionsgirl wrote:

> Tracy, everything you said is true. It makes a lot of sense to hedge
> your long positions for "the day when all the suckers join in and
> create an opportunity on the short side". Use stops and puts or sell
> calls --whatever works, but we've got to keep our eyes on the trend
> to recognize a real reversal. I thought we were going to see one
> about 3 weeks ago, but it didn't happen.

Sep 15 06:13 PM