On September 9, long time chartist Richard Russell indicated that he saw a rare “double non-confirmation” [emphasis mine]:
We may have seen a rare "double non-confirmation." On August 27 the Dow closed at 9580.63, a new Dow high for the rally. On the same day the Transports closed at 3714.63, which was not a new high -- in so doing, the Transports failed to confirm the Dow. Today the Transports closed at 3806.75, a new high for the ]Transports. But today the Dow closed at 9547.22, below their August 27 close -- in doing so, the Industrials failed to confirm the Transports. This is what I call a rare "double non-confirmation". First, the Transports were weak in that they could not confirm the Industrials. Today the Industrials were weak in that they could not confirm the Transports. These rare "double non-confirmations," in the past, have tended to signal the top.
Art Cashin recently piped in and said this market reminded him of 1987:
There’s just some eerie things about this—it’s reminiscent of spring and summer of ‘87 when nobody believed the rally and it kept going up despite skepticism, people shorting into it. It ate them alive until it suddenly turned.
Are we in for a repeat of the Crash of 1987?
Possibly. I have heard anecdotally that hedge fund leverage is now back to pre-Lehman levels, indicating a high level of systemic risk. William Pasek at Bloomberg wrote the that the US Dollar is now the preferred source of funding for the carry trade, which puts risk levels in context [emphasis mine]:
Now imagine what might happen if the world’s reserve currency became its most shorted. Carry trades are, after all, bets that the funding currency will weaken further or stay down for an extended period of time. It’s also a wager that a central bank is trapped into keeping borrowing costs low indefinitely…
Three-month London interbank offered rates, or Libor, for dollar loans are at a record low and fell below those for the yen on Aug. 24 for the first time in 16 years.
Think about the turbulence that would be unleashed by the dollar suddenly shooting 5 percent or 10 percent higher with untold numbers of traders around the globe on the losing side of that trade. It could make the “Lehman shock” look manageable.
Remember that in 1987, the stock market didn’t just spontaneously decide to crash in a single day. Before the October crash, the market had topped in August and was steadily declining before it took the ultimate plunge.
Today we have the combination of over-valuation and high risk behavior, but these things have a way of not mattering to the market until they matter. I respect Barry Ritholz’s comment that the current rally could very well be in the 6th or 7th inning.
The key to timing any potential downdraft is to watch the bearish tripwires.
Here is what I am watching for.
One is investor sentiment. James Grant, who could usually be counted on to be not just bearish, but apocalyptic, has become a bull. Despite this sign of bearish capitulation, the chart below of public sentiment, as measured by the AAII survey, is not excessively bullish. [click to enlarge images]
Watching the risk trade
As I pointed out in my previous post Risk on, the risk appetites are still rising. For the bear to truly come out of hibernation, investors have to show signs that their taste for risk is becoming sated. The chart below of the euro/yen cross, a measure of the risk trade, is still trending upwards.
If the USD is now the preferred currency of choice for the carry trade, then let’s look at some emerging market currencies against the greenback. The chart below of the Hungarian Forint against the Dollar remains in a healthy uptrend.
Hungarian Forint/U.S. Dollar
Turkish Lira/U.S. Dollar
Until these bearish tripwires are crossed, the path of least resistance for equities is still up. My inner trader tells me it’s too early to get outright bearish. The 50% Fibonacci retracement level for the S&P 500 is roughly 1120 - and under the circumstances that may be a realistic short-term target.
On the other hand, the trigger for the 1987 decline was the Fed's August decision to raise interest rates. While I have expressed my doubts about the willingness or the ability of the Federal Reserve to effectively implement its exit stratgies, the FOMC statement on Wednesday bears watching.