It is not altogether uncommon to watch with dismay as equities markets around the world plunge in the first, second, maybe third week of trading of the new year. Most of the time, commentators chalk it up to deferred end of the year tax selling – the idea being that by recognizing gains in the new year, one can defer taxes and, in so doing, enjoy an interest-free loan from the government. It often gets let go at that.
But 2010 will be different. We’ve all been hearing a steady drumbeat of, “equities markets are loosing upward momentum,” for months now. We’ve heard some of the most respected names in the investment world opine that the rally off the lows of last March has come too far, too fast. Some suggest that the capital markets’ valuation of risk is irrationally exuberant at the moment. Others suggest the potential for a next wave of the credit crisis – maybe downgrading of sovereign debt, perhaps an even larger collapse in commercial real estate lending. Still others point to the flagging impact of stimulus spending on the global economy, and the prospects for growing inflation and a concomitant need for central bankers worldwide to raise interest rates.
The theme of de-leveraging has played out throughout 2008 and 2009, and will likely continue for the immediate future. I have no prediction about what will happen in January, but I am prepared to issue a firm prediction that if (that is, “IF”) we see a January sell off, many commentators will seize upon it as evidence of one or more of these explanatory themes.
The problem with explanatory themes is that the global financial market, in all of its multifaceted glory, is really too complicated to explain. To attempt to do so is likely hubris, which in investment land can be one costly sin to indulge in. And at the risk of sounding too cavalier, who really cares why a market is tanking? All you need to know is whether it is, in fact, tanking. The most useful “themes” for an investor to focus on are not explanations for a bear market, but rather, descriptions of a bear market.
There are three descriptive themes that are worth holding in focus: (1) Fear and Loathing, (2) Abandonment of Risk Appetite and (3) A New Love of Safety. If you see those themes start to develop (which occurs over time, rather than as the consequence of a single event), you know you are in a bear market and that probably, these themes will take on a life of their own, momentum being what it is.
(1) Fear and Loathing. The Chicago Volatility Index (or “VIX”) has been trending lower throughout the latter half of this year, and remains comfortably under its 30, 65 and 200 day exponential moving averages (or “EMAs”). If we see a massive January meltdown, the question to ask is can the VIX vault above its longer-term EMA? If so, we should get nervous. If the shorter-term momentum, such as the 30 day EMA, overtakes the medium-term 65 day EMA or longer-term 200 day EMA, it could be a great time to start freaking out. But unless and until we see this sort of technical confirmation, any sell off in January might be viewed with skepticism.
(2) Abandonment of Risk Appetite. Vanguard total market vipers (VTI) is one of the broadest equities ETFs out there. Since March, it illustrates a clear trend of higher highs and higher lows. It currently trades above the downward price trend line spanning the 2007 peak through each of the peaks in previous bear market rallies we have observed since 2007. VTI also rests above its short, medium and long-term EMAs, in a relatively clear pattern of upward momentum.
Looks good? Not so fast! As VTI has rallied, volume has ground lower and lower. To some, this signals flagging conviction on the part of bulls. So, let’s see whether we get a very high volume sell off in this security come January, and more importantly, let’s see whether this sell off (should we get one) take VTI below its medium-term or longer-term EMA. We should also be watching to see whether the 30 day EMA drops below the 65 day EMA as well, a sign of short-term selling momentum overwhelming longer-term buying momentum, which generally accompanies and exacerbates falling prices.
(3) A New Love of Safety. Nothing says safety like a 10-year US Treasury. When people buy a 10-year US Treasury at a yield that hovers around the rate of inflation, it tells you they are starry-eyed in love with safety. This is the classic stuff of bear markets.
At the moment, yields are rather low, but are seemingly heading higher. The matter is complicated by several factors, not least of which being the Federal Reserve’s efforts to pin yields lower in hopes of spurring the nascent economic recovery. More complicated is the fact that both long-term and medium-term buying momentum are almost the same as long-term and medium-term selling momentum. For instance, the 65-day and 200-day EMA for the yen-year US Treasury yield are almost equal. We are on a knife’s edge at the moment, when it comes to the direction in the price of US Treasuries. If we see the 65-day EMA start to head into a downward sloping line that is trending below the 200-day EMA, we could see yields start to get tugged lower by trading momentum. Generally, investors fund a flight to US Treasuries by dumping risky assets. By the same token, a spike in yield can rapidly inflate the real price of stocks, raising the applicable discount rate for measuring the worth of future cash flows. That’s not so hot for equities prices either. Trends in the price of US Treasuries is something we should watch like a hawk throughout 2010, but particularly in the face of a major catalyst – like an equities sell off.
Another harbinger of starry-eyed love of safety is the US Dollar. Again, this is a toughie thanks to government policy which intervenes in the price of US Dollars at least as much as private sector investment behavior does. At the moment, the US Dollar has been in a downward trend of lower lows and still lower higher, but recently staged an impressive rally beyond the 65 day EMA. Will the 65 day EMA provide trading support for the US Dollar on the next pullback? If so, the US Dollar may go higher yet. And if the 30-day EMA (which is now upward sloping and indicative of short term buying momentum) should overshoot the 65 day EMA? This too would indicate that short term buying momentum has subsumed medium term selling momentum. The real test for the US Dollar for 2010 is not “can it rally from here” but rather, how far can it rally? If the US Dollar breaks above its long term 200-day EMA, it may be an indication that the US Dollar has farther to go. If so, would that be a love affair with safety? Perhaps – if interest rates in the US are still negative relative to inflation. Or, perhaps, a higher US Dollar would indicate something else all together. The question would be whether investors are willing to pay for the privilege of owning a low yield currency, rather than being paid for the risk of doing so. If so, it wouldn’t look like risk appetite was all that robust, and it would be hard to get all that excited about risky assets such as equities.
Last of all, what about gold? Traditionally, this is the stuff of bears; the ultimate store of safety for value. It’s in a confirmed bull market at the moment, but flies are buzzing in the ointment. The price of gold has fallen below its 30-day EMA and observed that area (an erstwhile zone of trading support) as trading resistance. The CBOE Gold Index hovers at the 65-day EMA, sniffing it out as either support or resistance. If support, Gold could likely go higher still, signaling a love of safety. If the 65 day EMA is resistance, on the other hand, one of the most publicly adored investment vehicles of the past couple of years could be trolling significantly lower from here, indicating that safety is looking a little withered in the eyes of investors.
Other asset classes will add to the pastiche of whatever market themes erupt or seep into early 2010. It will be helpful to avoid chalking up too much significance to any one event, but instead, to watch key technical levels in assets that, themselves, signify attributes of bear markets of years gone past.
Disclosure: Author is currently long VTI.