In the short term, several technical indicators have become very stretched to the downside, indicating a good chance for the market to temporarily find a near term bottom at these levels. Longer term, the evidence is not nearly as constructive.
Short Term Indicators:
Several of the short term indicators I watched have become very stretched to the downside. When so many indicators line up, it typically leads to the market finding a near term bottom. On the bearish side of the ledger however, it is a bit concerning how the market has not been able to rally (thus far) from its recent range.
Chart 1: NYSE McClellan Oscillator (Click to enlarge)
Something I keep an eye on daily is the McClellan Oscillator. It is part momentum indicator, part breadth indicator, measuring the moving average convergence/divergence of the net advances on the NYSE. In mid-June this indicator exceed 1.5 standard deviations below the mean, typically a very bullish signal and producing a short term buy signal. That being said, what should be concerning to bulls is the fact that this indicator is already approaching overbought (and will most likely even reach overbought by today’s close), while stocks have barely moved out of their recent trading range.
A useful indicator measuring short term sentiment is the put call ratio; a figure that describes what is being bought more frequently, bearish bets (puts) or bullish bets (calls). In this case the Put/Call ratio seems to be telling a similar story to the McClellan Oscillator. We can see that the indicator reached over 1.5 standard deviations from the mean, typically a very bullish condition and producing a short term buy signal.
A look at this week’s American Association of Individual Investors sentiment survey results.
Chart 3: AAII Bull – Bear Spread (Click to enlarge)
After reaching a nearly seven year high in the Bull-Bear Spread, the spread has dropped quite precipitously. The spread has made a partial recovery, back above the zero line, but still has room to run before being considered “overbought”. This chart may have some longer term implications as well. Bull markets tend to end with rampant optimism, a high that exceeds the level recorded during the 2007 high, and a level that has not been seen in seven years, may qualify as just that.
Chart 4: Percentage of S&P stock above their 50 DMA (Click to enlarge)
Looking at the percentage of stocks above their 50 day moving average, a simple measure of momentum, tells us a similar story. The indicator reached a short term oversold extreme, -2 standard deviations below the mean. The indicator has had a partial recovery back to the mean. Again, some more room to run on the upside, though I would have expected the market to be doing better.
Summary for the short term:
Most of the short term indictors I follow, which measure price, momentum, breadth, and sentiment, have reached levels that typically correspond with the stock market making an interim low. That being said, it has been curious to see the market fail to maintain a rally as these conditions have now existed since mid-June. While these indicators may collectively turn out to be showing a bullish divergence, it is still unusual to see all these indicators recovering while seeing no net price progress. If I were to simply be watching these indicators without looking at price charts, I would have expected the S&P to be 30 points out of its recent low range by now. If the market is going to rally, it should do so soon as we are currently touching the 200 day moving average, a well watched level of chart support. I believe the real test will be when all these indicators reverse from oversold to overbought; if the market is not at new highs when that happens and subsequently reverses, we may have seen an important top in early May.
While the short term technical indicators are lined up in the bulls favor, longer term indicators are far less constructive.
Near important tops in the market speculators tend to use margin to try and improve their returns. Ironically, once speculators are so convinced a trend is in place to the point where they are willing to increase their risk exponentially via buying shares on margin, that trend is typically near an end. NYXdata.com keeps monthly margin records dating back to the 1950s. While there is no hard fast rule regarding what dollar amount equates to a top, visually we can see some important relationships with a simple plot.
Chart 5: Margin Debt (Click to enlarge)
What is immediately evident is the amount of margin being used today, well above the amount being used during the high in 2000. What does that tell you-- the fact that investors are using more margin today than during a bona-fide bubble in the stock market?
Chart 6: Margin Debt/Free Cash in Margin Accounts (Click to enlarge)
By dividing the amount of margin debt by the amount of free cash in margin accounts, we can more accurately gauge exactly how leveraged margin accounts currently are. Free Cash is the amount of cash that is available for withdrawal from a margin account. It should give us a more accurate result (rather than using just the account size as our denominator) since this basically strips out added credits that may be the result of short or option sales. According to the most recent report, on average investors with margin accounts are leveraged by 3:1! The amount of leveraged being used today is nearly equal to the amount of leveraged being used in late 2007 and early 2008, which were levels reached right before huge declines in stocks. Clearly the danger of a highly leveraged market is that losses compound very quickly, and a continued selloff could cause a race to the exits. A second, and less thought of effect is that margin accounts being maxed out also means there is less buying power that can come into the market and bid prices higher. If anything, margin debt currently being utilized could be a source of selling power.
Long Term Buying Power:
Since the stock market is an auction process, cash on the sidelines is vital to a continued rally. One of the largest sources of long term buying power are mutual funds, so it is helpful to look at how much cash they currently have on their books.
Chart 7: Cash Levels at Mutual Funds (Click to enlarge)
Cash Levels (the blue line) are basically tied at all time lows. The other times cash levels have reached ≈3.5% were in 2000 and in late 2007, both times important tops in the stock market followed. This is not a precise timing tool, and the lows in cash levels tend to lead market tops by several months. Still, this certainly does not argue for a long and sustained continued advance.
Another long term concern continues to be a market that is historically expensive compared to long term averages. For example, let us take a look at the Schiller PE multiple.
Chart 8: Schiller PE (Click to enlarge)
Using long term historical averages as guidelines, stocks are fairly priced at about 15 times earnings. Stocks become generally cheap once prices fall to about 10 times earnings. Today stocks appear to be expensive at 22.62 times earnings. And they appear to just be falling from their historical overvaluation achieved in 2000.
Chart 9: Dividend Yields (Click to enlarge)
Dividend yields are in a similar position. In 2000, stocks were so overbought that they pushed the S&P dividend yield all the way down to a record low, nearly 1%! In many ways I believe some of our financial problems today are due to bad bets that were made in “the search for yield.” Many institutions that in the past were able to earn a respectable yield in stocks and government bonds were forced to try and make up for investing shortfalls by entering into the derivatives market. For example, many pension fund managers simply couldn’t keep up with their long term projected rates of return and tried to reduce their shortfall by selling insurance in the derivatives market against securities that were arguably designed to fail. Regardless, what is clear from this chart is that the S&P dividend yield, like the PE ratio, is still well into its “expensive” range. Investors are looking past the stability and relative safety of the lacking dividends in the hopes that they will more than make up for it in capital gains.
Since so much of the “Great Recession” is so linked to the housing market it also makes sense to take a look at home prices. What is actually quite amazing is that if you adjust for inflation, home prices in the long run, have basically not appreciated at all.
Chart 10: Case-Schiller National Home Price Index (adjusted for inflation)
(Click to enlarge)
We can see from this chart that once you adjust for inflation, home prices have actually been relatively stable for nearly a century. It has only been the last few decades, spurred by easy credit and low rates, that housing prices have shot up in true bubble fashion. If prices simply revert to the long term mean, aggregate prices could drop another -15%. But what typically happens with bubbles are prices do not just mean revert, but over shoot, so -15% may in fact be conservative, and would do further damage to the already hemorrhaging debt markets.
Chart 11: ISM Inventories (Click to enlarge)
There is no shortage of bearish headlines crossing the tape recently. Many of the gauges of the health of the economy have been disappointing. One thing that has really caught my eye is how businesses have assumed everything is going back to normal, and by normal I mean pre-recession 2007. Businesses have amassed a mountain of inventories, one of the largest in nearly 30 years. The question I ask is, how is the unemployed, underwater, already debt-laden consumer is going to buy it?
The market seems well primed for a short term relief rally based on a variety of oversold conditions, and indeed as of the writing of this letter, we have seen the market stage a rally off oversold lows and bulls may want to take a shot here. That being said, I am averse to offering an all out buy recommendation on stocks. The short term seems to be at odds with the long term. While we are no doubt in a cyclical recovery bull, it appears to be within the confines of a secular bear, which probably will not be over until we see long term valuations come back down to earth, the bad debts finally wiped out, and investors that truly despise investing in stocks.
Disclosure: I am short SPY.