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Bill L.
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Methodology: setups require certain criteria to be met before trades can be executed, which include weighted statistical studies on several indicators of price, breadth, volume, and sentiment . Amount of risk taken is proportional to how many indicators are aligned. I mainly trade market... More
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  • What Does Every Market Top Have in Common? 30 comments
    May 4, 2010 1:58 PM | about stocks: SPY

    Overview:
    If you have read any of my previous articles, you know I have been a bear for a few months now. Not an easy position to take with the majority of the professionals turning mega bullish. I can sympathize with Cassandra. However, if you look at every major reversal in the stocks ever, they all have a three things in common, and stocks have achieved this un-Holy trinity; they are overpriced, overbought, and most importantly over-believed.
     

    In this article I update a few charts regarding sentiment and momentum, address the BEA GDP reading, and offer some socionomic insights.
     

    Overpriced:
    In my previous article I wrote how PE ratios had reached 22 times earnings using the Robert Schiller smoothing method. Historically, once PE ratios reach these lofty levels going forward the 10 year return is …<dramatic pause> about a whopping 1%, with a high probability of negative returns during the holding period. If measured by either PE ratios of dividend yields, this is historically one of the expensive stock markets EVER (See my previous article for more details).
     

    The Bureau of Economic Analysis released their latest reading on GDP, showing the US economy grew at a annualized rate of 3.2%. This should not come to a surprise to readers as I pointed out in my previous article that more sensitive readings on the economy such as the Consumer Metrics Institute’s daily growth index had already shown a contraction. The CMI’s data shows a very sharp contraction, so expect future revisions to be in the downward direction closer to 2% annualized growth rate. Furthermore if the lead time remains consistent, next quarter’s BEA reading of the economy should show a GDP growth rate of 0% to -1.5%. Not exactly a V shaped recovery. Even if the argument is made that this is the normal growth rate of the economy, and thus the economy is healthy, PE ratios are not “normal,” as discussed earlier they are at one of the most expensive multiples ever. If PE ratios were to contract to a normal level (say a multiple of 15), with earnings remaining constant, that would imply stocks should fall 30% from today’s prices. Prices are likely to fall even further however since it is very unlikely that earnings will remain constant if stock prices are plummeting.

    Overbought - Momentum
    Another indicator I have been monitoring is  the relative strength index or RSI, and it to has reached levels not seen in years. A reading above 70% is typically considered overbought leaving the market vulnerable to a correction. The Nasdaq Composite recently had an astonishing daily reading of 82.5%. On a weekly basis, the Nasdaq recorded a reading of 76.2%, once again a reading not seen since the bubble in 2000 and far above the 67% reading of the 2007 all time high in the other indexes.
     

    Chart 1 – Nasdaq RSI – Weekly -Overbought


    Over-Believed – Investor’s Intelligence

    In my prior articles I have outlined the combined technical, fundamental, and macro-economic case for the continuation of the bear market. So the question is when the market will actually turn down. Looking at previous market tops, the most telling sign of a downward turn has been one sided, wildly optimistic sentiment. Many of the various gauges of sentiment that I track are now in that range.
     

     

    Investors Intelligence compiles a variety of extremely useful information; data that can be used to gauge sentiment of market participants.
     

    Chart 2: Investors Intelligence Percent of Bearish Respondents

    -Data compiled by Investors Intelligence, chart created by Market Harmonics, edited by myself.



    A chart I’ve shown previously, but have updated, we can see the percentage of bearish poll respondents jumped after the selloff in January- February, only to hastily disappear again. Percentage of bullish poll respondents has also quickly soared, now over the 50% danger threshold. At this point, one and all are optimistic and confident; few people are expecting any kind of correction, let alone another leg down in a cyclical bear market. 
     

    Over-Believed – Put/Call Ratio

    Chart 3: Put to Call Ratio + 5 Day Moving Average

    -Created using Indexindicators.com, edited by myself

     

    Another updated chart, we can see that we recently had a reading below .50 meaning people are making more than twice as many upside than downside bets using leverage. This is a much lower reading in my previous article, in fact it is the lowest reading for the entire rise since March 2009, and one of the lowest readings in the last 10 years. We can see that the relentless buying of calls has moved the 5 day moving average below two and a half standard deviations from the one year mean, which at the very least in the near term has previously signaled conditions ripe for a correction. I would also note that the 10 day and 20 day moving averages are also at extremes.
     

    Beyond the Put to Call ratio, I feel another subject that has gone largely disregarded is volume. You may be thinking, “I have heard many commentators talking about the low volume, and that has not seemed to affect the market’s performance.” True, but what I am referring to is the record setting volume in the options markets. Again, another paradigm of the topping process; speculators have rule over the market and do not even wish to own stocks anymore, but instead wish to make leveraged bucket shop bets on the movements of stocks. A few weeks ago in Larry McMillan’s daily research letter, he noted that he had seen more than double the volume in options trading on several hundred stocks, the quality of which he could only describe as “eye popping.” Looking at the list myself, I honestly had never heard of more than half of the companies. In short, breadth and volume have been contracting on the stock exchanges, a hallmark of a trend running out of steam, yet people are now taking incredible risks, betting big on the most flee bitten dog stocks there are.

     

    Some Other Observations - Socionomic Insight:

    And now for something totally different...

    As a socionomic exercise I like to pay attention to trends in fashion, art and music. What stands out in my mind is the recently released and Billboard top ten hit, “Telephone” by Lady Gaga. It has been absolutely striking to see the contrast in her last several hit music video singles. While “Telephone” retains her generally upbeat pop-dance style, the video does not take place in a glitzy Miami mansion, surrounded by scantily clad Adonis like models, such as in her 2008 hit “Poker Face.” “Telephone” instead depicts a decrepit prison, holding cell and a rundown diner. Gaga dances energetically, if not angrily, to scenes of sodomy and violent prison fights. The last scene depicts a mass murder were Gaga poisons the food at the dinner, dooming all the patrons to an agonizing death. She then dons an American Flag bikini and continues shaking her stuff in front of the recently deceased. The contrast can even be seen in the titles of her albums, her first album released in 2008, “The Fame” –produced in a bull market, and her follow up “The Fame Monster” – produced in a bear market.

    Still, music has remained relatively upbeat  and generally positive tone (looking at the top ten list), but the direction in trend appears to be down. The tone of the top ten list is not as upbeat and is devoid of any “bling” videos, where wealth, jewelry, and prosperity are shown off in a casual manor. The settings for dance music has become house parties rather than in exclusive clubs, etc. Once popular music is dominated by louder more aggressive music such as the heavy metal or gangster rap of the late 80’s early 90’s,  the stock market should be much more attractive in terms or reasonable prices.
     

    Closing Thoughts:
    People often say that picking a top is a fool’s errand, and to some extent I agree. However, what I believe is quite possible is to outline a “zone” in which reversals are very likely. As you can see from these updated charts many of the indicators that I follow have gotten even more overbought. The higher, the more overbought, and more over extended these measures I have outlined become, a reversal becomes more and more likely, and right now we are firmly in that zone.



    Disclosure: Long SPY puts. Long BGZ.
    Stocks: SPY
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