That Was Awful, But Was It The Start Of A Bear Market?

Includes: DIA, QQQ, SPY
by: ANG Traders

After the horrid first trading week of 2016, it would be useful to know what the future holds.

The future is analogous to the quantum realm; both are accessible only as probabilities.

We review several patterns that inform us on the likelihood of future events.

January 4-8, 2016, has gone down as the worst market opening week of all time - so it must be the start of the predicted bear market, right? Well, since we try very hard not to give the impression that we can predict the future, we can't really say one way or the other. All we can do is weigh the various factors and calculate a probability of future events.

The future, like the quantum realm, is not accessible to our senses. The quantum world does not operate like the three-dimensional (plus one time dimension) universe that we have evolved to live in. The sub-microscopic quantum world is accessible to us humans only as indefinite probabilities; a fact which is hard to reconcile with our sensory macroscopic experience.

The future, like the quantum world, can also be viewed as a pool of indefinite probabilities. These probabilities, which can give us an idea about possible futures, are calculated from historical information. Let's look at some patterns that might inform us about future probable outcomes.

Let's start with the fact that a bear market has been expected by an increasing number of market followers ever since the China-triggered drop last August. This fact alone pushes the probability against a sustained market turn. There is too much fear in the air to make a bear market likely.

You can see in the graphs below, that the bulls (green) are at 22.20 (below 35, is bullish), and the bears (red) are at -38.30 (below -50, is bearish) This means that there are almost twice as many bears as bulls (bull/bear=0.58). The fact that the bears are still above -50 means that it is likely that the recent slide is not quite finished, but the rest of the sentiment numbers indicate that it is likely to end soon.

These low bullish levels (22.20) are close to the lowest levels we have had in the last five years. Bear market breakdowns don't often happen when bullish sentiment is this low.

AAII Bulls and Bears

Work at the New England complex Systems Institute suggests that the panics that lead to crashes come from increased mimicry in the market. That is when more and more participants start doing the same thing in the market, making it easier for panic to take hold. That is why we watch for extremes in sentiment in either direction; if the crowd moves too far one way, a panicked reversal of direction becomes increasing likely.

The fact that the S&P 500 was in a trading range for most of 2015, indicates that there is no consensuses among participants. We don't see the herd running like blind bulls, therefore, we don't see a high probability of a serious market reversal at this point in time.

The money flows of investors as measured by the Rydex Total Asset Ratio are usually a contrarian indicator since they tend to be bullish before markets breakdown, and bearish before markets breakout. From the chart below, we can see that they are not bullish at all. This is another reason why it is unlikely that a new bear market is starting, even though we just experienced the worst starting week of any year.

Rydex Total Asset Ratio

Another factor that is referred to by many market pundits is the present valuation of stocks. This is tricky because there are different ways of measuring this. One way is through the Shiller Price/Earnings ratio, which as we can see below, is not at an extreme.

Shiller PE for the S&P 500

A different way to look at the value of equities is with the Price to Book Value for the S&P 500. Once again, no extreme value here.

S&P 500 Price to Book Value

So, as we look for factors that could provide us with evidence of a probable market breakdown in the near future, we come up empty handed. We find that the probability of this being the start of a bear market, is very low. We may not have reached the bottom of the correction, but it seems to be close at hand.

Having said of all that, the last decade has seen the proliferation of ETFs and algorithmic (high-frequency) trading to a level that dominates the major markets (~70%). Markets have always been driven by human brains and therefore human psychology, especially as it applies to crowds.

But it may be that psychological indicators are not as relevant as they once were, since only 30% of trading is done by living brains; if a majority of the algorithms start to mimic each other for purely mathematical/statistical reasons, then both the mimicking and reversal in direction could happen in microseconds. Witness the "flash crashes." We aren't saying that "it's different this time," just that the possibility is there. Algorithmic trading is new, so there is very little history for us to learn from.

Even though the market is likely to drop a little further, we don't see a bear market as a probable event at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.