“It’s different this time.”…. those famous last words carved into the headstones of thousands of lost investors of decades past. While we desire never to be caught with those words leaving our lips, in truth every market cycle has something different than the previous. Equally important, each market cycle shares similarities to one or more past bull or bear markets. Under that pretext, to best understand the current market we should consistently ask ourselves; how is this market environment similar to past markets and how is it different?
I thought it prudent to step back and re quiz myself on the above when I came to realize from current readings that, after sixty weeks of advance resulting in a gain of over 80% in the broad market, almost every market strategist and technician I know is bullish. In some cases wildly bullish with comments like “…any market correction must be at least a year away” and “the market is nowhere near a top”. …Wow. Now, I like bull markets, especially this one, and I hope it will continue. But, I am at heart a contrarian. So when I see a crowd leaning too far in any one direction, with growing enthusiasm, I cannot help but search for a counter argument to forewarn and forearm myself against the surprised stampeding herd.
Many of the arguments for further market gains rest in historical norms of indicators used by strategists for decades to measure the health of a bull market. In brief, the bullish arguments include:
1. The Advance Decline Line is at new highs, and it always declines before a Bull market high.
2. The percentage of stocks above their 50 day and 150 day averages is high, showing full market participation in the rally.
3. The number of new 52-week highs continues to expand and is stronger than any time since 1982! Here, too, this indicator should begin to contract months before a market high.
4. As long as small cap stocks are leading, the market is in fully bullish mode.
5. Breadth is more bullish than at any time in the last twenty years.
For the most part, the above are different measures of breadth. It is true that historically many, if not most bull markets peak after a prolonged period of breadth erosion. However, not all bull markets end so gracefully. What I will present in these pages is a basis for why it may be that the record positive market breadth is more a symptom of a liquidity driven rally than a prolonged bull market.
How is this market similar to past markets?
If we define the current environment as a cyclical bull market within a secular bear trend, what are the similar time periods with which we can compare?
Certainly, Japan’s equity market from 1992 is filled with liquidity driven cyclical bull markets to which we might compare the current market rally. Unfortunately, we have very little data other than price and volume. Thus, almost all we can say is Japan’s bull markets during the 90’s averaged about 50 weeks with 50% returns. But here, I would note that the tops of these rallies were consistently an inverted “V”, not the rounded tops of which most current market participants expect. The inverted “V” tops suggest there was very little warning, if any, of the change in trend.
Nikkei 225 1990-2003 Weekly
We might also look at the US market during the previous secular bear from 1968-1982. Here, a simple examination of the Advance Decline line shows an environment nothing like what current market participants expect. Remember the Nifty Fifty? Market breadth peaked in 1959 and fell precipitously from January, 1966 to January, 1975. It should also be noted that the cyclical bull market peak of September, 1976 was not preceded by a top in the Advance Decline Line. To the contrary, the Advance Decline Line peaked in July, 1977, ten months later. Since the Advance Decline Line is a measure of breadth, we can conclude that breadth did not behave in a “typical” manner for an entire decade of the last secular bear market, and could not have forewarned investors of the cyclical changes in trend. That alone should question what we currently perceive as normal behavior for some indicators. But, this empirical evidence of “abnormal behavior” is just a side note compared to more recent and pertinent data.
S&P 500 with NYSE Advance Decline Line 1960 – 1980 Weekly
The first chart below is of the NYSE Composite during the period just before and after the September, 2000 bull market peak. In the bottom panel of the chart I have the NYSE Advance Decline Line, above that the Percent of Issues Above their 150 Day Average and in the next panel a 10 Day Average of Breadth (Advancing Issues / Total Issues) and its 150 Day average (red).
One can say that the Advance Decline Line led the market top. In fact the Advance Decline Line peaked in the second quarter of 1998, before even the 1998 bear market. It was too long a lead time to suggest its declining trend helped market timing. It appears that when coupled with the 1960’s, we can say that the Advance Decline line’s behavior as a leading indicator is not as infallible as many believe. But what I find most significant and possibly more relevant to the current situation, is that the NYSE Advance Decline Line bottomed as the NYSE Composite was forming its high, and began to climb in December of 2001. Yes, breadth was rising as the broad market declined.
NYSE Composite 1998 -2003 with Breadth Indicators.
Another indicator illustrated is the Percent of Stocks Above their 150 Day Average. The Percent Above indicator is valuable because it measures the percent of issues in a long term uptrend. A stock can show up as a negative on an Advance Decline Line because of a bad day, but if it remains above its 150 Day average it can be considered in a long term uptrend. In the case of the market decline from the September 2000 peak, the percent of stocks in a long term uptrend rose from a low in the first quarter of 2000 to over 80% more than a year into the bear market!
The next indicator on this chart is the 10 Day Breadth; a simple measure of the percent of stocks advancing. In red is this indicator’s 150 Day average. Certainly, if a bear market meant that most stocks were declining, this indicator wouldn’t be showing us more advancing issues. But it is. The percent of Advancing Issues gradually increased until about the same time that the Advance Decline Line and Percent Above 150 Day Average Peaked.
NYSE Composite 1998 -2003 with the S&P 600 and Breadth Indicators
The chart above of the NYSE Composite and indicators is identical to the first except we have added the S&P 600 Small Cap Index in orange. While the broad market was declining from 2000 to 2002 there was a stealth bull market in small cap stocks. One need only think of the number of components in the Russell 2000 Small Cap Index relative the S&P 100 Large Cap Index to understand there are many more small cap stocks in the NYSE Composite than large and mid cap stocks combined. Small cap stocks are the engine of market breadth.
This was a unique situation, and what made it unique is what makes it similar to today’s market. But the market strategist or investor looking for breadth erosion to signal the end of a bull market would not have been able to identify the end of this bull market until after the fact.
What does the bear market of 2000-2002 have in common with the current rally?
The answer: excess liquidity provided by the Federal Reserve.
Remember Y2K? As the clock ticked closer to the end of the century many individuals and businesses were in a near panic, afraid that the computers we have grown to rely on will not function when the clock struck 12:00 am on January, 2001. In order to ensure a functioning financial system the Federal Reserve distributed $80 billion in funds in the fourth quarter of 1999, compared to $23 billion a year earlier, in addition to special options that allowed excess liquidity for January, 2000. After the Y2K issue was declared a non event, the Federal Reserve moved to take back as much liquidity as it could. But, there is no way the Federal Reserve can prevent the effect of excess liquidity echoing somewhere in the economy.
The Y2K fear was not the only event that resulted in the Federal Reserve pumping liquidity into the economy during the 2000-2002 bear market. We can never forget the tragedy of September 11, 2001. As a result, the Federal Reserve once again pushed emergency liquidity into the system in order to ensure its smooth function. In all the Fed injecting approximately $81 billion into the government securities markets, loaned approximately $46 billion from the discount window and executed a series of currency swaps with the European Central Bank, the Bank of England, and the Bank of Canada totaling an additional $90 billion.
Between the Y2K fears and the September 11th tragedy approximately $275 billion of excess liquidity was fed into the system. As noted earlier; somehow somewhere, excess liquidity always finds its way into the markets. Considering that in the middle of the greatest bear market decline in nearly three decades, and eight months after the 2001 emergency liquidity, the S&P 600 small cap index made a new all time high. I suspect that some excess liquidity found its way into speculative small cap issues. As a result, the market breadth indicators all pointed to a broad market bull that didn’t exist. Breadth measures showed the market to be stronger than the indexes could possibly portray as the advancing masses of low priced small cap securities overpowered their large and mid cap counterparts. Can you imagine what those breadth indicators would have looked like if all this occurred during a bull market? Perhaps that’s what they look like today.
As stated in the opening paragraph; to best understand the current market we should consistently ask ourselves; how is this market environment similar to past markets and how is it different?
A characteristic of virtually every bull or bear market is to continue in one direction until sometime after the majority of participants are convinced the trend is sustainable. With bullishness of both individual investors and market strategists at extremes it is time to ask ourselves “how can this market fool the most people?” Should we really expect it to simply continue higher until sometime after the indicators so many analysts are watching give a sell signal? Although past examples of liquidity driven rallies are limited, they consistently illustrate a sharp inverted V top indicative of a change in trend with little warning.
Disclaimer: This information was prepared from sources believed to be reliable, but is not guaranteed and is not a complete summary, or statement of all data pertinent to an investment decision. Opinions may change without notice. This report is published for informational purposes only and is not to be construed as a solicitation or an offer or recommendation to buy or sell any financial security. Trading and investing involves risk and past performance may not be an indication of future performance. Claassen Research, LLC and its author accept no liability for any loss or damage resulting from the use or misuse of this report. No Quantitative formula, technical or fundamental system can guarantee profitable results. All rights reserved. © 2010, Claassen Research, LLC.
Disclosure: No Positions