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Listen Closely To What Markets Are Telling You.

  • Written by Syndicated Publisher 247 Comments247 Comments Comments
    December 3, 2011

    To suggest financial markets have been volatile as of late is simply a wild understatement.  Although we’ve certainly seen this type of volatility in terms of percentage moves over short spaces of time in the past, we can’t remember when we’ve last seen this degree of volatility within the context of whipsaw back and forth movement.  Although it may sound hard to believe, if one looked only at closing S&P prices and added up the interim high to low and low to high movements of the SPX since literally May 1 of this year, the S&P has traveled 1,233.83 points!!!!  More than the entire value of the SPX as of the close the day after Thanksgiving.  Now how’s that for volatility over a seven month period?

    Has this played havoc with fragile human emotions?  C’mon.  You may remember that we saw many a headline Street soothsayer turn outright bearish at the end of September, lowering equity allocations as well as equity index targets.  Speaking of defensive portfolio postures and the chance for the S&P to breach 1000 to the downside.  Four short weeks and 186 S&P points to the upside later, giddy strategists and other assorted Street fortune tellers rushed to upgrade equity outlooks literally right on top of the highly anticipated late October Euro bailout plan (which in hindsight has turned out to be neither a bailout nor a plan).  We watched in strange amusement as increasing beta exposure recommendations flooded the Street, of course coming after a blistering four week 17% run to the upside in the SPX.  The immediate result of these recommendations of the pros?  A very quick four week 10% loss in the S&P, as a proxy for equities broadly.  It’s never easy, is it?  After all, it’s the job of the financial markets to disappoint the greatest number of participants as possible at most all points in time.

    Having said all of this, we hope it’s helpful to keep in mind amidst all of the financial market and human emotional volatility of the moment some very long cycle equity market fingerprint character points that have proven themselves more than useful over time.  Infallible?  Nothing is infallible.  These are guideposts.  And to be honest, they will come across as incredibly simplistic.  For years we have used the relationship of the 10 and 40-week exponential moving averages of the S&P as an important risk management tool.  It’s one of many in the toolbox, but its track record over the last few decades has been spot on.  When the 10-week EMA crosses down through the 40 week EMA, it’s telling us to sit up and take notice.  As you’ll see in the chart below, this has occurred four times in the last 20 years – early 1994, late 2000, late 2007 and a few months ago.  You already know the second two dates were incredibly prescient in terms of foreshadowing the character of the longer down cycle to come.  These crosses, both on the downside and upside are separated by years, not quarters or months.  This is exactly why we personally deem them very useful.

    In the spirit of honesty, we temporarily broke below the 40-week EMA in the summer of 2010, directly in front of QE2.  Was it QE2 that saved the day for equities in the late summer of 2010? We’ll never know as free market forces were not allowed to play themselves out.  But the break was never sustained and correction back to the upside happened within weeks.  The 10 week EMA has broken to a level noticeably below the 40 week EMA with the recent break, quite different than last summer’s “kiss”.

    Okay, the reason we wanted to revisit this now is that with the intense equity rally of October, it was starting to look like this most recent downside cross was a huge head fake.  But as of this writing, the 10-week EMA remains below the 40-week EMA suggesting a new upside trend of substance has not yet begun.  Quite the opposite.  And yes, after the 20% 2011 top to bottom move in equities this year that for now ended in early October, more than a number of strategists proclaimed that that we’ve had our bear market cycle and we’re now onto an all new bull market cycle for equities.  The fact is that for now no one knows with any certainty.

    But as you look at the chart above and specific to our current circumstances, we need to remember that a return of the 10-week EMA to near the 40-week EMA AFTER a major equity cycle top is not the exception, it’s the rule.  You can see it happened three times after the 2000 peak and twice after the 2007 equity peak.  Are we yet again living through this repetition in human decision-making?  You already know the correct answer, time will tell.  But for now, the 10 week EMA has again approached the 40 week EMA and has now been repelled to the downside, exactly as we’ve seen in prior cycle peaks of meaning.

    Again, no one indicator can be called the Holy Grail in this wonderful world.  For corroboration of message with the indicator above, we’ve historically used a “slower” version of this weekly moving average cross by introducing the 15-week EMA, as opposed to the 10, into the mix.  If we get a signal from the 10-40 EMA relationship that is corroborated by the 15-40 EMA relationship, it importantly strengthens and reinforces the message of directional trend.  For now it’s telling us there is no new bull trend yet and that risk management remains the primary order of the day.  Also important in this corroborative relationship is the fact that the 15 week EMA never came close to “kissing” the 40 week EMA over the last few months.  Could an ECB print or QE3 change this?  It could change this current message in a heartbeat, exactly as we saw in the late summer of last year, but we’re not there yet, and neither is the ECB or Fed.

    Final, but far from exhaustive, indicator of current interest pertaining to the immediacy of the here and now.  Although it’s just our view of life, the October move in equities was largely reflective of short covering based on the interplay of the TRIN indicator and advancing versus declining volume.  What was lacking at the time was a meaningful acceleration in advancing volume.  Well, very much tangentially related is the very simple variable that is new highs for equities.  We’ve put the following chart together that graphically expresses this concern.

    As you look back historically, equity market moves off of major trend lows have come with an explosion in new highs.  Within the context of ongoing bull markets, you can see that post corrective periods ending with price bottoms of substance, we also see a very meaningful move higher in the number of new highs registered as the major averages recover.  It has been an incredibly consistent pattern.  This is a key fingerprint of both newly emerging and/or continuing equity bull markets.

    Alternatively, have a look at the late 2007/early 2008 period in the chart below.  Equity rallies post the very meaningful 2007 peak never saw a coincidentally meaningful expansion in new highs.  (Please be aware that we’re using a 12-week moving average of new highs to smooth out what would otherwise seem short term data noise).  We even saw this snapback in new highs post the summer 2010 period.  As you can see, every post correction equity rally seen over the period covered in the chart below that was to subsequently reveal a continuation of the the bull saw the 12 week moving average of new highs move back to a level of 175 at least.  We did not even crack 60 with the latest October rally.  Very different than last summer and very different than the prior 2003-2007 bull cycle.

    There is one other short-term linkage here.  The lack of recovery in new highs in late 2007/early 2008 also corroborated the real world event of a recession.  Again, the expansion in new highs post the summer 2010 lows likewise suggested no recession.  Exactly as the folks at the ECRI had predicted using their leading indicator data last summer.  So here we stand today, we have not seen really any expansion in this moving average of new highs post the late September/early October lows AND the ECRI folks have essentially put their reputations on the line standing firm and unwavering with their forward recession call.  We’ll just have to see how it all plays out.  Are equities leading the economy via the message of new highs experience?  Again, time will tell.

    So amidst the 24/7 headline news barrage of the moment and the incessant short term meaningful price volatility that has become a hallmark of the recent market environment, we hope it’s important and helpful in decision making to step back and have an unemotional and disciplined look at what have been very important equity market major trend fingerprint indicators over the last few decades.  Guideposts, not Holy Grails.  Guideposts deserving of our attention and ongoing monitoring.  If equities are about to embark on a new up cycle, as so many strategists suggested just one month ago, all current patterns will reverse, and quick.

    From Market Observations – Contrary Investor.

    Images: Flickr (licence attribution)

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