The Stock Market
Introduction and Disclaimer
An earlier version of this article was submitted to Seeking Alpha but was rejected because it contained no "in-depth, fundamental analysis". A brief search of the SA website disclosed references to fundamentally based articles on the Acting Man website. So I sent Pater a note claiming knowledge of a fairly accurate, purely mechanical method to identify significant long-term turning points in the market. I offered to tell him a few days in advance the target point of the next signal. He graciously offered to publish my article here. If it can be arranged, I will post its buy and sell signals as they occur in the future. This information is for educational and entertainment purposes only, it will never be a recommendation to buy or sell anything. But I believe that it will prove interesting to consider and watch over time.
Things Not Obvious to San Francisco Fed Chief
Marketwatch reports that San Francisco Fed president John Williams (a noted dove if memory serves) doesn't see the stock market as particularly overvalued at present, even though it sports a CAPE (cyclically adjusted P/E) or “Shiller P/E” of approximately 24, which is in the upper decile of all historical observations – we refer you to a recent article by Doug Short on market valuation in this context.
John Williams is correct insofar as we have not quite yet reached the crazy CAPE valuations of the 1929 peak or the tech mania peak. Of course those are not his yardsticks. With regard to valuations he says:
“With respect to stocks being near-record highs and the Fed’s hand in that, Williams said the media talks more about stock prices than the Fed does. Williams said policy makers take economic data, household wealth and money in the stock market into account, but they are not drivers of monetary policy.
“If you look at the valuation of stocks today compared to earnings and dividends and relative to historical averages, it’s not obvious that the stock market is overvalued. In fact a lot of models will tell you that it’s undervalued given how strong profits have been.”
Which 'models' might he be referring to? We hope not the so-called 'Fed model', a favorite tool of bubble spin doctors, which has been thoroughly debunked by John Hussman on several occasions (see e.g. here for an excellent overview).
When it comes to the S&P's dividend yield, one doesn't really need a 'model' to judge where we stand. A functioning pair of eyes will do just fine:
SPX dividend yield since 1926. Note that the level of administered interest rates and t-note yields has for the better part of market history proved irrelevant for dividend yields. Thus the 'Fed model' must not only be viewed skeptically with respect to price/earnings ratios, but also with respect to dividend yields. Since the beginning of the late 90s bubble, yields have remained at paltry levels – click to enlarge.
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Where Are the Bears?
This is the question asked by the Macrobusiness blog in Australia. It presents the charts showing the current bear percentages of the Investors Intelligence (II) and American Association of Individual Investors (AAII) polls, which have recently declined to near record low levels. Note that at the same time the bull percentages remain well below previous record highs, so that the ratio of bulls to bears does not look as extreme as one might expect. Still, it is undoubtedly noteworthy that no-one believes there to be much downside. Once the II and AAII bear percentages fall below 20%, you are really only left with the perma bear hard core. In fact, what we find quite astonishing is that this dearth of bears has been extremely pronounced throughout the year:
Bear percentage in the II survey: it hasn't gone above 25% even once in 2013 – click to enlarge.
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Equity Fund Flows
Marketwatch recently reported a few interesting data points. The first one comes courtesy of Charles Biderman's TrimTabs, which keeps an eye on various gauges of market liquidity and other factors influencing supply and demand for stocks (such as buybacks). So far in 2013, retail investors have apparently put almost as much money into equity mutual funds as in 2000, which continues to be the record year for inflows (it was incidentally also one of the worst possible times ever to buy stocks). However, 2013 isn't over yet. So far this year, $277 billion have flowed into stock funds. There are interesting timing choices visible on the chart showing the monthly breakdown of these inflows. Apart from the record inflow in January, the biggest inflows have been recorded in July, September and October – pretty much at a time when prices were at their maximum distance from the 2009 low, ie. at the current cyclical bull market's beginning (at the time of the low, there were near record high outflows).
So far, 2013 is the biggest year for equity fund inflows since 2000. After nearly 5years of rising prices, retail investors are finally gathering up their courage …
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Skew Index Rises Sharply
One of our readers pointed out to us last week that the recent strong rise in the so-called CBOE SKEW index should also be counted among the various divergences that make the stock market's current advance suspect. Skew measures the perceived tail risk of the market via the pricing of out-of-the-money options. Generally, a rise in skew indicates that 'crash protection' is in demand among institutional investors (institutional/professional investors are the biggest traders in SPX options). The basic idea is similar to the CSFB 'fear index' or the Ansbacher index (which compares the premiums paid on equidistant calls and puts).
A unusual move in the skew index (which historically oscillates approximately between a value of 100 and 150) is especially interesting when it diverges strongly from the VIX, which measures at the money and close to the money front month SPX option premiums.
Basically what a 'low VIX/high skew' combination is saying is: 'the market overall is complacent, but big investors perceive far more tail risk than usually' (it is exactly the other way around when the VIX is high and SKEW is low). In other words, a surprising increase in realized volatility may not be too far away. Below is a chart showing the current SKEW/VIX combination.
Warning Signs Continue to Proliferate
The stock market's advance becomes ever more suspect. Even though a 'blow-off rally' remains a strong possibility in view of continued monetary pumping, there are a number of factors that represent extremely strong warning signs and can usually only be observed in the late stages of a bull market.
There is for instance the narrowing of the rally to a handful of 'story stocks' that trade at ever more absurd valuations and seem to be able to inexorably rise into the stratosphere, discounting a glorious future that may or may not eventuate (stocks like AMZN, TSLA, NFLX, FB, CRM, YELP, LNKD, DDD, PCLN and so forth). In many cases valuations have become so stretched that even if one assumes that the most optimistic scenarios painted by some analysts and the buyers of these stocks actually do come true sometime in the next ten or twenty years, these stocks would still be overvalued.
Similarly, the pace of IPOs has vastly increased. Whereas IPOs were in 'slumber mode' for much of 2009-2012, issuance has really taken off this year and is at the highest level since 2007. Not only that, but many stocks are once again soaring by up to 100% on their first trading day, which is strongly reminiscent of the insanity that reigned in 1999 to early 2000.
Another facet reminiscent of both the 2000 and 2007 peaks is the huge amount of actual and announced stock buybacks (which are often financed by leveraging balance sheets). These buybacks help earnings per share to increase even as revenues stall, creating a Potemkin village of corporate profitability.
Investing by Ruler
The Barron's big money poll for the fall of 2013 is mainly one thing: not surprising. As usual, the respondents have applied their rulers to the charts and decided to simply extrapolate: they love what has been going up, and hate what hasn't.
For gold aficionados there are great contrarian news buried in the poll: only 3% think gold will be the best performing asset class over the next 12 months. They are similarly down on treasury bonds, which are the one asset class on which the poll respondents have been most consistently wrong over the past several years.
Equities get the most love with 80% convinced they're going to keep outperforming, and within that asset class, US stocks are held to be the best, with 89% bullish on US large cap stocks (it probably doesn't get more stretched than that). Of course US stocks have been among the best performing stocks in the world over the past two years or so, so this is another case of extrapolation ad infinitum. 71% are bearish on gold, a full 91% are bearish on treasury bonds. In other words, whatever has been going up the most is liked best and what has been going down is hated with a passion. How imaginative of these worthies. The one exception to this rule is the US dollar. It is liked by a solid majority in spite of the fact that it has been going down lately, a warning sign if ever there was one.
Opinions Differ …
David Tepper of the Appaloosa Fund recently opined in an interview at CNBC that the 'US stock market could easily rise to a multiple of 18 to 20'. According to Zerohedge, he seems to think that 'taper or no taper', it is all bullish. Continued multiple expansion is indeed what he must hope for if he is long (as he presumably is, judging from what he said), as earnings growth has largely disappeared. Of course, the fact that the Fed's inflationary policy is continuing unabated continues to represent a strong tailwind for financial assets such as stocks. As Bill Bonner noted today, the question is however always 'how much of it is already priced in'.
Not only that, we would argue; it also depends on the faith of market participants that central banks have 'things under control' and that the policy is actually not counterproductive. As our readers know, we expect this faith to be shaken profoundly at some point, but we have no idea when the time will come.
Quite in contrast to Mr. Tepper, Tom de Mark, the inventor of the TD sequential system embraces a rather apocalyptic view. As a reminder: in 2011 and 2012, Mr. de Mark got a remarkable number of market calls right. Especially impressive was his analysis of the 2011 correction as we recall, during which he often foresaw turning points with pin-point accuracy. However, all the public exposure apparently ended up harming him – his 'hot hand' became a tad colder as time went on. Then he disappeared from the public glare for a while, granting interviews more sparsely. Recently he talked to Bloomberg/Business Week again though:
Euro Area Credit Markets Remain Calm, But …
Below is an update of the usual suspects, CDS on sovereign debt, euro basis swaps and a few other charts (keep in mind that 4-in-1 charts use different scales, which are identified by colors).
No-one seems to be worried in euro-land at present, in spite of the continued increase in various sovereign debtbergs. There is however a small degree of concern visible in Slovenia, which is going through a political crisis. As Reuters reported last week:
“A dispute over the leadership of Slovenia's ruling party erupted on Wednesday, posing a threat to the euro zone state's four-party coalition government and its efforts to avert an international bailout.
The mayor of Slovenia's capital Ljubljana, Zoran Jankovic, announced he would run for the leadership of the center-left Positive Slovenia (PS), the main ruling party, in a move that prompted dismay among the other coalition parties. Jankovic, who set up the PS in 2011, resigned from its helm in February, enabling his successor, Alenka Bratusek, to form a coalition government with the three other parties and to become prime minister of the tiny Alpine country.
The parties had refused to join a coalition if Jankovic remained PS leader. They cited a state anti-corruption commission report which said in January Jankovic could not explain the origin of a big part of his income in past years. "I decided to be a candidate for the president of Positive Slovenia. This was a difficult decision. I will explain my reasons… at the congress," Jankovic told a news conference, referring to a party gathering planned for October 19. Bratusek has said she will seek re-election as PS leader.
"This is not good for Slovenia. Jankovic has a better chance of winning and if that happens the government will collapse," said Meta Roglic, a political analyst at daily Dnevnik.”
What Megaphone? Tell Us How High Will We Go!
Yesterday Art Cashin remarked that (we are paraphrasing): “Everybody is asking me how big a rebound we'll get once the budget impasse is over”.
Nothing illustrates the current stock market psychology better. People are not at all afraid of a big decline because the budget talks may continue to falter – all they are interested in is 'how high will we jump once the rally resumes', as though a resumption of the rally were a birthright.
The reality is though that from a long term perspective, the market continues to be in a very precarious position. Our friend B.A. has mailed us an updated chart of the SPX megaphone formation we have previously discussed in these pages. We have added an alternative interpretation of the wave count in black brackets to the proposed A-B-C-D(?)-E(?) wave count shown in the chart annotations, but note that this doesn't alter the ultimate conclusion. Also, keep in mind that this is something that could happen, but obviously doesn't have to happen. The secular bear market could reach its long term trailing P/E target below 10 in other permutations of prices and earnings as well, especially if the central bank continues its massive inflation program without pause.
The long term megaphone formation of the SPX, with two possible wave counts – click to enlarge.
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Mini-Bubble in Singapore Dies Sudden Death
Recent events in Singapore's stock market slightly influenced the performance of the gold mining junior ETF GDXJ, as the ETF's largest component stock is,, or rather was, Lion Gold (with a weighting of 4.78%). Lion Gold is a gold investment company that has its main listing in Singapore and plunged by 71% in a single trading day. Luckily for holders of GDXJ, the ETF's other component stocks rose enough to produce a positive close for GDXJ on Monday in spite of Lion Gold's collapse.
What makes the event so interesting to us is that similar to what has recently occurred elsewhere, an enormous speculative bubble in small cap stocks had developed in the otherwise staid Singapore stock market (we are lately observing bubbles of varying intensity in small and micro-cap stocks across the globe). Stocks in companies with a few million dollars in revenues soared to market caps in the billions. All seemed well until the plug was suddenly pulled two days ago, seemingly out of the blue.