The 'Do or Die' Point For the Bearish SPX Elliot Wave Count Approaches
Two weeks ago we posted a missive entitled 'What Are the Markets Discounting?'. As we pointed out, the Elliott wave count for the S&P 500 index – the basic idea of which we first discussed a few months ago – has become very popular among e-wave practitioners. This is easily explained: the decline from the 2011 high looks like an impulse wave (this is to say, a move consisting of five waves).
Under the rules of Elliott wave theory, this means that the primary trend has turned down. Hence, any rally developing from the 'wave 1' low is regarded as a counter-trend corrective move. The problem with corrective moves is that they are fiendishly difficult to 'count' in real time, as there are many different, often quite complex possible shapes a corrective wave can take.
An additional difficulty arises when the wave concerned is a second wave. For one thing, second waves are 'allowed' to retrace up to 100% of the first wave, but not more. This creates a problem insofar that as long as the market remains below (in case of a bearish trend) or above (in case of a bullish trend) the point at which the putative first wave commenced, one can not be certain whether the retracement is indeed only a corrective wave.
The chart illustrating this bearish wave count that we posted two weeks ago is reproduced below (mind, this is only a rough outline that conveys the major 'waves 1 and 2' view. Far more detailed wave counts are posted by various specialists on the web).
The chart we posted on January 19, outlining the bearish wave count alternative for the SPX – click chart for better resolution.
Looking at what the market has since then done, we appear to remain well within the pre-turning point portion of the path we projected in the above chart.
This is what the SPX looks like as of yesterday. The market has not yet invalidated the bearish wave count - click chart for better resolution.
It is however clear that if this is indeed a 'wave 2' retracement rally, then there is no longer a lot of room for it to continue. If the market were to close above the high of early May 2011, then this wave count would have to be abandoned. We recommend that readers take a look at this 'bullish alternate' count posted by Jason Haver at Minyanville. This appears to us to be the next best alternative if the above wave count turns out to be incorrect.
What we like about Haver's view is that it retains the basic idea that the one degree higher wave, this is to say the advance from the 2009 low, is in fact a primary corrective wave. There is in our opinion no other way to count this higher degree wave without coming into conflict with e-wave rules.
The Technical/Sentiment and Fundamental Data Backdrop
There are two reasons why we are bringing this up. For one thing, the 'decision point' for the bearish wave count is very close. Secondly, Dr. Faber reminded us yesterday 'not to underestimate the power of the printing press', and we have admittedly at times been guilty of doing so.
At the moment, these are the major technical and fundamental aspects one needs to consider:
the bearish evidence consists firstly of the impulse wave that was put in place after the 2011 high. Secondly, current sentiment data appear to confirm that the retracement rally has the character of a second wave. Several of the quantitative sentiment indicators we watch (positioning indicators and surveys) have produced larger extremes of bullish consensus than existed at the top – and this is typical of second waves in a primary bear market.
However, not all of the indicators have confirmed this new high in bullish sentiment. This may actually represent a bearish divergence, especially in the case of the Investor's Intelligence poll, which diverges markedly from the AAII poll which recently hit a 6 year low in its bearish opinion percentage.
The investment advisors surveyed by II are by contrast far more cautious. However, the entire gamut of sentiment indicators surveyed by Jason Goepfert's 'sentimentrader' site now shows 18 sentiment indicators (including nearly all major options related data, several Rydex related data points, liquidity premia on ETFs and surveys) at bullish extremes (which are contrarian bearish for the market), with exactly zero indicators at a bearish extreme (contrarian bullish for the market). The so-called 'dumb/smart money' spread has opened up to an unusually large 25 percentage points, with 67% of the 'dumb money' confident of a rally and only 42% of the 'smart money' confident of one.
Meanwhile, the bullish evidence consists mainly of a fundamental datum: the heavy monetary pumping by central banks around the world. Barry Ritholtz at the Big Picture blog has recently published a few charts that have been put together by Jim Bianco, showing the size of the balance sheets of eight major central banks. Below we reproduce the chart showing the combined size of these balance sheets (Fed. ECB. BoJ, BoE, PBoC, BuBa, SNB, and BoF):
The size of the balance sheets of eight major central banks combined has nearly tripled since 2006 - click chart for better resolution.
Especially noteworthy in terms of monetary pumping in recent months were the European central banks (i.e., the ECB as well as the euro-system CBs in various member nations), the BoE and the SNB, all of which have been creating money at a furious pace. The BoE and the SnB are engaged in 'QE' type operations, with the latter trying to keep a CHF-euro peg in place. The ECB meanwhile has launched its 'LTRO's, theoretically temporally limited expansions of central bank credit, but as we all know these will very likely never be taken back in practice.
The Federal Reserve meanwhile has markedly lowered the bar for 'QE3' – presumably a fall in the stock market or an especially weak unemployment report would suffice to trigger another round of money printing by the merry pranksters in Washington.
Alas, a 'falling stock market' would of course imply – if the decline begins 'in time' – that the above bearish wave count could turn out to be correct.
However, bears should keep in mind that while 'QE1' and 'QE2' were underway, the stock market kept grinding higher (very slowly, but relentlessly) in spite of numerous warning signs from the sentiment front that were evident at the time as well.
On the other hand, when the corrections finally struck, they wiped out many months worth of gains in the space of a few days or weeks. We believe a similar outcome will ultimately also be the fate of the current rally.
What we do not know for certain is whether it will happen earlier, or later as indicated by Jason Haver's alternate count. Either way one must continue to be aware that the risks are very high. With every day the market rises, the risks will in fact increase further.
Some Anecdotal Evidence
A Bloomberg report yesterday apprised us of the following: “Global Strategists Abandoning Bearish Views”.
What this headline immediately tells us is that these 'global strategists' have so far missed the rally. Where were they at the lows? As always, the market sentiment of these 'experts' merely follows prices. After stock prices have fallen, they become bearish. Shortly after they do, prices are rising again. Once they have risen and the risks have therefore greatly increased, they turn bullish again. It's a good thing they are only 'strategists' and are not actually investing other peoples' money.
“Strategists at the biggest banks are capitulating on their bearish forecasts after the best start to a year for global stocks since 1994 and gains of more than 7 percent in emerging-market currencies.
Just two weeks after saying that investors should “remain cautious,” Larry Hatheway, the chief economist at UBS AG (UBSN), raised his recommendations on global shares and high-yield bonds in a Jan. 23 note to customers entitled, “Wrong, but not too late.” Royal Bank of Scotland Group Plc (RBS), and Benoit Anne, the global head of emerging-markets strategy at Societe Generale (GLE) SA, said their estimates for developing nations were proven wrong.
The MSCI All-Country World Index (MXWD) climbed 5.7 percent in January, surprising strategists at Bank of America Corp. (BAC), Goldman Sachs Group Inc. (GS) and Barclays Plc (BARC) who had forecast first-half losses because of Europe’s debt crisis. JPMorgan Chase & Co. (JPM) and Citigroup Inc. (C), which predicted the rally in stocks, say it will continue as the U.S. housing market rebounds and China eases lending restrictions to bolster economic growth.
“In hindsight, everybody was so beared up at the end of last year,” Mary Ann Bartels, the New York-based head of technical and market analysis at Bank of America, who predicted on Dec. 27 that the Standard & Poor’s 500 Index would probably fall about 15 percent in the first half before recovering, said in a Jan. 31 phone interview. “There was nowhere for the market to go but up.”
With the benefit of real time assessment instead of that of hindsight, we should note here that at this particular juncture, everybody seems suddenly 'bulled up'.
What makes anyone think that this new consensus view will prove more prescient than the 'beared up' stance at the recent lows turned out to be?
At the lows, the risks were of course still great due to the euro area debt crisis – as we noted at the time, the 'crash risk', while still very low, was far higher than normal – but it should be clear to everyone that once prices have risen as much as they have since then, the risks can not have become smaller: they have increased further.
We were also struck by two articles that describe the growing dichotomy between stock buybacks by corporations and the activities of insiders. Readers need only to consider the headlines of these two articles that appeared on the same day (namely yesterday):
- “Rash to some, stock buybacks are on the rise” in the NYT and
- at CBS News.
The NYT notes:
“The principle behind buybacks is simple. With fewer shares in circulation, earnings per share can rise smartly even if the company’s underlying growth is lackluster. In many cases, like that of the medical device maker Zimmer Holdings, executives are able to meet goals for profit growth and earn bigger bonuses despite poor stock performance.
“It’s clear there’s a conflict of interest,” said Charles M. Elson, director of the at the University of Delaware. “Unless earnings per share are adjusted to reflect the buyback, then to base a bonus on raw earnings per share is problematic. It doesn’t purely reflect performance.” In addition, executives, who are often large shareholders, stand to benefit from even a small, short-term jump in stock prices.”
A most readers will remember, during the 1990's mania, stock buybacks were all the rage. They were seen as a 'tax-efficient way of returning money to shareholders'. What could be better than a shrinking share float? Alas, it turned out that companies soon began to issue so many stock options to executives, that the share float often did not shrink at all. The gains that were supposed to be accruing to shareholders really flowed into the pockets of managers. The attitude toward buybacks has therefore subtly changed over the years, and the above excerpt from the NYT article reflects this change in perceptions.
Moreover, if you consider the chart below, corporate stock buybacks have a major drawback: their timing truly tends to stink. There are almost no buybacks when share prices are low, but they tend to explode when shares become overvalued.
Stock buybacks by corporations are rising once again - click chart for better resolution.
Meanwhile, here is the view from the corporate insiders who are selling the same stocks hand over fist that their corporations are concurrently buying back:
“Insiders don't sell low. Just look at how they behaved in October. As the market soared to enjoy its best month in 24 years, insider selling came surging back after two straight months of near-record lows.
Corporate insiders, including CEOs, CFOs, chairmen and directors, sold nearly $21 worth of U.S. stocks for every $1 they purchased last month, according to new data from Thomson Reuters.
Insiders always sell more than they buy. What's significant is that as stock prices recovered, so did insiders' drive to sell. October's sell/buy ratio came close to its monthly average going back to December 2010, which stands at almost $24 to $1. That marks a sharp increase in selling activity compared with the previous couple of months.
In September insiders sold just $6 in stocks for every $1 they bought. In August they sold a bit more than $3 for every $1 in purchases. Note that insiders also sold far fewer shares when the market was tanking back in June.”
Interestingly, the only 'lesson' the author of this article gleans from this is that investors should not sell into a panic decline, as insiders tend not do that either. He fails to mention that it may perhaps be a good idea to join insiders when they are selling.
The insider sell-buy ratio since December 2010 - click chart for better resolution.
Why An 'Easy Fed' Is Not Necessarily Good For Stocks
The WSJ published an interesting article yesterday that quoted Barry Knapp of Barclays Capital, who made a number of historical and theoretical observations that appear pertinent to the current situation.
As the WSJ relates:
“The knee-jerk reaction in the stock market, of course, has been to believe that low interest rates forever = high stock prices. The theory is that financial repression forces investors to move money to riskier investments, such as stocks. However, Barry Knapp at Barclays Capital has been arguing for several months now that history suggests financial repression isn’t necessarily a good thing for stocks, particularly from the vantage point of price to earnings multiples.”
Knapp's argument is one that we agree with, and it flies into the face of the constant stream of assertions that the 'stock market is cheap'. Cheap relative to what? Bulls regularly cite the so-called Fed model, according to which earnings multiples are a function of the height of the 'risk-free' interest rate on the 10 year treasury note. This model is one investors would do best to reject out of hand. All it ever represented was a way to rationalize the crazy p/e ratios of the bubble of the 1990's. There is zero statistical evidence that shows that it 'worked' over any other period of history.
It is of course true that the level of interest rates has an influence on the evaluation of titles to capital. Lower interest rates tend to drive up the pries of capital goods relative to goods that are closer to the consumption stage. Insofar there is a theoretical kernel of truth in the Fed model. However, stock prices depend on a great many other things as well. As Knapp noted last October:
“The late 1940s and early 1950s, noted by Bernanke as “the most striking episode of bond price pegging [by the Fed]”. A combination of public policy uncertainty and monetary policy missteps (the unintended consequences of financial repression) coupled with a series of geopolitical events, led to extraordinary levels of price instability and uncertainty. This substantially raised equity risk premiums and compressed valuations. During the recession of 1949, S&P 500 PE multiples reached a low of 6x.
“The parallels with today are striking. We believe it is these similar factors that drove multiples to historic lows in the 1940s and help explain today’s low multiples environment. Public policy uncertainty is high, monetary policy is extraordinary accommodative and negative real rates are aimed at stimulating the economy (which should provide a dose of inflation and chip away at the highest debt to GDP since 1946 (that is financial repression). While the mountain of debt in the 1940s was built up defending our country (as opposed to financing consumption), both periods, nonetheless, followed the crises. Much like the threat of another war (Korea) and another financial downturn likely influenced investors’ attitude toward asset prices in the late 1940s and early 1950s, the looming threat of another financial crisis, this time in Europe, weighs on investors today.”
As it were, secular stock market cycles tend to oscillate between valuation extremes. The often cited 'reversion to the mean' is a pipe dream. The reality is that the market always 'reverts to extremes', not the 'mean'. It does not help investors when 'global strategists' with no skin in the game tell them that the 'market looks cheap at 15 times earnings' when subsequently, the market goes to 6 times earnings. Ceteris paribus, this will produce a loss of over 60%.
Knapp then makes an additional point that fully agrees with the Austrian viewpoint on why the manipulations of the Fed are extremely harmful:
“Stock market pundits generally don’t talk much about inflation, but it plays an important role in multiples, in part because inflation expectations play a role in determining what investors believe future earnings growth will be. In an interview, Knapp says the connection here is between the Fed locking interest rates at zero and the volatility of inflation, which he says has an inverse relationship with P/E multiples.
“If you peg interest rates for six years (starting in late 2008), it’s impossible that you won’t get some pickup in inflation volatility,” he says.
Knapp says that to look for real-world examples, look no further than corporations, such as steelmakers, trying to estimate what their cost structure will be or for retailers, on what they can charge for clothes they sell.
Knapp says. “You don’t know where input costs are going, you don’t know where your final prices are going.”
What we have here is a variation on the theorem of the impossibility of socialism. The Fed's interventions in fact make rational economic calculation impossible. Without rational economic calculation, it is no longer possible for entrepreneurs to correctly appraise the future.
After having been duped by several boom-bust sequences in a row, businessmen have adapted somewhat and increasingly refuse to invest in new capital. The ratio of net domestic capital formation to GDP has been in a steep decline since the late 1960's (not coincidentally, around the time when the 'gold anchor' was abandoned). This decline has accelerated over the past few years and turned into a veritable collapse. Many businessmen these days would rather hoard their cash than risk more malinvestments.
So tell us again, why is the stock market 'cheap'? Why should investors pay up for stocks when entrepreneurs are no longer able to rationally calculate and correctly appraise future conditions? It makes no sense – hence we should expect that the secular bear market won't end until these crazy monetary policies are abandoned. Another 'reversion to the extreme' – in this case to extremely low valuations – is highly probable.
Lastly we want to remind readers again that the ratio of mutual fund cash to assets remains a mere 0.1% above the all time low recorded near last year's market top. This indicator continues to show that the medium to long term prospects of the stock market are extremely poor. It is the best indicator we have regarding the sentiment of mutual fund managers. It is basically saying: 'they have never been as bullish as they are now'. Unfortunately, the long term record of this indicator also shows that 'they are always wrong'.
The mutual fund cash to assets ratio, via sentimentrader. It continues to sit a mere 10 basis points above its all time low - click chart for better resolution.
The Dash To Trash
Another worrisome datum is presented by the year-to-date returns of the fixed income universe. As a chart posted by 'Econompicdata' shows, the worst rated fixed income securities have produced the by far best returns so far this year:
Fixed income returns in January: trash fared best - click chart for better resolution.
This shows that investors have become oblivious to risk – it proves indirectly that complacency about economic risks is very high.
Addendum 1: The FOMC Laugh Track
showing the number of times FOMC members broke into laughter at their meetings as the housing bubble approached its peak. There seems to be an extremely close correlation between the mood at Fed meetings and the the moves in asset prices. Note the subdued atmosphere at the stock market lows in 2002-2003. By 2006, the meetings had turned into a regular laugh riot. This of course jibes perfectly with social mood theory.
Social mood in action: the frequency of laughter at FOMC meetings - click chart for better resolution.
Addendum 2: MF Global Funds Traced After All
It seems that the trustee for MF Global has tracked down the 'vaporized' customer funds after all. The problem though is getting them back – that seems nigh impossible. Collateral that is put up in derivatives trades always takes legal precedence – unless the party it was pledged to acted fraudulently, it can not be forced to disgorge such funds.
The details are in this NYT article. A brief quote:
“While authorities have traced hundreds of millions of dollars to banks, MF Global’s trading partners and even the firm’s securities customers, investigators remain uncertain about whether they can retrieve the money.
Some recipients were entitled to payouts from MF Global, which could make clawing back the money difficult. For instance, securities customers withdrawing their money as MF Global began to collapse were paid from accounts that belonged to futures clients, according to other people briefed on the matter.”
Ultimately the task of recovering money falls to Mr. Giddens [the trustee charged with returning money to wronged customers, ed.], who collected the final claims on Tuesday, the last day customers were permitted to file forms outlining what they are still owed.
He has not said how far his investigation has come. He has deployed a team of 60 lawyers and hired 100 consultants from Deloitte and 60 forensic accountants from Ernst & Young to help sift through some $327 billion in wire transfers in and out of MF Global the month before its collapse.
As Mr. Giddens’s team hunts for the money, it is quietly coaxing some recipients to return it.
“We are pressing our investigative team to now come up with actionable intelligence that the trustee can use to determine the location of remaining customers assets, and most importantly, if we can get those assets back under the trustee’s control for return to customers,” Kent Jarrell, a spokesman for Mr. Giddens, said in a statement. “The trustee will use all appropriate and legal means to get those assets.”
We are keeping our fingers crossed for MF Global's clients.
Addendum 3: Jazz For Cows
On a lighter note, here is a fascinating and funny short video of a New Orleans jazz band serenading a herd of cows. The bovine creatures after a little while seem to be forgetting about their grass-munching activities and instead congregate at the fence, raptly listening to the band.
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