The US Stock Market
There can be no doubt that the US stock market continues to be mainly supported by strong money supply growth as detailed in our previous missive. However, from a technical perspective, the entire rise from the 2009 low continues to look corrective in nature. On a long term chart the action in the market is strongly reminiscent of the 1970s bear market, even though the fundamental backdrop seems quite different. One question is of course whether it really is all that different: after all, the government has tweaked its calculation of CPI numerous times, with the goal of lowering it in order to slow down entitlement spending that is indexed to 'inflation'. Originally this goal was kept secret – it was maintained that what was needed was a 'more accurate inflation gauge'. Today, in the course of the recent budget debates, this fiction has been discarded and it is openly discussed that lowering the government's expenses should be the goal of once again altering the CPI calculation (this requires a certain degree of chutzpa, which we have noticed has become quite pervasive, as people have generally become more and more used to an environment reeking of growing authoritarianism). Naturally this makes what is already (and always has been) a useless number even more useless. According to the Shadowstats web site, if one were to employ the calculation method of 1980, CPI would today stand at a level comparable to what was seen in the inflationary 1970s.
We would hasten to add that this “measure” is just as inaccurate as any other measure of the “general price level”. It is simply not possible to measure something that lacks a constant against which such a measurement could take place. Since the price ratios of all goods, including money, are continually changing in the unceasing market process, such a constant does not exist.
A long term chart of the SPX, showing the blow-off stage of the 1990s bull market and the secular bear market period since then. One problem is that the wedge-like advance from the 2009 low seems corrective in nature, i.e., it is probably a counter-trend move – click chart for better resolution.
For a comparison, let us take a look at the SPX during the 1970s. There are two points worth making about this chart: for one thing, recognizing that one was still in a major bear market in real time in early 1973 must have been very difficult. The market had just made a new all time high after all. Certainly the preceding advance from the 1970 bear market low was only a three wave advance, but it was conceivable that the 5th wave was about to be put into place. However, the market subsequently lost more than 50% in less than two years.
The other thing worth noting is the very different shape of the first wave up of the new bull market that began in late 1974. As can be seen, this is a clear five wave advance without overlaps, in other words, an impulse wave. This is the main difference to the rally since 2009 (although one could arrive at a very tortured looking impulse count in this case as well, but it is certainly not obvious).
The S&P 500 during the 1970s. Recognizing the new all time high in early 1973 as a bull trap must have been difficult. Likewise, when the rally from the 1974 low developed, it was met with great skepticism. Only very few people believed that a new secular bull market could have begun. Clearly though, an impulse wave could be discerned – click chart for better resolution.
The Great Fallacy
Apart from these longer term considerations, we would note that on a short and intermediate term basis, the market looks increasingly risky as well, in spite of its astonishing ability to ignore negative fundamental developments thus far. Among the negatives are a noticeable slowdown in earnings growth, the ongoing recession in Europe and Japan, and the shaky condition of the US economy (officially, the US economy remains out of recession, but we will only know for sure with a big time lag). Moreover, systemic risk remains in our opinion as high as ever. Investors are relying on one last bastion to which they have tied their faith: the world's central banks. Although even entire governments in the industrialized world have come under suspicion and are as such no longer deemed creditworthy – a development held to be “impossible” as recently as early 2009 – investors seem to think that this one arm of the government apparatus, its major economic central planning division, is somehow capable of suspending economic laws.
We see examples of this every day. We call it the 'potent directors fallacy', a term originally coined by Bob Prechter: the quite erroneous belief that a few suits in Washington or wherever can wave a magic wand and make all the risk go away. Only yesterday a friend sent us a report per e-mail entitled “The Fed's Secret Plan”. We come across similar missives almost every day; the implication is always that whatever the central bank wants is definitely going to happen. However, this fundamentally misconceives the workings of the market. While it is true that the central bank can and does distort prices with its activities, the important point one needs to keep in mind is that its artificial setting of interest rates and money supply growth is in essence fighting the market. In other words, the policy is not congruent with the wishes of economic actors – it seeks to subvert them. This introduces distortions, as price signals are falsified. Economic calculation is no longer based on reality, but on an artificially distorted price structure. This can make it appear for certain stretches of time – often quite long ones – that the policy is “working”. In reality, it merely furthers investment in economic activities that will later turn out to have wasted scarce resources, in spite of resulting in a temporary improvement in economic statistics in the short to medium term. At some point reality catches up and all these errors are unmasked – ideally when the central bank voluntarily abandons its loose monetary policy (this is what happened from 2006-2008, when central bank tightening slowed down money supply growth and ended the real estate bubble). In the event that it just continues inflating without cease, it will eventually risk a complete collapse of the underlying currency system.
It will be very interesting, not to mention quite scary, to see what happens when this last bastion of investor faith crumbles as well. And crumble it must at some point, for the simple reason that central planning doesn't work, no matter how well-intentioned or well-educated the planners are.
Market Sentiment and Risk Indicators
One reason why we think the risks have increased quite a bit even in the short to medium term is that market sentiment has become very lopsided again. We show a few examples of this phenomenon below, but would add that it can of course become even more lopsided. This is not a precise timing indicator, it rather is a heads-up. In addition, the market rally is marked by growing divergences between prices and momentum indicators as well as a steady downtrend in trading volume. We omit the chart of mutual fund cash this time, but want to point out that the mutual fund cash-to-assets ratio remains a mere 20 basis points above an all time low, at currently 3.6%.
A weekly chart of the SPX shows the divergences between price and momentum oscillators (to keep things simple, we always use RSI and MACD) as well as the steady decline in trading volume – click chart for better resolution.
To illustrate the situation on the sentiment front, we want to show a few of the perhaps lesser known indicators in addition to a few of the well-worn ones. First, the positioning of hedgers in stock index futures. Sentimentrader provides an 'all indexes combined' measure that is dollar weighted (so that the e-mini counts for the appropriate fraction of the big S&P futures contract for instance). On the other side of the trade are of course speculators, both large and small. When hedgers hold a very large net short position such as currently, speculators hold the offsetting net long position.
Hedgers hold a very large net short position in stock index futures ($32 billion value). Speculators are commensurately net long – click chart for better resolution.
On the options front, a very low equity put/call ratio was recently recorded, but as the chart below shows, it could go even lower:
The raw daily CBOE equity only put/call ratio – very low, but even lower levels have been seen in early 2012 – click chart for better resolution.
Next we want to take a look at the NAAIM survey of fund managers. This shows both their net positioning (the survey replies range from “200% short” to “200% long”, i.e., leverage is included in the positioning data) as well as their level of conviction (they are asked how strongly they believe that their current positioning is correct). As it were, their conviction is currently at the highest possible level:
The NAAIM survey: fund managers are very much net long, and their level of conviction is at the highest possible level – click chart for better resolution.
In a similar vein, sentimentrader has constructed a 'risk index' that combines the risk indexes published by Citigroup (Citi Macro Risk Index), Westpac (Risk Aversion Index) and UBS (G10 Carry Risk Index Plus). Currently market participants seem to see no risk whatsoever – which of course means that risk is probably very high.
The combined risk index is approaching a multi-year high and is well above the level considered dangerous. Note that it has been very consistently high over the past year, which is considerably more concerning than a brief spike would be – click chart for better resolution.
Risk appetite or aversion is also reflected in the positioning of traders in currency futures. To illustrate the current situation we want to show two sets of positioning data, the commitments of traders in the Mexican peso and the Japanese yen. Arguably yen positioning has been influenced by the recent election in Japan, but we believe the yen remains a mirror of 'risk on' and 'risk off' environments. The peso by contrast is almost the ultimate risk currency. Not surprisingly, small speculators currently hold a record net long position in peso futures.
Commitments of traders in the Mexican peso: speculators are piling into the currency en masse – click chart for better resolution.
The commitments of traders report in the yen is a study in contrast: speculators continue to hold a near record net short position – click chart for better resolution.
Next, we want to look at the Hulbert Nasdaq sentiment index. Mark Hulbert measures the average net long exposure recommended by stock market newsletter writers. Since the Nasdaq is the 'high beta' index, we regard it as especially relevant for the risk appetite environment.
Market advisors are extremely enamored of the Nasdaq at present – click chart for better resolution.
Lastly, although it is very close to breaking out to new highs for the move, the broad NYSE stock exchange index (NYA) continues not to confirm the breakouts to new highs for the move we have seen late last year in the SPX, the Nasdaq and a number of other indexes. The NYA has yet to best its high of early April 2011 – i.e., it hasn't made a new high in almost 21 months. It is probably a much better reflection of the investment results of both mutual and hedge funds than the popular, but more narrow indexes.
The NYA – although the ascending triangle looks actually not bad, the index continues to remain below the highs it made 21 months ago – and thus the non-confirmation remains in place – click chart for better resolution.
Lastly, we want to show a chart we discovered over at Elliott Wave International (EWI) that confirms something we have written about in the past, namely how extremely unusual it was for the Fed to announce 'QE3' and 'QE4' when it did. Normally the Fed reacts to economic market developments in counter-cyclical fashion. As the chart put together by EWI shows, the announcement of 'QE3' really was the very first time in the central bank's history when it veered from its script.
For the first time in its history, the Fed has not acted in a counter-cyclical manner when it announced 'QE3' and 'QE4', while promising to leave the federal funds rate at 0% until 2015. A sign of panic? It is definitely highly unusual, and we believe very risky. What are they going to do for an encore when the market and economy falter again? – click chart for better resolution.
The consensus opinion on the stock market for 2013 appears to be 'it's going to be a repetition of 2012'. Most mainstream forecasts we have seen predict that the market will advance by another 10% or so. Almost no-one is looking for an increase in volatility or expects risk aversion to increase markedly.
Given that high risk appetite has pertained throughout 2012, it seems certainly conceivable to us that it will do so for a while longer. There are not too many events scheduled for the first quarter that look like they could become catalysts for a move toward greater risk aversion. However, this changes late in the quarter or early in the second quarter with Italy's election (depending on the yet to be decided date – we will look at the euro area in more detail in Part Three).
An unknowable factor is at what point the distortions in the US economy's production structure we discussed previously will begin to matter. It is not possible to 'time' this. All we can state with confidence is that it will matter at some point, as a production structure that ties up more consumer goods than it releases is not sustainable (this matter is subject to additional complications due to the global division of labor and the relatively free trade environment; one should actually construct similar charts of all major economic regions to get a more comprehensive picture. However, since most central banks are moving in unison, i.e., almost all of them are currently pursuing a loose monetary policy, it seems likely that the growing imbalances are a global problem).
It would represent a momentous change if the stock market were to enter a downtrend in spite of the Fed purchasing bonds to the tune of $85 billion per month while leaving its administered interest rate at zero. If and when that happens, we will have confirmation that the loose monetary policy has resulted in so much capital consumption that it is no longer possible to fund bubble activities by diverting scarce resources. Will this happen in 2013? We can of course not be certain, but it looks to us like the chances are quite good.
Charts by: Sentimentrader, Bigcharts, Stockcharts, EWI
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