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Last year around this time, I wrote what I thought was a pretty good article for Seeking Alpha. I’m aware that most of what I write must sound like the esoteric rantings of a bizarre, sci-fi- & fantasy baseball-obsessed mad man. But I actually felt a modicum of pride about this one.
I was pleased with it because they selected it as an “Editor’s Choice” piece and it was the most popular article on the site in terms of pageviews. Apparently it resonated with others. But the most interesting thing about it was that the strategy I talked about played out perfectly. I’m sure that’s 100% attributable to luck because my upcoming book tentatively titled “Jeff Was Wrong” is getting so big I’m probably going to have to split it into three volumes.
The basic idea of the trade was to recognize that the market was, in the first quarter of 2011, making a short-term top. I looked at a bunch of different indicators, all of which suggested that the market might be topping out. It turned out that the market was topping out. The market would spend all spring and summer chopping violently around before falling off a cliff in late July and August.
Which brings us to…
You can see where I’m going with this and I’ll stop you in your tracks. I don’t necessarily think that the first quarter of this year is a perfect analog.
Yes, the market has run pretty much straight up for a period of several months.
Yes, the market is doing it on better-than-expected economic data but with that same long-term, global backdrop of slow growth, high uncertainty, and latent fear.
But the fundamentals today are different enough that it’s worth some extra thought and analysis before concluding that the market is at or near a short-term top.
Let’s look at some current data. Buckle up because we’re going to cover quite a bit, much of which is rather sophisticated. There’s no fluff today, just a lean diet of hardcore economic indicators. Understanding this stuff will make you stronger.
Is the market overbought?
First we have the Relative Strength Index (RSI). This is one of the most popular measures of whether the market is overbought or oversold. It doesn’t give perfect signals, but in general, it gives decent ones, especially when used in conjunction with other tools:
Right now the RSI is high, but not high enough to really stand out. By no means is it flashing a danger signal. Also, you can see that the market was technically oversold for most of January and February and yet the market kept going up. That’s why you don’t trade on the RSI alone.
Next we have the % of stocks on the NYSE that are over their 50 day moving average.
This one is telling a significantly more concerning story. You can see that the % of stocks above their 50 day moving average — stocks in a clear bull trend — peaked back in February and has been rolling over since then. Technical analysts like it when the market is going up and the percent of stocks above major moving averages is also going up. When the market is going up and this is going down, it means that a smaller number of stocks on the exchange are keeping the overall bull market afloat.
Along these lines, we also have the % of stocks above their 2oo day moving average.
77.5% is a large reading, but not extreme. Last spring it was around 81% and in the fall of 2009 it was over 90%. After each one of those readings the market would spend the next 6 months trading in a range. The market would go a little higher, then lower as it consolidated a new base.
It’s not just about the absolute reading. It’s also about how much time the market spends in territory like this. Right now the market has spent two months with 70% or more of the stocks on the NYSE above their 200-day moving average. But I’ve seen markets spend an entire year in territory like this. So this isn’t abnormal by any stretch of the imagination. Pay attention to it, though. If this starts to break down with the broad market appearing to hold steady, it could be a sign that the bigger trend is shifting.
As I said, don’t ever use single indicators like this to make a decision.
Next we have everybody’s favorite contrarian indicator, the AAII Investor Sentiment Survey!
Right now, everybody’s bullish. 45% bullishness isn’t extreme, nor is 27% bearishness. The standard deviation on those run about 10 percentage points. So when bullishness starts getting up into the 50s or bearishness falls to the teens, that’s when I take notice. That’s when it’s easier to say that everybody is too bullish.
Sentiment about risk is changing, too. Again, it’s not a perfect gauge, but one of my favorite big-picture proxies for risk appetite is the Euro/Yen currency cross.
If that just made you spit your coffee all over the monitor, don’t panic. Allow me to explain. Generally speaking, when the world wants to take risk, more Euros than normal get bought. When the world is freaked out, lots of people hide out and buy the Japanese Yen. So when you relate one to the other, you get a pretty good proxy for broad, global risk appetite.
As you can see, this bottomed out around the turn of the year and since then has been trending solidly higher. The world, apparently, is in a risk-taking mood. Incidentally, this was something else that I pointed out last year. While it wasn’t apparent in the headlines or the index data, investors had been quietly getting more and more concerned about risk well before the crash in the late summer. The Euro/Yen cross was trending down pretty much all year long.
And finally, let’s check in with my ol’ pal the LIBOR-OIS spread. This is where I go when I want to measure the health and nervousness of the credit markets.
Nobody was paying attention because it was Christmas, but I talked about this last year. When the ECB stepped in and decided that it would finally take a page from the Fed’s playbook and expand its balance sheet, it spelled the end to the short-term fear and mistrust plaguing European debt markets.
Since then, LIBOR-OIS (and it’s cousin the EURIBOR-OIS spread) has been going straight down. If you are still one of those people that are worried about an acute credit crisis in Europe, it’s time to stop ignoring the data and get with the program. Don’t get me wrong. It’s still a gargantuan mess over there and some of these countries are going to be struggling for a long time. But there is not going to be an acute banking crisis over there like we saw in the U.S. in 2008. Not based on what the markets are saying and not based on what sovereigns and institutions like the Fed and ECB have communicated.
As I’ve written over and over again since the beginning of this newsletter, the world has changed in a major way during the post-crisis years that not everybody is fully aware of or willing to articulate properly. In the post-crisis years we have become especially averse to and afraid of short-term acute pain. I suppose that’s normal psychology for the period after trauma like 2008. The point is that we are willing to do anything — and I mean anything – in order exchange not just acute pain, but potential acute pain, for long-term chronic suffering.
It’s why the Fed has “printed” trillions of dollars. It’s why we are willing to bail out any entity deemed systemically important. It’s why we are willing to ignore massive imbalances between the revenues our country earns (taxes) and the expenses our country has (Social Security, Medicare, Defense) with little serious discussion about how to rectify that condition.
We do all this because we are, as a nation, absolutely terrified of short-term, acute pain.
Free lunches do not exist, and the crazy thing about this is that our rational brains know that all we’ve done is spread that short-term pain across future years and future generations.
Over the long run, I think the path of market and the economy is very clear. It’s probably obvious to you, too. Slower economic growth than we all got used to and a range bound market that more closely resembles the 60′s & 70′s than the 80′s & 90′s.
So what was that strategy again?
The point of this exercise is to illustrate that it’s tough to say the market is obviously overbought right now. At least when you look at the underlying data and technicals.
That’s not to say the market can’t or won’t correct. I’m just saying that if you’re trying to make a case that the market is extended too far to the upside, it’s a difficult case to make. The stock market is extended, but not abnormally so. There’s plenty of room to run, and given the risk-appetite of the investing world right now, it could last a little while longer.
And we could certainly see a correction, too. Markets don’t always reach extreme levels before snapping back the other way. Sometimes they change direction before a turning point is obvious or necessary.
The bottom line is that you have some discretion about how you work these readings into your existing views. If you are in the optimist camp, you can feel good about buying stocks right here, at least for a while. If you’re fundamentally pessimistic, then now is when you want to start thinking about taking some chips off the table. And this almost certainly is a sub-optimal spot for long-term investors to enter the market.
The strategy I outlined a year ago was a yield/income strategy. It was simple and elegant. As a lifelong game-player, I tend to shun strategies that are overly complex and dependent on a path of very specific outcomes and decisions. When dealing with things like the economy, curveballs arrive on a daily basis and it makes it really hard to execute a complicated strategy.
Even though it was a yield strategy, step one was to sell all your dividend stocks.
Step two was to just hang out and wait for the shakeup. If there’s one thing you can bet your last dollar on, it’s that a shakeup is coming. I haven’t the faintest idea when, I just know that it will come. This is not just a function of our modern economy and the decisions we’ve made about it, but it’s also the way that markets work. They go up, they go down, people freak out and they go down some more, then they go back up again. This happens with disturbing regularity.
So if you’re cautious, step to the sidelines. Buy some Treasuries (which always go up in a market freakout) and hit the slopes or play some golf. If you’re optimistic, stay long, but get some longer-term defenses in place. The VIX is about as cheap as it gets. Take advantage of it. Don’t be greedy.
The final step is to go shopping when the shakeout happens. Get out there and scoop up some nice dividend stocks. Lock them in at higher yields. As an example, Altria is yielding about 5.4% today. Last August it was yielding 6.5%. Yields go up when the price of these things go down.
Now — I’m certainly not advocating that you run out and do this. This, like everything we talk about on here, is a thought exercise. It’s a discussion, or food to inspire other conversations.
The purpose of this newsletter is NOT to dispense financial advise. That’s what you pay your financial advisor for. If you are getting your financial advice from some faceless guy on the internet who you know nothing about and who knows nothing about you, then it’s entirely possible that you also need another kind of advice.
That, I’m not sure I can help you with.