What The Past Can Tell Us.

1970s Bear Market

1930s Bear Markets


Inception: The Dow Jones Industrial Average opened at 40.94 on May 26, 1896.

Lets closely examining data regarding Dow milestones and secular bear markets. I’ve included tables above and brief notes. After a quick review, these charts revealed an important pattern.

Inference

Not all milestones are equal. The Dow appears much more attracted to certain psychological levels (i.e. 100, 1,000, and 10,000). While it seems to race to these important levels, the Dow has a much more difficult time leaving them behind.

Why This Matters

The market’s propensity to linger at such levels creates an opportunity for those who can correctly identify when the index has, in fact, departed 10,000, or when it will.

Next, I examined bear-market lows for clues. (chart above)

Key Observations

In the first bear market, the low occurred almost three years in. It took another 10 years to leave the 100 level.

The low occurred later in the second bear market -- a full seven years in. Still, it took the Dow another eight years to leave behind the 1,000 level.

In March 2009, the Dow put in a low nine years into the present bear market.

A Starting Point

The bear market low provides a starting point. From there, the market must work its way back into shape before finally conquering key psychological levels and ultimately transitioning to a secular bull phase. That repair takes much time -- eight to 10 years from the low, history would suggest.

To the Charts

Starting with the bear market low, I’ve examined the charts of the two previous secular bear markets looking for similarities. But, first let me make a point about an obvious difference in the two charts. In the first, the Dow spent most of its time above 100; in the second, the Dow remained stuck below 1,000 for the entire bear market. Despite this important difference, the result was nearly the same: It took eight to 10 years after the low to finally leave behind the key psychological level.

About the Charts

Above are monthly charts of the secular bear markets. The key psychological level is clearly shown with a blue horizontal line. The moving averages are set at 10 and 20 months to approximate the 200- and 400-day moving averages. Yellow highlights signify a negative cross (10 crossing below the 20), while green highlights indicate a positive cross (10 crossing above the 20).

Golden Crosses

In technical analysis, a crossover involving an index’s short-term moving average breaking above its long-term moving average is referred to as a “Golden Cross.” This is because the crossover is supposed to signal a new bull market. However, that’s not always the case. Markets aren’t that simplistic.

The Golden Cross (highlighted in green) is quite instructive, though, in my investigation. Take a moment to review the charts. I’ll meet you on the other side to share my findings.

A Pattern Is Revealed

In both cases (1933 and 1975), the first Golden Cross led to more upside -- significantly so in the 1930s. But, these markets didn’t run away. They came back and spent five years trading sideways. Multiple moving-average crossovers occurred (positive and negative) during this time.

Interestingly, in both cases it was the third Golden Cross that led the Dow away from the key psychological level (100 or 1,000).

Go back to the charts and see for yourself. Beginning with the bear market lows of 1932 and 1974, count out the number of Golden Crosses that occur before the 100 and 1,000 levels are left behind for good.

Interesting, harh?

Easy as 1-2-3

Intermediate- and long-term investing should be informed by such market analysis. Don’t rush to buy after the market has run so far, so fast. A disciplined and patient approach will serve investors much better.

In fact, a tremendous amount of patience may be needed.

Based on the results of my investigation thus far, I’d say we may see Dow 10,000 again as far out as 2017 or 2019.

In the meantime, I’ll be counting crosses – 1… 2… 3!

Get Set..., GOLD..!

We’re getting close to a big inflection point in the yellow metal, and it’s the next stage of the rolling sovereign debt crisis.

Note that the ETF SPDR Gold Shares (GLD) inhaled another five tonnes of gold yesterday (its second purchase this week), which brings its holdings to just under 1,125 tonnes.

Also note that the HGNSI Gold Sentiment Index fell 14 points to 18% as of the close on Wednesday and was unchanged again yesterday. The last time the HGNSI was at 18% was on the early February low in gold (February 5-12). So not only did the ETF inhale more metal yesterday, but sentiment is once again reaching levels that were last seen when most gold bulls were ready to throw in the towel altogether.

I'm eagerly awaiting today’s HGNSI reading, which will no doubt be even lower despite the fact that both gold and gold stocks are higher than their early February nadirs (which is another positive divergence to note on top of gold and gold equities’ continued divergence since February from their negative correlation to the dollar index).

Or at least, it would be my assumption that the HGNSI might drop again today. Some gold bulls just can’t seem to shake the memories/scars of 2008, even though it's not 2008. It’s 2010, and Treasury bonds (a dollar deflationist's best friend) are in a bear market that began to accelerate to the downside this week as a large buyer clearly stepped away from the market. (If I had to guess, I’d say he probably speaks Mandarin.)

The implications of the bond market’s downside acceleration are pretty clear in my view. It means that the Fed’s much-talked-about “exit” will be postponed yet again, and that the Fed will soon have to start monetizing mortgages and Treasuries again. And when the Fed does cry “uncle,” gold will rally, and the dollar will be smoked (assuming the market doesn’t look ahead for once and anticipate this inevitability).

Incidentally, while I'm thinking about it, note that per the Fed’s balance sheet data that was released just after the close yesterday, the Fed’s balance sheet grew to another new all-time high in the most recent week. Pretty ironic given that Ben Bernanke was just on the Hill last week talking about an “exit.” Don’t you think? Don’t worry though; the Fed is going to shrink that back to where it was pre-2008, which will be the first such shrinkage in history, and at the same time manage to not implode the financial system (wink, wink).

Returning to the idea that the market might just anticipate the Fed crying “uncle,” this has, in fact, occurred before, and I believe it’s reasonable to expect such anticipation by the market again. After all, this isn’t rocket science. Recall that gold last anticipated the Fed would announce MBS and Treasury monetization when it began to rally in November of 2008 -- well before the Fed announced its MBS buying in December and its Treasury buying in March of 2009. So, it’s not like something like this is unheard of.

In short, I think this week was a pretty important development for gold, because it’s rather clear that the same sovereign debt fears that are weighing on the PIIGS and the UK have now set up camp in the US bond market as well. As for why this hasn't affected the dollar yet, I don’t know. That’s the weird part. But it will affect it eventually as it becomes clear that the Fed will have to print again.

I still tend to think we’re getting close to a big inflection point in gold, and it’s the next stage of the rolling sovereign debt crisis. This time it’s going to hit the US. That's about the most bullish event for gold imaginable, and when the market recognizes it for what it is, gold will explode along with the gold stocks -- probably much like it did back in September of last year.

Whether the dollar gets hit against the euro or not shouldn’t matter, but I’d be lying if I said I find it nearly impossible to believe that the dollar won’t fall against the euro and some of the other major currencies (like the AUD and CAD, where it's already sinking) if the bonds keep tanking like they are. And we all know this will force the Fed’s hand to do more monetizing (probably somewhere around 4.25% in the 10-year, which at our current two-day pace of yield rises will be hit sometime on Monday).

Will the Emerging Markets Continue to Steam Ahead?

With investors’ risk appetite emboldened by the prospects of an economic recovery, emerging-market equities (+104.0%) have outperformed mature-market equities (+73.3%) by a considerable margin since the commencement of the cyclical bull market in early March 2009. But these numbers camouflage the fact that the past six months have been characterized by essentially a sideways movement in relative performance. This raises the question as to how investors should place their bets over the next few months.

Emerging-market equity prices, as measured by the MSCI Emerging Markets Free Index, are primarily driven by commodity prices and in particular by metal prices, as seen from the comparison of the MSCI Emerging Markets Free Index with the Economist Metals Price Index in the graph above. In short, emerging-market stocks are currently fairly priced given the level of metal prices.

However, the outlook for emerging-market equities is less positive given the cloudy outlook for metal prices owing to China’s credit tightening, and high stock levels of some metals at the London Metal Exchange. Improved global industrial production and stronger economic growth in especially developed economies are likely to underscore metal prices and therefore emerging-market equities, though.

The relative performance of emerging markets versus mature markets, as measured by the ratio of the MSCI Emerging Market Free Index and MSCI Global Index, is also driven by commodity prices and specifically metal prices. The relative risk of investing in emerging-market equities has increased as the ratio has surged ahead of metal prices. At best, the MSCI Emerging Market Index could maintain the current relative levels against the MSCI Global Index should metal prices move sideways. But metal prices heading lower could lead to significant underperformance by emerging markets compared to mature markets. Metal prices need to rise substantially to ensure further outperformance by the MSCI Emerging Markets Free Index.

With the CRB Index again having fallen to below its 50-day moving average, it looks as if traders’ short-term appetite for commodities is waning. Based on the analysis above, the same could hold true for emerging-market equities, especially with the Shanghai Composite Index -- the big gorilla in the group -- battling to climb back above its 50-day line and now also trading 13 points below the key 200-day average.

Should We Follow The Vix?

Came across an interesting article on Bloomberg the other day, titled VIX Doesn't Work As Signal For Stock, Birinyi Says.

Investors looking for clues about the US stock market should probably ignore the Chicago Board Options Exchange Volatility Index, according to a study of the VIX by Birinyi Associates Inc.

Speculation that equity returns will be positive after the volatility gauge decreases and negative when it climbs has little basis in fact, Birinyi said. The VIX provides a summary of historical price swings and tends to move in lockstep with equities instead of forecasting their direction, the firm found.

“The VIX is alleged to be an indicative indicator and has become a staple of analysts and journalists alike,” Laszlo Birinyi and analyst Kevin Pleines wrote in a report to clients yesterday. “We respectfully disagree and ultimately conclude it is a measure of current volatility with little or no predictive or indicative value regarding the course of the market.”

This sparked a blogstorm.

We have Chris McKhan of Optionmonster. We have MarketBeat from the Wall Street Journal. We also have David Rosenberg via Josh Lipton yesterday in What the VIX Really Tells Us:

The VIX index slides from 42 on October 9, 2002 to sub-18 exactly five years later and the S&P 500 doubled; the VIX then surged to 50 by March of 2009 and the market was down 60%; the VIX then went on to plunge from 50 on March 9, 2009 to sub-18 on January 19 of this year and the stock market soared 70%. Since January 19, the VIX has been flat and so has the equity market.

And why not.., let me chime in further too.

The header and the first few paragraphs are a bit more controversial than the actual work. Here's Birinyi's summary:

For those whose time and patience is limited, we will at the outset present our conclusion: The VIX is a coincidental indicator with limited predictive value. It details, perhaps better than other measures, the volatility of the market today but not tomorrow or the day after.

In my opinion, he's right. There's some notion that the VIX today does some magical job predicting volatility of tomorrow. After all, it's a measure of 30-day forward market prices for volatility. But at the end of the day, the VIX does a better job telling you what has just happened in realized volatility (volatility in SPX itself) than it does in actually predicting what will happen over the next 30 days. Correlation is greater to the recent past than it is to the 30-day future it seeks to price. Now that makes perfect sense to me, I mean what else would you base options pricing on?
I'm not sure I understand Rosenberg's counter-argument, it doesn't refute Birinyi's basic point, which is that the VIX is simply a coincident indicator.
Now none of this is to say the VIX is useless. The VIX can give useful info when compared to ... itself. It generally mean reverts, which we can objectively define as gravitating toward its moving averages. As it stretches, it's not the worst idea to look for a reversion. Well, usually not the worst idea.
The VIX also gives clues when viewed under a subjective lens. Take right now for example, the VIX is at something like 21 month lows in absolute numbers. But at the same token we have a 10-day realized volatility in SPX near seven. Given that the market's rightfully assuming (for now) that realized volatility will pick up, it's understandable to have a VIX premium here. So I'm not reading much into it right this second. If the non-volatility persists though, you have to start seeing the VIX drift again, otherwise it's just too much Fear.
If you're looking for some sort of predictive magic, it's not there. But for some info on the margins, there's plenty to glean.

Differing views Of The Pros.

The stock market has gone nowhere year-to-date, but perhaps, if some hedge fund managers are to be believed, it’s really just setting up for something a lot more dramatic.

Jon Markman of Markman Capital Insight writes this morning on the Buzz and Banter that he’s not looking to spook anybody, but he’s been chatting with some top hedge fund managers who think the market is setting up now much as it did in early October 1987, right before the largest single-day crash in the post-Depression era.

Check out the above chart of the S&P 500 in the fall of 1987.

The managers Markman is talking to see today as the equivalent of around October 3. They speculate that the August top equates to the recent January top. The decline to the 100-day average in September is the equivalent of the recent decline to the 200-day average in early February. The advance to the lower high in October is equivalent to the recent advance to 1,123 on Wednesday.

"Now these managers think the next set of steps would be a sharp decline on Thursday or Friday, a series of 0.5% to 1% single-day declines next week, followed by a plunge, let's say, next Friday and a crash around March 15,” Markman writes.

The professional money-makers Markman is kibitzing with argue that there are many fundamental, structural, and economic factors today that parallel those seen in 1987 -- not just the chart analog.

Markman rattles off the list: legislation that could cause investors to dramatically lower their estimates of stock values, a lack of liquidity, a sense of overvaluation after a steady recent advance, revelations of a massive budget deficit, and expectations of a sharp fall in the value of the dollar and an expectation of higher interest rates.

As for what he himself personally makes of all this, Markman tells his clients that, for now, he wouldn't give this scenario more than a 40% chance of playing out, however.

"Valuations are not extreme, interest rates are low, sentiment is still largely poor and governments are much more highly attuned to, and experienced in, dealing quickly with markets that threaten to unravel,” he emphasizes.

Checked with Mike O’Rourke, BTIG’s chief market strategist, for his views on what these well-heeled hedgies are preaching.

Are conditions now, in fact, similar to those in October 1987?

O’Rourke’s answer: no. He doesn’t see any indications that this stock market is ready to take such an awesome tumble.

"I see the market as in a recovery rally,” the strategist tells us. “Liquidity has slowed down and dried up, but that’s because we had a nice rally and now we’re consolidating and building a base.”

He adds, “I would view this as a market rest rather than some ominous sign out there that we will see a crash.”

Right now, in terms of sectors, O’Rourke favors Technology.

"Valuation is attractive,” he says. “We know the leaders in the sector are performing, and many of them put up record revenue numbers in the fourth quarter. And this is all during the great recession so imagine what happens when some economic strength emerges.”

In contrast, O’Rourke says he’s steering clear of Energy and Materials.

"There is a lot of speculative activity out there,” he says. “In 2009, China was restocking and getting ready for this stimulus spend-out and probably purchasing at above-trend rate. This year, that takes a breather. I wouldn’t want to take the risk of being there.”

Sam Stovall, chief investment strategist at S&P Equity Research, notes that, since World War II, there have been 70 times that the stock market has fallen by 20% or less.

It takes, on average, two months to recoup losses from a pullback (5% to 10% decline); four months from a correction (10% to 20% decline); and 12 months from a bear market.

"This is why investors have stuck with stocks,” Stovall says. “They know that these are usually good buying opportunities. Unfortunately, most people know when to get out, but not when to get back in.”

But what about a crash during a secular bear market?

"We’re not exactly sure what would happen next,” Markman says. “There isn’t enough data.”