Saturday, December 21, 2013

Market Analysis December 22 2013

Have We Topped Out?

Those who played the Fed drama from the long side this past week (or, even better, shorted the VIX) once again were rewarded. Even the most stubborn traders are beginning to get the hint. The brief knee-jerk downward move after the Fed announcement was incredibly perfunctory, showing that the Bears are getting worn out and rattled from all their abuse. The market remains dangerous, but the Fed is hammering home month after month that it has no intention of raising rates and no intention of doing anything again (as opposed to the horror of May 2013) to spook the market any more than it has to.

Having learned those lessons, what do they imply about the future? We need to decide if the market is over-extended, fairly valued, or under-valued. After that, it is up to random events, corporate earnings and overall economic realities to deliver our profits and losses.

Where's All the Money?

We are going to tackle this question, of market valuation, from a couple of different angles. First, the chart below, "Taper Fears Halt Fund Flows," is quite illuminating.The top panel, "Cumulative bond+equity+balanced flows," shows that when the uncertainty of taper talk started going into overdrive last summer, cumulative money flowing into bonds and equities went flat. That money is sitting under mattresses, in gold, or overseas. Or, perhaps, it is sitting somewhere else of significance to us. Which leads us to the bottom panel.

The bottom panel, "Money Market Mutual Fund Assets," shows a rise in money market mutual fund assets during the same period, since last summer. It started going up when Bernanke decided to scare the pants off everyone and sent REITs into a tailspin due to fears he was on the verge of madness suddenly allowing rates to rise. What a coincidence! Actually, it's no coincidence at all. Rather than stick money into bonds or equities while the specter of a market break and collapsing bond prices due to taper was hanging over everyone's heads, savvy investors were parking their money in that "someplace else," namely, the parking lot of money market funds.

Note also in that bottom panel what happens at the start of each year - 2010, 2011, 2012, and 2013. The money market funds go down. Where do they tend to go? Why, into bonds and equities! This is the "January Effect."

One might, in simplistic technical analysis terms, see the recent sideways action with a slight upward bias of money market fund holdings as being a bear flag for such holdings (Bullish for stocks, that is). If it is, the money market outflows easily could resume into 2014, at least to the lows of earlier this year. If that happens, then the market will start to run out of ammunition. But it has to happen first.

Taken together, these two panels suggest to me that there is a lot of money sitting on the sideline because the Average Joe has not trusted the gains we have seen since May, when Bernanke made such foolish comments that spooked the market badly. Joe's been waiting for the other shoe to drop ever since, which would cause an avalanche of selling, enabling him to get in the market at choice lower prices. The problem with that thinking is now plain, as Bernanke and company actually did learn something from last May and this time dressed up their mini-taper and made it seem almost like a non-taper. The market spurted higher, and once again Average Joe is left with his pile of money in his money market funds, watching the market run away from him yet again. Will he finally give in and start moving some of that money into stocks and bonds? What do you think?

Market volume has been atrociously low during this period. Average Joe is too scared to risk his money, so primarily the pros are benefiting from this market rise.The pros are counting on the "dumb money" to start flowing into the market again.

In summary, the top panel suggests that the flow of money that was interrupted over the past six months could easily resume it's upward trajectory. The bottom panel shows where such money is available and ready for action.

Is the Market Pricey?

Our other approach to valuation is a historical one. The market fluctuates in value over time between extremes of prices as a ratio to corporate earnings. The correlations are astonishingly similar over a span of 150 years - when the same limits are reached, the same things happen, over and over and over.

The above chart, courtesy of, "Real S&P Composite: 1871-Present with P/E10 Ratio" is informative. It shows that the market tends to bottom in roughly the same area, 4-8 PE/10, while it tends to top in a similar zone, 22-44 P/E10. P/E10 is different than straightforward P/E only in the use of a 10-year average of real earnings.

Currently, the S&P P/E10 is shown as 24.7. This is within the zone of previous market tops, though in the lower part of that zone. This chart suggests that the market is fully valued, in fact could be getting toward over-valued. However, it also shows that the market is not in bubble territory such as in 1929 or 2000. The uptrending regression line also suggests that the market is relatively less over-valued now than it has been at previous such over-valuations in the past, i.e., the market has tended to become more comfortable with slight over-valuations over time, making them less over-valued. Whew.

The bottom line is that earnings are vital to carrying the market higher. The January earnings season this time around is incredibly important, perhaps much more so than usual. A good earnings season will help to justify current valuations and pave the way to higher ones.

Let's look at another chart to see how over-valued the market might be, or whether the chart above is simply scaring us.

This chart, courtesy of Business Insider, "Markets Chart of the Day," shows the S&P 500 Forward 12-Month P/E Ratio over the past 15 years. The three horizontal dashed/squiggly lines are: 1) the 5-year average at 13.0; 2) the 10-year average at 14.0; and 3) the 15-year average at 16.2.

First off, the 15-year average is skewed a bit higher than the others because of the mania. However, that period of time is as much a part of stock market history as the catastrophic collapse of spring 2009, so don't discount it too much.

What this chart shows us is that the market currently is fairly valued. In fact, if we throw out the 15-year average for the reasons above, it is slightly over-valued. However, the market has been much more over-valued in the past, as you can see on the chart itself. If it is currently over-valued, it is not over-valued by much. That suggests that current valuation is of little significance in predicting future market direction. In fact, it is quite reasonable to conclude that for a market to get very overvalued first has to be a little over-valued, so a little over-valuation is a necessary precursor to much higher valuations later. Or, the market could get spooked by earnings, realize it is slightly over-valued, and tumble until it is under-valued.

Notice the double-bottom on the lower chart, when the market actually did get under-valued. That happens during times of sheer panic. We see no signs of such panic brewing because of fundamentals at the moment that are comparable with the housing etc. crisis of 2008 (the "Great Recession"). The economy may be sputtering a bit, but it is absolutely undeniable that it is in recovery mode. That is when it tends to head towards becoming over-valued, as it did following the recession (not so "Great") of 1990-1991 and the Recession of 1982.
Taken together, the valuation charts suggest that the market is properly valued, but it is nowhere near a bubble state. It very easily could get a lot more over-valued, i.e., go higher from here. Valuation really is not a determinative factor in this middle range of valuation.

Bottom line: there is no reason to think the market is going to abruptly stop increasing its valuation here - though anything is possible. Betting your money on the market suddenly coming to its senses and realizing that it is getting ahead of itself, and collapsing because it has a moment of Jungian clarity, is a great way to lose that money, though anything is possible.

The Nikkei

The Nikkei 225 is a market that you ignore at your peril. It is where a lot of US funds are parked, and it is easy to invest in, directly through Japanese stocks that trade in the US like SNE, or through ETFs and the like which track it and other Japanese indexes. The unhedged EWJ is perhaps the largest and most well-known such fund, but there are many others.

If you aren't invested in the Nikkei, but are curious, consider hedged funds such as DXJ and DBJP. The reason to consider a hedged fund is that the Nikkei 225 and the Yen have a very strong tendency to move in opposite directions. If you are unhedged, a large fraction of your gains from a move higher of the index will be wiped out by a depreciating Yen (though, should the Nikkei fall, that implies an appreciating Yen, which would cushion the blow to your portfolio). Do your own due diligence, don't make investment decisions without it.

Many analysts are projecting the Yen to weaken substantially over the coming years. That implies a strengthening Nikkei 225.

I don't have a lot to say about where the Nikkei 225 currently is that the chart below doesn't say, so let's have a look.

As you probably don't need me to say, but I will anyway, the Nikkei currently is at a hugely important juncture. It has been in a megaphone pattern since its collapse in the early 1990s and is hanging at the very top of that pattern.

Megaphone patterns are usually considered topping patterns. However, in this instance, that's not very likely, considering this megaphone followed the epic collapse of the bubble of the 1980s. This megaphone is much more likely to be a reversal pattern, so that when it is breached, it will show a distinct change of trend. The change of trend here would be higher.

Without going into a lot of fundamentals, the Abe programme in Japan appears designed to bust the Nikkei 225 higher by stimulating consumption and exports by depreciating the Yen. Unlike in the US, the Japanese monetary stimulus is just beginning. It literally has years to go, and traders know all about what the US QE did to US stocks. If the Abe stimulus affects the Nikkei 225 anything like the US Fed QE experiment affected the US markets, the Japanese markets could shoot higher for some time to come. Of course anything is possible, the downtrend line could hold, and the Nikkei 225 could fall to new lows. We need a break above 16000 for confirmation.

So, minus all the gobbledy-gook, the bottom line is: if the trend line shown is breached, that would be very Bullish for the Nikkei 225. A break above 16000 is going to trigger an awful lot of buy stops by robots around the world, and a break back below 13000 would trigger an awful lot of selling. Be on the watch right now for any break above 16000, which the odds (fundamentals) seem to favor happening.

Sunday, December 15, 2013

A Look at the Market December 15, 2013


I don't really worry too much about fancy technical studies. You can do a lot more with simple trend lines, volume profiles and market tempo. Studies just get in the way.

However, with the overwhelming consensus among the chattering class being that the market has nowhere to go but straight down, it's always nice on a weekend, when there's nothing better to do, to look at a study or two. The weekends are when the Bogeymen come out and fill the chat rooms with doubt and fear.

Above, we present the McClellan Oscillator (this is courtesy of Financial Iceberg, a great site). It is pretty self-explanatory. The market may or may not be bottoming out for the medium term right now, only time will tell. However, this particular indicator, for what it is worth (and there are many, many other indicators out there for everyone to use to prove whatever point they are trying to make at any particular point in time), suggests that the market is oversold. Naturally, it could get more oversold. If you like to play the odds, you look at stuff like this and act accordingly.
Let's look at that again, this time in color

In a general sense, there is absolutely no indication anywhere that I can find, using objective indicators rather than truisms like "the market is too high" or "the Fed is running out of money," that the longer-term trend higher is over yet. If you call a top every time you see a small pull-back, eventually you'll be right. However, that's no way to trade and succeed.

Bubble Bubble Toil and Trouble

I am going to get Socratic here for a moment, it's just more engaging that way in a narrative sense.

It is not different this time. When it is time to sell, you sell, take whatever gains or losses you have, and get out. OUT. I can't remember if it was the movie "Poltergeist" or "The Exorcist" that had the demon entity saying "GET OUT" in that classically malevolent way, but that's what I'm thinking of here. You get out, and you don't look back. That is, unless you are prepared to wait for a decade more or less to get your money back.

I am reminded of the guy who walked into his broker's office in 1955 or thereabouts to sell his RCA stock. When asked why he wanted to sell all of a sudden after holding for years, he replied that he had bought it in 1929 and vowed then never to sell it until he got every single penny back.

Is there a bubble in the market right now? Actually, yes, I think there is.

Is the market itself in a bubble? I don't see one. Valuations overall are not extreme. This does not strike me as a 1999 with the Nasdaq suddenly at 5000. I would instead say that it is properly valued, given company earnings.

So, how can I say there is a bubble, but there isn't?

Because there almost always is a bubble either brewing or in full maturation.

Well, where is the bubble at the moment then? Here, I am going to ruffle some feathers. Sorry about that. Again: where is the bubble right now?

I think that valuations of the social media stocks and some alternative energy issues are dramatically over-inflated. Markets vastly overshoot. That's what they do. That's what they always do and have done since at least Roman times. I think if you are looking for a bubble, look in those areas. But don't assume that means the entire market is in a bubble. Bubbles in individual sectors do have the potential to drag the entire market down for a while. Those kinds of limited bubbles, though, don't drag the entire market down for too long - just long enough to ruin whoever actually was over-leveraged in the actual bubble sectors, like dot.coms in 2000 or real estate in 2008 or silver in 1979 or the Nikkei in 1987 or....

The things about bubbles is that they can last far, far longer than any smart guy thinks they will. But when they pop, they pop and fall so fast you will never catch the balloon before it hits the ground. And then you have to wait. And wait. And wait some more. Along with everyone else. And probably wind up selling right at the absolute bottom because it's obviously never going to come back and you could use the money to buy lunch that day.

No, I'm not going to name any names, though I could. Do your due diligence.

Incidentally, in terms of bubbles lasting longer than you would ever think, below is a video of Ron Insana (brought to my attention by ChessNwine on Stock Twits) pointing out the real estate bubble over five years before it burst. The smart play at that time was not to short real estate - that only became the smart play five years later. Our brains are often far ahead of reality.

Event Risk

We obviously have to watch for what the Fed does, because most unfortunately the government has assumed control over the direction of the market without anyone realizing it at the time. If the Fed really wants to wreck the market, it can do so at any time with one twitch of Bernanke's eyebrows. Do I like that? NO. I'd be much happier if the government had never started meddling with the market and the S&P 500 were somewhere like 1620. We have this overwhelming event risk now that is oppressive. That said, we must trade the market as it is and not how it should be.

One interesting aspect is that the event risk alone is keeping a lid on the markets. I know you will find this hard to swallow, but so many people are staying on the sidelines, afraid of losing their life savings, and so many keep going short because of the sheer precariousness of the underpinnings, that the market might just be exactly where it should be. Market volume has been terrible because of that, when you would think it would be going crazy. Fear is rampant. That's what happens at market tops - you get crazy volume leading into it. Remember 2000? I do. Crazy volume happened, crazy volume that has been declining ever since (yes, still). We have seen just the opposite of that craziness in 2013. It is very weird.

Price-earnings do not suggest a bubble ready to crash. Valuations are roughly where they should be, with sectors rotating up and down fairly normally.

Yes, maybe I'm a crazy loon too.

Game This Out

I don't believe the Fed and Obama and all the rest want to wreck the market right now. They don't have to, and they have enough troubles. Employment is only okay, is is hardly great. Yes, unemployment dropped to 7%, but only because hordes of people have dropped out of the work force. That's hardly terrific.

The MO of the current Fed is that, when they want to do something that will be market-changing, they send very discrete signals. You get the drip-drip-drip of Fed Governors coming out and making speeches that roil the market. We haven't had any of that so far this time around. That makes me think they aren't going to do anything decisive.

The last thing that Bernanke wants to do is cause a crash right before his handover to Yellen by tapering, right during the holiday season. People will go and burn down his house if he does that. Yellen won't want to cause a crash as her first act. Nobody wants to go down in history as "the crazy crash lady." Besides, she has a reputation of being even softer on this issue than Bernanke.

The Fed's accumulation of assets is working wonderfully from a balance-sheet perspective. If they keep this up long enough, they could fund the entire government with the income from the assets they are acquiring (I'm only partly joking there, I have no idea how far these crazy loons will go with this). I think that Paulson and Bernanke and this entire crew should be tried and convicted of something. It can't end well.

But that doesn't mean it ends now.

If we have to be mind-readers, then be a mind-reader.

Play the odds.