How Far Can It Go?

X-factor Report 22 September 2014

by Lance Roberts, StreetTalk Live

This past week was quite eventful as the Federal Reserve made a rather boring policy announcement, Scotland voted for its independence and Alibaba posted the largest IPO ever.

The reassurance by the Federal Reserve that monetary policy would remain “accommodative” removed concerns that the Fed, while not “refilling the punchbowl,” are not “removing” it altogether. Then, Scotland decided to remain united with the United Kingdom. This brought additional relief to markets as concerns over disruption in currencies, and other imbalances were resolved quickly.

This “relief” put enough upward pressure on the markets to create a short covering push that drove the S&P 500 to new all-time highs and pushed the markets into further overbought, extended, bullish territory. When I discuss this, I am often asked exactly what is meant by such a statement. This week, I am going provide a basic course in technical analysis as the “overbought, bullish and extended” theme is likely to remain intact for several months to come.

A Base Understanding

Let’s start our journey by taking a long-term look at the S&P 500 from 1995 to present.

Currently, the price extension of the market, relative to its long-term moving average (3-years), is at a level greater today than at the peak of the market in 1999.

This observation has not gone unnoticed, and there have been quick snaps by the “bullish proletariat” that the current environment is in “no way” like 1999. But in reality there are indeed many similarities. In the past couple of years, we have seen similar surges in the number of companies with negative earnings being IPO’d, massive increases in margin debt levels and share “buybacks” driving earnings.

However, the “bulls” are right – while there are indeed similarities between the current extension of this bull market cycle and that of 1999, they are indeed different. However, ALL MARKET BUBBLES ARE DIFFERENT. Throughout history, there is not ONE asset bubble that is like any of the others. They have all been different, but they have eventually all ended the same. This one will also – leaving only two questions that must be answered: “when” and “what will cause it?”

Sorry, I don’t have an answer for either. And no one does.

This is why we must realize a couple of things.

1. We are in a “momentum” driven market which means that “fundamentals” have less importance at the current time in the “buy/sell” decision-making process. This will not ALWAYS be the case; it is just the case right now.
2. When markets are being driven by excessive optimism and “greed,” the “trend is your friend” until it isn’t.

This is why, despite my ongoing concerns about the market overall, the portfolio model has remained primarily fully allocated all year. Price has only been moving in one direction – up. The chart below shows that (3rd highlighted box) since the onset of QE-3 by the Fed at the end of 2012 corrections in the market have consistently become smaller and smaller.

This conforms to a pattern as identified by John Hussman as a “Log Periodic Bubble” to wit:

“The chart below presents what we estimate as the most “optimistic” pre-crash scenario for stocks. Though I don’t believe that markets follow math, it’s striking how closely market action in recent years has followed a “log-periodic bubble” as described by Didier Sornette (see Increasingly Immediate Impulses to Buy the Dip).

A log periodic pattern is essentially one where troughs occur at increasingly frequent and increasingly shallow intervals. As Sornette has demonstrated across numerous bubbles over history in a broad variety of asset classes, adjacent troughs (say T1, T2, T3, etc) are often related to the crash date (the “finite-time singularity” Tc) by a constant ratio: (Tc-T1)/(Tc-T2) = (Tc-T2)/(Tc-T3) and so forth, with the result that successive troughs come closer and closer in time until the final blow off occurs.”

One of the ongoing misunderstandings by the media, with respect to my work, has been if it has a “bearish” tilt it means that I am not invested in the market and have missed the rally. As regular readers know, this is hardly the case.

As an investor, there is little benefit in reading what could make the markets go higher – you are already invested. If the markets do rise, terrific. What is important to understand is what could potentially go wrong that would lead to a significant loss of capital over a very short time frame. “Bear” markets are always fast and violent which is why individuals almost never get out of the way in time.

Clarifying Over Bought, Extended & Bullish

What exactly is meant by the markets being overbought, over extended and overly bullish? These are concepts, which once understood, will hopefully lead you to managing your money more successfully over the long term.

What Do You Mean By Overbought?

The old market axiom states that: “For every buyer there is a seller.” If that is indeed the case then how can a market become overbought? This is a question that I get often asked .

Before we get into the raw technical analysis of showing the “overbought” condition let’s rationalize what one is and how it occurs.

First, while it is true that there is always a buyer and seller in every transaction it is the “supply and demand” of those buyers and sellers at a particular price point that affects the overall price. Let me explain.

Imagine two rooms of 100 individuals each that want to buy shares of ABC stock. Room A has 100 individuals that current own ABC stock and Room B has 100 individuals with cash wanting to buy shares of ABC. The table below shows a very simplified model of this process.

At $10 a share there are numerous buyers but sellers are few. The demand for the shares drives the price higher which entices more sellers. As long as the demand for shares outpaces the supply of sellers – the price is pushed higher. However, at some point the price reaches a level that exhausts the supply of buyers. The next price decline occurs as sellers have to begin lowering prices to find buyers.

So, while there is always a buyer and seller for every transaction it is the relative supply and demand for those shares at current prices that determine the “overbought” and “oversold” conditions.

The chart below shows the overbought/oversold condition of the S&P 500 as represented by the number of stocks on “Bullish Buy Signals.” The premise is that when most stocks in an index are on a bullish buy signal then most everyone that is going to buy stocks have likely already bought. Conversely, when very few stocks are on bullish buy signals most individuals have likely sold their holdings as prices declined.

The chart shows the 10-month moving average of all stocks in the S&P 500 which are currently on a “buy” signal as represented by the bullish percent index.

The index is currently declining from the most extreme level that we have seen historically since 1996. Every other time that this indicator has peaked and begun to decline, a correction has been associated with the process. The current level is typically where intermediate to longer term tops have been formed. It was important to note the level where the peak in 2007-2008.

Another indicator that further supports the analysis above is the NYSE New High/New Lows index. The premise is the same as the bullish percent index above which says that if the majority of stocks on the NYSE are hitting new highs then it is likely that buyers are being exhausted.

The chart below shows the 10-month moving average of the NYSE High-Low index. Again, we see that this index is hitting levels that have normally denoted an intermediate term peak in the market.

It is important to understand that just because the indicator has reached an extreme level – the market will not necessarily fall apart immediately. It is a warning sign that suggest that the further upside in the market is relatively limited compared to the downside risk that currently exist.

The average correction that resolved the overbought condition, since the end of the last financial crisis, has been between 10-15%. It is for this reason that I continue to suggest NOT chasing the markets at the current time. There will be a correction of some magnitude in the near future that will allow for a safer entry of new capital into the markets. Patience, however, will likely be tested before that opportunity presents itself.

How Can A Market Get Over Extended?

Now that we have defined what overbought means – I can explain what I mean by over extended. As I discussed in “Visualizing Bob Farrell’s 10 Investing Rules”:

“Like a rubber band that has been stretched too far – it must be relaxed in order to be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.

The chart below shows the S&P 500 with a 52-week simple moving average. The bottom chart shows the percentage deviation of the current price of the market from the 52-week moving average. During bullish trending markets, there are regular reversions to the mean that create buying opportunities. However, what is often not stated is that in order to take advantage of such buying opportunities profits should have been taken out of portfolios as deviations from the mean reached historical extremes. Conversely, in bearish trending markets, such reversions from extreme deviations should be used to sell stocks, raise cash and reduce portfolio risk rather than “panic sell” at market bottoms.

The dashed RED lines denoted when the markets changed trends from positive to negative. This is the very essence of portfolio “risk” management.

The idea of “stretching the rubber band” can be measured in several ways, but I will limit our discussion this week to two: Standard Deviation and Distance.

Standard Deviation is defined as:

“A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of the variance.”

In plain English this means, and as shown in the chart below, is that the further away from the average that an event occurs the more unlikely it becomes. As shown below, out of 1000 occurrences, only three will fall outside of the area of 3 standard deviations. 95.4% of the time events will occur within two standard deviations.

For the stock market – one way that standard deviation is measured is with Bollinger Bands. John Bollinger, a famous technical trader, applied the theory of standard deviation to the financial markets.

Because standard deviation is a measure of volatility, Bollinger created a set of bands that would adjust themselves to the current market conditions. When the markets become more volatile, the bands widen (move further away from the average), and during less volatile periods, the bands contract (move closer to the average).

The closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. This is shown in the chart below.

The dashed red line is the 50 week moving average (or mean) with a dashed blue line representing 3-standard deviations. As shown in the chart above, 3-standard deviations encompasses 99.7% of all probable price movement. There is currently on 3-out of-1000 chances that the market will move substantially higher from here.

Historically speaking, this is where both intermediate and major peaks have formed.

If this an intermediate term top then the market should correct back to the mean and maintain the current upwardly bullish trend. If it is a major top then, the market will correct through the mean and most likely to either 2- or 3-standard deviations below the mean and reverse the upward bullish trend to a more bearish downward trend.

As stated above, another way to measure over extension is simply by measuring the percent distance above, or below, the moving average the price currently is.

The chart on the next page shows this more clearly. The gold colored vertical bars represent when the price of the index has risen 5%, or more, above the 50-week moving average. The reddish bars represent a move of 5%, or more, below the moving average.

Currently, with the index more than 8% above its 50-week moving average there is little questioning that the markets are extended to the upside. From this point, there are two things that could occur. If this is only an intermediate-term top, and the markets are going to remain in a bullish trend, then any correction should remain confined to a retracement back to the 50 week moving average.

However, if the markets are building a longer term top then a reversion past the 50-week moving average will denote a possible change into a bear market. Bull and bear markets are denoted below by how they trade either above or below the 50-week moving average.

Measuring Extreme Optimism

As I quoted stated recently in “Bear-ly Extant:”

“It is a bad sign for the market when all the bears give up. If no-one is left to be converted, it usually means no-one is left to buy.” – Pater Tenebrarum

That quote got me thinking about the dearth of bearish views that are currently prevalent in the market. The chart below shows the monthly level of bearish outlooks according to the Investors Intelligence survey.

The extraordinarily low level of “bearish” outlooks combined with extreme levels of complacency within the financial markets has historically been a “poor cocktail” for future investment success.

Much like measuring overbought and overextended conditions – overly bullish optimism, or a “lack of fear” of a market correction, are historically seen at intermediate and longer term market peaks.

Optimism and pessimism can be measured through several types of indicators from volatility measures to investor actions and sentiment surveys. For simplicity purposes this week we will focus on a couple of the more common measures of investor “complacency” which show a complete “lack of fear” of a near-term market correction. These are the Put/Call Ratio and the American Association of Individual Investors, and Institutional Investors, Sentiment Surveys.

The first chart below is the 10-Week Moving Average of CBOE Total Put / Call ratio. It measures the level of “fear” or “greed” in the overall market. Put options are bought when investors are expecting to the market to decline. Conversely, when investors expect the market to rise they buy call options. Therefore, when investors are becoming excessively bullish the put/call ratio falls to its lows and vice versa.

Currently, the put/call ratio is at levels that have been normally associated with peaks in the market. What we find is that when the ratio falls below .9, as we are currently, that the sentiment is getting exceptionally bullish. Conversely, when the ratio rises above 1.0, bottoms are in the process of being made.

The market has advanced in spite of a turn-up in the put/call ratio. This suggests that the underlying story of the market is much weaker than the headline suggests.

With bullish sentiment and complacency at extreme levels, it only further supports the idea that the current risk of investing new capital in the markets outweighs the potential reward. It is very likely that sometime within the next couple of weeks to a couple of months that the markets will experience at least an intermediate term correction.

Could it turn into a more serious correction? Sure. However, we won’t know that until we get there. I hope this week’s letter helps clarify things.

For now, holding a little extra cash certainly won’t detract significantly from portfolio performance but will provide an opportunity to take advantage of panicked sellers later. It’s not a question of “if,” only of “when.”

Have a great week.