Volatility and Price Action

On March 13th, I made a call that I thought it was time for the markets to begin consolidating. Now some may label that call incorrect as the markets have moved a couple of percent higher, even surpassing 2,100 at one point, but I stand by the call. I think late-comers to the rally pushed the S&P 500 that 2% higher.

Specifically, I guessed we’d “see about 7 weeks of sideways consolidation.” Well in order to get a sideways move, the market will need to see a little correction soon. I suspect we’ll get one starting this week. It wouldn’t surprise me to see a move downward of about 5% in the S&P 500 to the 2,000 – 1,975 area over the course of this week and possibly the next. That stem created last week on a weekly chart is the tell.

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But here’s the thing. I think market participants will completely overreact to the 5% or any move downward. I think the bears will start beating on their keyboards and cranking out articles and blog posts saying things like, “See! I told you! Here comes the real start of a 50% correction!” Pay these cranks no mind.

Instead, utilize the negative sentiment to leverage a potential move in volatility. I could see the VIX spiking to 20 in an over-reaction by hedgers. Those same late-comers to the rally in February will overdue it with VIX options potentially causing a spike.

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So how do you leverage the potential? As usual, if you’re a futures player then just structure your option strategy to take advantage of the fear. For the ETF traders and retail guy trying to swing trade some profits off his work salary, there’s the ProShares Ultra VIX ETF, UVXY. Now this ETF is a trading tool only and it’s not for the faint of heart. If you’re going to trade it then you have to be nimble and ready to take profits. The moves are sudden and quick, but profits can be spectacular if you accurately time an upward thrust.

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You can see in the last two moves of late summer last year and the start of this year, that perfectly timed trades have huge potential. In a 3 week run last August, UVXY moved up almost 300%. From late December to February, it moved up 150% in just 6 weeks. Again, not for the undisciplined. If this puppy isn’t played right, it’s easy to get shell-shocked and lose any profit potential.

Are these calls bold? Maybe, in that I don’t have any quantitative analysis to back my assessment. It’s just the gut feel I’m getting from price action and general sentiment. It can be dangerous to trust someone else’s instincts, let alone your own. A trade like this requires precision and a hawk-like watch over the action. Trading volatility can very often turn into a sucker’s bet. Let price action as opposed to greed guide your moves.

Time For an Energy Release

The S&P 500 is up 8% on the un-abating bounce off the lows in the 2nd week of February. Were you able to participate or were you too scared?

Regular readers will recall that I suspected we could see action like what has occurred in my previous post. That’s 2 for 2 in my last two major market calls. Don’t get used to that sort of accuracy. Right now I’m in a zone. Regular speculators understand that zone. Sometimes you get in it and you take on risk, fitting moves together as if breezing through a Rubik’s Cube. These times are fleeting though as the HFT shops will be sure to remove any edge you perceive yourself as having and cold water will be splashed on my zone. Make hay while the sun shines.

I suspect the current bounce has utilized most of its positive energy and the market will need to take a little break. It doesn’t necessarily need to correct but just work off some of the speculative energy that has driven its 8% gain over the last month. If I had to guess, I think we see about 7 weeks of sideways consolidation and then a catalyst at the end of May or beginning of June will present itself to drive the S&P 500 back up to the old highs.

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Don’t discount the positive effects of the ECB’s expansion of it’s QE process. The TLRTOs have been released for potential use in investment grade assets plus they’re able to plug another €250 billion annually in the EU on top of current output. The media creates narratives with potential false attributions so be careful how you position your capital. Don’t be a sucker and necessarily fall for all the misleading accounts of spurious correlations like oil and short covering which were the du-jour narratives last week.

In stale and tired fashion, I want to reiterate that I believe we are currently in a topping process which began last October. That doesn’t mean that we can’t see new highs on the S&P 500, so for longer term capital it still would probably behoove you to significantly liquidate in preparation. But if you fashion yourself a trader, there’s potentially still money to be made opening new long positions.

Lastly, gold related equities have just been playing in another universe in relation to any other sector since the start of 2016. One of the stocks from the J-perp Watchlist is up 600% over the last 9 months. Have a read of the original post and the portfolio update page for more info.

Update 3/29/2016:

Ignore that 600% nonsense from the previous paragraph. PLG had a reverse split that I somehow missed. The position is actually showing a loss and I have corrected the tracker to account for the reverse. PLG is on the watchlist, however, the actual J-perp portfolio has had a great run to start the year so go have a read anyways.

Should the Investing Public Be Worried if Some of the Biggest Banks are Genuinely Scared?

Questions of investing and speculating always require context within time-frame. Players in all asset classes, professional or not, approach the game from their own perspective.

Traders surfing the waves of volatility may be looking only days or weeks out. Investment managers overseeing a growth-oriented portfolio may be looking ahead months or quarters while a value-oriented portfolio manager may be looking years out. The 401k-watching worker bee may be wringing their hands at every market move and every ignorant headline despite the fact that they have 30 more income-earning years left before retirement.

The game is tougher than ever even for the professionals and it’s difficult to decide a course of action with the information overload coming at market players. Determining what’s noise and what is actually valuable information is critical in making the right moves within your portfolio.

I have long been pounding the table on building cash reserves while staying invested in the markets. I’ve also stated that I thought the downturn of late 2015 was the start of the next major bear market. I think that dip and recovery in 2015 was the bear waking up and the poor start in 2016 is investor realization of that bear. However, because everybody now sees it, the markets aren’t going to execute a full-frontal stage-dive. That’s not how these things work, right?

I think we get a recovery into new highs followed by another much smaller correction and consolidation potentially followed by another new high. After that, I suspect all the bull energy will be fully used up and the bear will begin in earnest. Remember, these are simply my suspicions based on behavioral observation of the markets; nothing more than forecasts of potential outcomes.

It’s been a long time since I’ve hit readers with some good old chartporn, but I’m in the mood to throw a bunch of squiggly pics out there to possibly help the reader better assess the market situation in 2016. Observe a 20-year, monthly chart of the S&P 500 along with some relevant indicators.

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Observe the long-term breakdowns in the indicators matching the actions of 2008 and 2000. Does that mean crisis is imminent? Nope, but I do think it reinforces my call that a new bear has started. Notice also in 2001 and 2008, we saw strong support and a bounce off of the 50-month moving average. Too many technicians are looking for that and thus too many algorithmic shops will be front running ahead of that signal, blowing out orders to drive the market higher.

I suspect this bounce we are currently in the midst of may be a bit stronger than people realize. Market players have been so used to the V-recoveries and yet they’ve already forgotten what they can be like. It appears that players are numb to the potential of a multi-week to multi-month V-bounce from the January 2016 lows. Despite what I surmise about a stronger than expected bounce, nobody can blame investors for either running for the hills or shoving their heads into the sand.

We’ve already seen the peak in net profit margins for this business cycle in the largest US corporates at the same time that markets continue to be overvalued, despite the corrective moves in December and January. Observe the following chart courtesy of ZH via Thomsen Reuters via Barclays. It depicts how the recession fuse has likely been lit.

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And with recession generally comes a bear market correction. Or is it the other way around?

Regarding overvaluation, have a look at this comparison chart from AQR depicting market returns based on various starting points of the Shiller P/E. AQR is the shop that Cliff Assnes, billionaire hedge fund manager, founded and runs.

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This coincides with GMO valuation models for future returns based on current valuations. There are plenty of Shiller P/E naysayers who believe that the indicator is bunk. The fact of the matter is that evaluating a normalized 10-year look at P/E ratios is a simple and intelligent way of quickly gauging valuation levels compared to prior periods. Of course every period in history possesses its own specific circumstances as the backstory of the valuation levels, but the raw Shiller P/E paints a clear picture for equity performance going forward.

Besides I don’t see or hear anybody calling Bob Shiller a dumb man. Despite what you may think of his ratio, Shiller is a respected academic even within the professional financial community.

Let’s take a look at a chart from one of every perma-bull’s favorite bear-shaped piñata, Dr. John Hussman. Unfortunately, Hussman catches a lot of flak. Less so after admitting to his analytical mistakes coming out of 2011 but I think he catches a bad rap for simply calling it how he sees it. Hussman’s analysis is based on a quantitative and thorough study of the markets. Can the same be said of a vast majority of the financial blogosphere? No it cannot, including myself. Observe the Hussman Hindenburgs. They nailed the current action coming into Q4 of 2015.

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The criterion of the Hussman Hindenburg is detailed in the upper left corner of the chart. Dr. Hussman’s Hindenburg indicators proved to be quite prophetic in 1999 while essentially nailing the top in 2007. For your own long-term holdings, ignore these signals at your own risk. Dr. Hussman, like Dr. Shiller, is respected amongst fellow financial professionals. Have a look at Research Affiliates’ (“RA”) own analysis on current valuation levels.

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In a research piece they published in July of 2015, RA evaluates the differences in relative valuation metrics (CAPE, Hussman, Tobin) and absolute valuation metrics. They came to the following conclusion.

Our answer to the question “Are stocks overvalued?” in the U.S. market is a resounding “Yes!” Our forecast for core U.S. equities is a 0.8% annualized real return over the next decade. The 10-year expected real return for emerging markets equity, however, is much higher at 5.9% a year. The return potential of the nondeveloped markets is so high, in fact, that the valuation models, warts and all, paint a very clear picture.

May want to rethink that lack of EM exposure going forward, depending on your time-frame.

Shall we move on to a couple of less orthodox indicators of potential trouble in the markets? Observe the two following charts which pertain to income as opposed to valuation or price action. In the first one, created by McClellan, we get an interesting correlation to total tax receipts for the US government as compared to US GDP.

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Notice that in 2000, the US crossed the 18% threshold and stayed there awhile before rising even higher at the beginning of the market selloff. For the GFC of 2007, America almost got to 18% but not quite and we still literally almost vaporized the entire financial system. Currently, we’ve reached 18% but that may or may not mean anything. In each previous occurrence, tax receipts stayed at the level for months or even years so this is an indicator worth watching but only in conjunction with many others.

Interestingly, federal tax receipts as a percentage of GDP currently reached 18% right before the markets began selling off last year. Repeat after me. Correlation is not causation, but the timing is still interesting.

The other chart that doesn’t get a lot of coverage but is very well known is net worth of US households and non-profit organizations as a percentage of disposable personal income. You can find it courtesy of our friendly Federal Reserve Bank of St. Louis and their FRED tool. The grey vertical bars in the FRED charts denote recessions.

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It’s been a clear indicator in 5 of the last 6 recessions and we also had that annoying fakeout in 1987. Much like the prior graph, this particular chart should be coincident with additional economic indicators if one is attempting to forecast potential economic as well as investment outcomes.

I want to move on to a particular area that everyone should be concerned about and that is nonperforming loans (“NPL”) at major banks. Not just at US banks but around the world. China’s commercial banks have raised fear levels in even the most seasoned professional investors due to their NPL levels increasing so drastically in 2015. I’ve long stated how debt levels in Italy have the potential to dismantle a good portion of the financial system because the Mediterranean Boot is such a key economic cog in the European Union. Some of the biggest commercial banks in Italy are on the verge of toppling during a period where now the ECB is less amenable to the previously used “bad bank” options. The pressure is beginning to mount for Italy’s leadership to formulate a strategy around potential bank failures.

You might be inclined to observe the following chart and think all is at least well for the US.

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But take a look at the following chart in commercial-only loan performance and begin to understand why the total situation looks toppy from the economy to the markets.

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For the record, commercial loans comprise approximately $2 trillion of the outstanding debt within the banking system. It is clear to see that a bottoming and an upturn occurred before the last 3 recessions and market dislocations. Now we are currently in the early innings of an upturn in NPL. If commercial loan performance behaviorally adheres to what we saw in the prior two recessions, we will see at least an additional 2% of total commercial loans become impaired assets. That’s potentially between an additional $40 billion to $50 billion at minimum that banks will have to provision for. No easy task in light of current leverage levels and collateral utilization across the repo and derivative space.

This is especially concerning because of the systemic importance of each bank to the entire financial system. Just look at the consolidation that has occurred since 1990.

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Couple this concentration with a lack of regulation allowed by Gramm-Leach-Bliley and you can see that debt impairment at the banks is not going to have a happy ending. And if you think Dodd-Frank was the answer to all of our problems, I might stop laughing sometime in March.

What would work to alleviate a lot of the financial pressures around the world in the short term is a weaker dollar. I don’t say that as a proponent of a weaker dollar. Rather, I am stating that currency exchange due to a weaker USD could help sugarcoat revenue reporting across international corporates. It would relieve pressure in the management of reserves for countries with an excess of US treasuries. The oil price could stabilize temporarily but it is well-documented that abundant supply and less-than-expected demand is still the story. Commodities could lift and thus commodity producing countries who are already fighting with their reserves issue could see a double-positive impact. All these effects would be temporary as world debt levels are at unsustainable levels and a bear market for all assets has potentially already arrived. It just has yet to completely sink its claws and fangs entirely into the world’s financial system.

Coming back to the initial question behind this post. Should the investing public be scared? Maybe not scared. Let’s call it aware. They should be aware of all the happenings that are occurring right now. Cash levels should be raised. Certain assets should be paired down depending on losses, gains, and risk exposure. More importantly it’s time to take stock in your own investing psyche. If you are building cash levels, will you have the courage to act at the appropriate time? That’s what raising cash boils down to. Do you have an understanding of the intrinsic valuation levels of specific asset classes that will motivate you to put cash to work?

Aside from brushing up on your ability to properly assess valuations, take a look inside yourself and evaluate your ability to deploy cash when fear is running rampant and the nadir of multiple markets appears to be nowhere in sight.

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Here’s What’s Going to Happen

The S&P 500 is going to test one more time around the recent lows. Then it’s going to climb a wall of worry and easily establish new highs in 2016. How do I know? Because markets don’t enter catastrophic downturns when every investor is expecting it. That’s how you get a correction and then a resumption of an uptrend. There is plenty of technical damage to work off, but look at the facts.

The zero bound continues. Cheap money still exists and that money is going to get spread around in one last gasp to extract economic rents from as many greater fools as possible. The world is drowning in debt but that won’t matter until the last breath is drawn and the final game of musical chairs is played.

Regarding the current situation, 2010 and 2011 illustrated perfectly how the large money will sucker investors twice before supporting the next leg up of this market. Technicians call them inverted heads & shoulders. I call them inverted STFU. Observe.

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Watch for the same set-up before allocating any hard-earned capital. The reason this scenario works and will again is because of good old fashioned herd mentality. Markets correct. The experienced players advise to stay out and expect a rebound with a retest of lows before jumping back in. The low gets retested and everyone rejoices by betting on red and black, then the rug gets pulled out one more time. The strength of the current bounce is prognosticating another dip before the markets put the climbing gear back on.

Bet accordingly.

Triple Top Into the Chop & Drop

I hate to keep writing about corrections and being a fear mongerer. At this point, it’s pretty useless as the S&P 500 stays constantly bid under all conditions. The last little correction lasted a week exactly and took the SPX down approximately 4%. Before that was the approximate 6% correction we saw from January 23rd to February 3rd. That was 11 days and a casual observer of the market would have thought the rails had come off of everything the way sentiment crashed so quickly.

Honestly, I’m getting tired of hearing myself with the correction talk, so this will be my last post regarding correction or downturn talk for a little bit. I’ll find something else to entertain and possibly inform you with, because this subject is tired. Especially, when you consider the following charts. I originally titled this post as I meant to write it several days back, when the SPX looked like this:

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However, we seem to have experienced a “clear” breakout so we’re not technically talking about a triple-top anymore…unless it’s a bull trap. Is it a bull-trap? Hindsight will inform us. In my humble and probably very ignorant opinion, I think it’s a bull-trap. There’s just enough buying power left to draw in some last suckers before corrective action. It’s not unheard of for a third top in a triple top to be higher than the first two. The tape shouldn’t be ignored but neither should the myriad of signals running counter to the tape.

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Of course, I could be wrong. I’ve been early to the short party before, and I took a couple lumps to my account and ego for being a wannabe, turn-calling notshot. I maintained tight stops so the damage was minimal, but top calling is a suckers bet that continues to be fun to make.

Complacency is the topic du jour around the financial blogosphere and professional commentaries. The VIX pushed under 12, as denoted by the blue line in the following chart. Recently, hitting or going sub-12 tends to be a precursor to a spike in volatility but it is far from indicating a definite, imminent move.

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Many commentators and “experts” have been turning to more esoteric signals to ensure that the S&P 500’s new highs are a “legitimate” breakout in a positive trend. For the record, I happen to really enjoy and appreciate the consistently insightful commentary put out by the three sources I’m about to list. All the same, have a look at these 3 articles:

1. Chris Puplava – http://www.financialsense.com/contributors/chris-puplava/further-signs-market-bottom-building
2. Bespoke – http://www.bespokeinvest.com/thinkbig/2014/5/30/long-term-vix-chart.html (no mention of unprecedented easing the last 6 years)
3. Tom McClellan – http://www.mcoscillator.com/learning_center/weekly_chart/equity_options_vs._index_options/

Maybe it’s my lack of statistical sophistication or inexperience in professional money management, but these 3 articles seem to be really stretching for evidence that a significant correction is not going to occur this summer and the breakout in the S&P 500 is 100% the real deal. I like to keep things simple, by observing the obvious signals. Market leaders at the time(biotech and small caps) broke down several months ago. Now they’re retracing to perfectly natural Fib. areas before potentially continuing downward which I think will have the effect of finally pulling the S&P 500 with them. Volume is anemic. The VIX is saying, “Wait a second here.” Is it because it’s the start of summer? All sorts of economic indicators have given a red light or at least a yellow light, despite all the cheer leaders. High yield fixed income keeps getting bid higher and higher with no downturn in sight.

So many signals are readily apparent but we still need a trigger. In my last post, I thought that the high yield bond market may be the catalyst for a downturn in the S&P 500, but maybe it just finally gets pulled down with the risk indexes without junk correcting. What will the trigger be? Who knows? It could be anything. Maybe we get some sort of sell-off in another asset class causing a fixed income dash to cash, with the best returns being locked in from their high yield segments. Geopolitical activity may induce fears, although nobody in the markets seems to give a damn about the chess moves conducted by Russia or China. The markets continue to confound even the savviest.

“YEAH, YEAH, YEAH! We’ve heard all this non-sense in your last post! How does this apply to AND what the hell is a “chop & drop?”

Well “chop & drop” is a pattern that is seen typically before major dislocations. John Hussman, Ph. D, who is consistently labeled as a perma-bear and broken clock, generates very good and widely read commentary that does skew to a negative outlook. He just calls it how he sees it based on his extensive research. Everybody’s got an opinion. It’s just a matter of whether you value it or not. I happen to value his commentary, but I don’t base my decisions on how I speculate by any one market commentator. It’s all about taking in as much as possible from as many credible sources as possible to assist one in firming up their own mental picture of the state of things.

Anyways, he put out a piece recently titled, The Journeys of Sisyphus. Have a read if you’re in the mood for some confirming of your bias to your own negative outlook. In the piece he produces several Dow Industrial Jones charts leading up to the major downturns of the last 85 years. For the record, he did not comment on any chopping and dropping in the post. I only reference his work because of the charts. My commentary is in no way affiliated with Dr. Hussman, nor has he endorsed this post in any shape or form.

The first chart obviously displays 1929. In it you can observe the pattern of a notable correction with a recovery into some sideways chop followed by another notable correction leading into a final, euphoric run-up. This pattern of “chop & drop” almost always occurs in the final two years.

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Before presenting the rest of the charts, I am fully aware of the human brain’s abilities in the area of pattern recognition. It’s one of the distinguishing factors of our intelligence as a species, and is a key differentiator from the unevolved brains of other species as well as machines…for now. These set-ups could just as easily be illusory conjunctions of patterns established by a biased mind attempting to create the ability to foresee market outcomes. In other words, I could just be full of it. Believe me, I get that. I’m still going to present the rest of the charts and you the reader can establish your own outlook.

Here in 1972, we have the “chop & drop” but with a pseudo final run-up to sort of fakeout speculators. Compare this to 1929 where the chop went right into the final drop.

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The action in 1987 lacked an initial heavy drop and recovery into the chop. Instead prices consolidated(or chopped) until that first drop before the extremely euphoric run-up prior to Black Monday.

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Finally, we’ve reached a time where a majority of readers may have actually had some money in play. The bust that started it all for a lot of us, the Dot.Com bust.

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In 2007, the action was tight with the chopping and dropping occurring in less than a year. The outcome was still the same, a mega bust. In fact, if you think about the action of the dislocation it was kind of tight, too. All the action was essentially squeezed into 2008. Yes it began in November of 2007 and bottomed in March of 2009, but the real gut wrenching, heart breaking action occurred in 2008.

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And finally we come to the present, 2014. Now remember this whole exercise is pure speculation, but what I think we saw in that 6% correction in February was the first drop. We already recovered and have chopped along since then. At some point in the summer we could then move into a more serious drop of at least 10%. I suspect this may signify the last major drop before recovering into the final euphoric run-up which could last into 2016 before a major dislocation.

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Of course I run the risk of being wickedly wrong. But as I provide these posts free of charge and I do not manage money professionally, I’m ok with sticking my neck out and assessing the cycles of fear and greed as such. There’s no career risk. As for reputation risk, I’ll wait till my small following of readers can no longer be labeled small before I worry about my street cred.

Just for kicks, here’s some statistics and notes regarding the Triple Top pattern from forex-tribe.com. It’s a good site to use for a little education into basic technical analysis patterns. However, they do not list where they obtained their data and how it was quantified. I was reluctant to even share it, but it’s just for kicks. If you’re relying on old school patterns without quantifying risk and reward ahead of time, well then shame on you.

Alleged triple top statistics:
– In 85% of cases, there is a downward exit
– In 50% of cases, the target of the pattern is reached once the neckline broken
– In 84% of cases, a pullback occur
– In 85% of cases, there is a pursuit of the movement once the neckline broken

May closed out at a one-year high for the S&P 500. This is a very, very infrequent event; which is why the cliché “Sell in May and go away” even exists. Don’t be surprised if May selling just gets pushed back to June and July. Do not take your eye off the ball for any reason out there if you’re aggressively trading. For you long money players, take some time to consider the charts we reviewed today.

Don’t discount that sovereign debts are at all-time highs across all the developed nations. Don’t discount that every major economy is monetizing debts or manipulating currencies via swaps or taking some other related action to sway economic activities. Don’t discount that credit derivatives exist in the hundreds of trillions with multiple collateral lines traced to multiple counter parties amongst the holders of said derivatives. Don’t discount negative GDP reads in developed nations. Don’t discount anything. Nothing is what it seems in the markets anymore and it could pay big to be prepared well in advance of what historical price action has already told us.

I’m signing off but before I go, the biggest laugher of the week has to be that Italy and Great Britain are including prostitution and illegal drug sales in their respective GDP calculations. Seriously, you just can’t make this crap up anymore. Good day.