Sunday, October 11, 2009

Dear Speculators,

The following article was originally published at The Agile Trader (www.theagiletrader.com) on Monday, October 12, 2009. If you would like a free one-month trial to our twice-daily service, please click HERE and then click the red "subscribe" link at left.

Since at least 1962 the SPX has tended to move in a cyclical pattern of roughly 4 years in duration, with important cyclical lows arriving very close to once per cycle. This first chart shows the SPX, looking back to 1962, on a log scale, with vertical dashed lines showing up every 1,008 trading days, which is very close to once every 4 years.

The cyclical lows, corresponding to the blue dashed lines, were pronounced and obvious for about the first 20 years on this chart, until 1982. The lows were still significant but somewhat less obvious and a bit distorted at times in '86, '90, and '94. Then, in 1998 and 2002 those cyclical lows were again very pronounced and obvious. Finally, in 2006 the low arrived about 3 months early, in July rather than October, but the market did take off and rally for about a year, forming a double top in July-October '07. But, since that '07 top the market has collapsed, into the March '09 low, and then rebounded sharply, retracing almost half of the '07-'09 decline.

So, where do we stand now in terms of the 4-yr cycle?

In my view, the massive money-pumping operations that have been in place more or less since 9/11, and most impressively since the collapses of Bear and Lehman, have probably distorted the waves of the 4-yr cycle, if not permanently, then at least by throwing a giant "hiccough" into the equation.

Following the 4-yr cycle low in July '06 we would normally have expected the SPX to rally for an average of about 26 months (just a bit over 2 years) before flattening, topping out, and then forming another cyclical low about 4 years after the prior low (in this case around July-October 2010). But the top came a full year early, in mid-'07. And in the context of the roughly 50% decline on the SPX from October '07 into March '09, my working assumption is that a new, seasonally off-kilter 4-yr cycle bottom (in March rather in than in the July-October period) was formed around the March '09 SPX low.

Our next chart shows the median (blue line) and average performance (purple line) of the SPX following its 4-yr cycle lows, using our look-back period to 1962. The median and average performance lines are accompanied by the 1-standard deviation (1SD) envelope (-1SD and +1SD, grey lines).

There are several interesting features on this chart:

• The steepest part of the average and median cyclical rally (A) lasts about 150 trading days, averaging about a 25% advance over approximately 7 months.
• The 2nd phase (B), tends to be a stair-step affair, advancing to about the +44% area (adding a 19% gain relative to the cyclical low) over the ensuing 1 ½ years (until the yellow highlight on the chart). At that point, the 1SD envelope has narrowed considerably, indicating that there tends to be a relatively small variation from the average performance, with about 68% of all cases falling within 10% of that average. So, a "normal" cyclical rally involves a gain of between 34% and 54% in a period of just over 2 years.
• Subsequent to the end of phase B, average performance flattens out, with the 1SD envelope now beginning to widen. The variation in performance following this 26-month mark now begins to increase during phase C. The probabilities now increase that there will be a cyclical bear market.
• Following phase C, in phase D, there is a brief period when the 1SD envelope expands sharply. During this phase (D), the odds of a very sharp market decline (a climactic bear move) are the highest).

OK, having studied the average and median performances, with their 1SD (normal) envelopes, let's zoom in to look at just the first 2 years and include the current SPX performance off its March 9 low.

The March-October '09 rally of +58% is outside the 1SD envelope by about 18 percentage points, and is, in fact, outside what would be the 2SD envelope, meaning that, statistically speaking, it should happen less than 1 in 20 times (in this case, in less than 1 in 20 4-yr cycle lows, or less than once every 80 years. -- Gee, that sounds about right when conceived in the context of the Great Depression, which is often thought of as having been inaugurated with the Crash of '29, 80 years ago this month).

Now, to get a more specific sense of the flavor of these cyclical bull markets, let's take a look at a chart that examines the first 2 years of each cycle, as the market has rallied off its cyclical lows.

This chart is a bit noisy, but we can see some more interesting features.

Only one rally off a cyclical low in the past 47 years has even come close to the magnitude of the current one: that was in 1974, following Nixon's resignation. That rally lasted about 193 trading days (just over 9 months) and took the index up about 53% from its low. (That's 5 percentage points less than the gains made during the current rally.)

Assuming that our working model for the market's 4-year cycle is correct, and that a new cyclical bull was launched in March '09, the first phase (phase A) of that rally is likely to either be complete or very close to it. And we would appear to be ripe to be entering phase B of the rally, a choppier, shallower uptrend that may last 16-18 more months, or until roughly the spring of 2011.

But let us add this caveat: the SPX's March - October rally has carried the index up as far off the March low as the market rises on average over the first 3 years of a 4-year cycle. So, it is possible that the upside targets for the entire cyclical bull market have been achieved. More likely, the extremity of the cyclical bear market (from October '07 to March '09) has set the market up for this 7-month rally of unprecedented size, and there is still some more upside to be found over the next 16-24 months. But, we should keep our eyes open to the possibility that the size and steep slope of the current rally may have created a condition of market exhaustion.

When determining whether a market is exhausted or not it's important to gauge sentiment. One new-ish sentiment gauge that I've just recently run across is the National Association of Active Investment Managers (NAAIM) Survey (brought to my attention via Jason Goepfert's work at Sentimentrader.com). The NAAIM asks active investment managers whether they are bullish or bearish on the market. They can answer by saying they are anywhere from 200% short the market (leveraged) to 200% long the market, and their scores are averaged. In the history of this survey, the average answer has ranged from a high of 96 in January '07 down to a low of -3 in October '08. When this indicator is at a high level, bullishness is pervasive (and may be overdone). When this indicator is at a low level, bullishness is scarce, and the market may be near a low.

But here's the really interesting part of this survey. They measure the standard deviation of the series of answers. When the answers are bunched in a relatively narrow range, the standard deviation is tight, and confidence is high. When the answers are spread out and there is little unanimity among respondents, standard deviation is wide and confidence is low.

We measure the level of confidence (red line in the bottom pane) by subtracting the standard deviation from 100. When the Confidence indicator is high, confidence is high. And when the Confidence indicator is low, confidence is low.

So, what's the situation right now? We have Bullish Sentiment (green line in middle pane) just beginning to descend from a very high level. And we have Confidence at an extremely low level (a very wide divergence of opinions). The only other time in the past 3 years that we've seen a configuration like this one was on May 8, 2008 (yellow highlight in the middle of the chart), when the SPX was forming a very important local top.

Granted, we only have a little bit more than 3 years' data on this series, but it fits hand-in-glove with our studies of both the CBOE Equity Put/Call Ratio moving averages (5-dma and 21-dma), which we examine frequently in our daily work. On this chart we can see that when these contrarian indicators are at low levels (as they are now) the market tends to top out, and when they're at high levels the market tends to bottom. The yellow highlights on this chart show up on the same dates as they appear on the chart above.

We've also included blue highlights on this chart to show where troughs in the Equity PC 21-dma have correlated to short-to-mid-term tops on the SPX.

As we head into the teeth of earnings season for the stock market, it's clear that we stand at an important crossroads. In terms of the duration of the rally off the March lows, we have hit the 7-month mark, or 150 trading days. Statistically this is a point at which rallies from important cyclical lows tend to flatten their slopes and head into choppier periods. Moreover, sentiment, as measured on our CBOE Equity Put/Call Ratio moving averages, on the NAAIM Survey, and on the VIX (which we examine daily in the Morning Call, and is now testing its cyclical low near 23) has become quite complacent (bearish).

On an anecdotal basis, I was listening to Bloomberg Radio in my car today and heard a couple of pundits talking about how sentiment going into earnings season is excessively negative. None of these disembodied talking heads mentioned a methodology of measuring their claims. But with the consensus for forward 52-wk EPS up just 13% off its lows for the year...

and with the SPX up 58% off its lows...

...with a Price/Earnings Ratio of 26.6 on trailing operating earnings (above the 95th percentile of all historic readings), with a P/E Ratio of 15.4 on forward earnings (above the average of 14.8 over the past 7 years), and with a P/E Ratio on trailing reported earnings of a whopping 120...

...and with an the consensus of analysts' estimates for the forward operating EPS growth rate of almost 73% following the worst earnings debacle since the Great Depression...

...it strikes me as far-fetched to describe market sentiment as negative.

Is it possible that the economy will snap back in response to a mother lode of stimulus and recently (electronically) printed cash sitting on the sidelines, as though nothing of significance ever really happened during the Faux Armageddon of '08? It's possible. But, with the employment picture continuing to worsen (the Employment/Population Ratio continues plummeting despite what jiggered stats like monthly jobless claims and the unemployment rate may say), with median income still declining (and consumer spending comprises about 70% of the domestic economy), with the consumer's balance sheet only minimally if at all repaired, with money-supply growth at about 0% over the past quarter (we'll look at that chart again next week), and with banks continuing to decelerate or contract their lending operations (a subject we'll discuss at more length in the weeks ahead), I remain hard pressed to discern from whence the economy's and the market's V-shaped recovery is supposed to derive.

It's possible that a surge of electronically manufactured liquidity may make its usual seasonal/holiday pilgrimage into the stock market as we head toward year-end. We'll certainly be alert for that possibility. But from everything I can see about market sentiment and expectations, there's already an awful lot of optimism that's been expressed since March, and the market remains overdue to rebuild a higher wall of worry than the one that it is now trying to climb.

Note: The subject of the dollar-adjusted SPX price, its implications for inflation, and where we stand with regard to the inflation/deflation polarity will have to be postponed until a future edition of this missive. We ran out of room for this week.

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Best regards and good trading!