Below is an excerpt from a commentary that originally appeared at Treasure Chests for the benefit of subscribers on Monday, October 30th, 2006.
For the record, at the time of writing this analysis we went to neutral from being bullish on future prospects for the stock market, which also happens to be our current position short-term. Longer-term we are bearish on the broad market and endeavoring to identify a high confidence intermediate-term shorting opportunity for the benefit of our subscribers. Below is just a small example of the monitoring of key factors in this regard, where process continues to unravel before our very eyes. Please notice the comments below are a month old now, but still capture the essence of the day, as our goal is to remain ahead of the curve.
Why are we not as confident about continued bullish future prospects for the stock market? In a nutshell, and something that will not be surprising to those who have grown to understand these things, the reason we have become more neutral about the stock market's future is because participants are becoming less bearish as measured by the fact open interest put / call ratios did not follow prices higher last week. This of course means that new fuel to squeeze prices higher is harder to find. What's more, if this condition does not change soon, or worse, ratios turn lower because bearish speculators are finally exhausted, then once the shorts are all squeezed out, stocks will fall precipitously barring intervening factors failing to resurface in response to such a development. (i.e. market participants begin shorting stocks again in response to weakness, or bad news, like a new and bigger war in the Middle East.)
It's important to understand the above described condition set is not etched in stone yet however, because the crazed 25-year old hedge fund managers those responsible people on Wall Street let lose on us every year may still not be finished for the season (October to May) just yet, but as you can see in the attached, if they decide not to leverage up their portfolios further, meaning they will not need to buy more protective puts to go against these leveraged positions, more recently (since 2002) this has marked a top in stocks. Again however, it's a bit early to come to any conclusions in this regard, but as you can see in the attached directly above, open interest put / call ratios are falling against rising prices, meaning hedge funds are no longer chasing prices higher in concert with bearish speculators shorting stocks, both now displaying signs of exhaustion. And as mentioned, this is always a deadly combination from a historical / market mechanics perspective, so we must be on guard, especially with technical conditions for stock so stretched.
Are technical conditions stretched for stocks? Answer: Without question, even from a risk-adjusted perspective when measured against the CBOE Volatility Index (VIX), which in its own right is sporting a very bullish looking triangle that appears destined to break higher any day now. It's interesting to note however that when put against stocks, as measured by the S&P 500 (SPX) on a daily plot (see below), although indictors are now running negatively divergent to price, at the same time they could easily run higher if enough buying were to appear. In this respect a confluence of technical evidence on the weekly SPX plot does suggest prices should continue to blow off into November before key indicator resistance is encountered. Moreover, we must concur with Dave's objective published yesterday (reserved for subscribers) as a likely topping target at this point all things be known. (See Figure 1)
Within this context the question then arises, just how important is this turn? Is this that Grand Super-cycle Degree top in stocks you have heard me yapping about for some time now? Well, one thing is for sure, if it's not, gold will be going much higher given technicals are suggestive the Dow / Gold Ratio appears set to move lower. Aside from that however, and focusing specifically on stocks as measured by the SPX, whenever the turn lower does arrive in coming days, weeks, or months, when put against the VIX as the ultimate definer in terms of participation limits (i.e. those willing to throw caution to the wind), a very good argument can indeed be made this top is the real McCoy alright. Take a look for yourself, where as you can see below while the top in 2000 was a nominal price peak, the 'real' blow-off is just occurring now, and we are ever so close to a crescendo if history is a good guide. (See Figure 2)
Of course Dave could be right, where through the addition of energy and precious metals stocks to the broad indexes they go on to see new highs down the road, but this is all conjecture. The fact of the matter is we don't know how these stocks will perform into the future if inflation mechanisms falter. What's more, the fact price managers are already using extreme measures to extend the current cycle, like margin requirement reductions, is suggestive we are very close to exhausting available measures, characteristic of 'end game dynamics'. And although we may not be there yet, where analog / historical comparisons of past manias suggest we should indeed expect further strength in stocks into next year, if not into early 2009 in consideration of other trading day comparisons (see below), this should not be considered a long time by any standard.
Further to this, and in an attempt to put a comprehensive picture for you together, it should be noted that Figures 4, 5, and 6 (in attached analog charts above) are suggestive comparisons of the current bubble in US stocks are best made against domestic historical examples, as demonstrated in the SPX's departure from the Nikki's nominal price echo bubble witnessed in the early 90's (see Figure 6). Moreover in this regard, we find it no coincidence Figures 1 through 3 are telling us after a correction sometime in the near future, prices should run up once again to put a final top in early 2007, again, as mentioned above. We find this very interesting because such a pattern falls within an acceptable variance from the two previous Super-cycle Degree monthly counts on the Dow (see Figure 2) as well, considerably enhancing the validity of theses observations. (i.e. such a top would be seen 6-months prior to the first Super-cycle top of the Grand sequence seen in 1929.)
What could keep stocks in a manic state next year, and quite possibly beyond? As mentioned previously, the Feds still have both fiscal and monetary policy initiatives that can and will likely be employed as the Presidential Election in 2008 approaches, initiatives that will be throttled if the economy remain on the skids. Additionally, interest rates can be cut, margin rates can be reduced further, and speculators can start increasing short bets on the market again, all of which would work to potentially lift stocks one last time.
As you can see in the totality of messages found in the above however, we are very close to a point where stocks will begin what could potentially be a very big slide, so caution is warranted. Remember, debt is your enemy and should be avoided at all costs. Collapsing stock markets will likely spread to other asset prices, at least temporarily, and even into precious metals markets, especially affecting the shares under such circumstances. This is why your portfolios must be constructed with a great deal of care in mind, where unwarranted risks should be avoided. Therein, one should not play with savings you cannot afford to lose. We will have more to say on this subject at a later date.
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Good investing all.