More Downside to Come?
(March 24, 2005)
Dear Subscribers and Readers,
Please continue to post your thoughts or vote in our poll on whether you believe that investors (retail and institutional alike) are taking too much risk. Are the record low credit spreads between investment grade and high yield bonds and emerging market debt indicative of a general lack of respect for risk? Currently, there are three "yes," and zero "no." Going forward, we will create a new section in or discussion forum that will be dedicated to polls only. All our polls will be conducted in that section from now on and readers will be welcomed to create their own polls in that section as well.
In a way, this is a continuance from last Thursday's commentary - a commentary about the potential/beginning deterioration of credit quality not just in the U.S. but around the world as well. In that commentary, I discussed the general lack of respect for risk - as evident by the record low credit spreads and also the continued strong inflows into international equities. I have no doubt that a significant number of hedge funds and retail investors are now on the long side (in a big way) in the high yield and the emerging markets (and some have been buying debt in the local currency as well). I also discussed my beliefs that the underlying theme this year will be a surprise in the emerging/international markets - probably a crash of a major emerging market economy accompanied by a rising dollar and a "flight to quality." The first sign of a potential reversal occurred approximately six week ago when the relative strength of the Bank Index vs. the S&P 500 broke through the support line which dates back to March 2003. I have discussed this before - that the performance of the Bank Index has historically been a good leading indicator of the general market. Following is a weekly chart (updated to yesterday) of the relative strength of the Bank Index vs. the S&P 500 from February 1993 to the present:
As I mentioned in the above chart, the relative strength of the Bank Index broke though the support line (from very high levels - which just makes it the more authoritative) and has stayed down since. In fact, it managed to break to a new low yesterday afternoon at the close.
The higher-than-expected CPI (core and non-core) report yesterday morning makes me further convinced that we are heading towards that path - as the Federal Reserve now has no reason to not raise rates unless there is a major collapse somewhere - either the collapse of a major domestic cooperation or a collapse of an emerging market economy. Like I have mentioned before, the Central Banks around the world are now cutting back on credit - and the "marginal" users of credit will be the first to go. I have also been discussing that this "marginal user" may very well be China, as China has also been embarking on a continuing binge of overinvestment and a continued increasing reliance on foreign energy sources. Note that I have been discussing this overinvestment and overcapacity issue in China for awhile - even though it hasn't so far manifested itself any way in the foreign press. That all changed, however, with last Friday's press release from the Brilliance China Automotive Holdings - with the Board actually warning investors that the demand of automobiles in China has significantly slowed down during 2005.
With credit spreads near or at historic lows and with the general lack of respect for risk in the market (bond in the debt and equity markets), I believe that there is a high probability of an "accident" somewhere in the world this year - whether it is the collapse of a major hedge fund or a major company - most probably preceded by the widening of spreads and a slowdown in the world economy (or a collapse of a major emerging market economy). I believe the commodities market will also take a hit - and that the U.S. dollar will experience some kind of Renaissance during 2005 as the market experiences a "flight to quality" event not unlike what we saw during the 1997 to 1998 period of the Asian Crisis and the Russian and LTCM crises.
Please keep in mind, however, that I still do not believe that the cyclical bull market is over yet. Bull markets end in exhaustion, and this one definitely hasn't exhausted itself yet. Rather, I see a substantial "break" in this cyclical bull market - not unsimilar to the July to October 1998 period when pessimism was rampant across the board. Historically, there has always been a substantial break in the middle of a bull market (even during a cyclical bull market) and we have not had one so far (the declines during 2004 did not really get that oversold) and it looks like that we are on that path right now. Moreover, the rest of the world has also, in general, topped out before the U.S. stock market. A substantial break in the emerging markets in the next six to nine months will fit that scenario perfectly (this is not unsimilar to the huge decline of breadth that one usually sees in the domestic stock market before it tops out). While most of the world will be taken along for the ride on the downside, most of the ensuing liquidity will most probably make it back to the U.S. market - and once it is over, those moneys will be invested in U.S. stocks. This is what happened after October 1998 and it will most probably happen again. Such an event will give rise to the "blow off" phase - a phase which will finally suck in all investors and which will finally generate a top.
It is to be kept in mind, however, that trying to argue over whether this cyclical bull market is over or not is not an important issue at this point. Death of the bull market or not, the next six to nine months look to be perilous times.
Okay, so much for the big picture and the long-term. Let me go ahead and now and talk about the current market - this is one is for the traders.
Various traders and stock market commentators alike have been talking about an oversold market - and that the market is due for a hard bounce. First of all, I would like to say this: Sure, the market can bounce substantially here - especially if we follow the historical precedents in 2004. But we are now in 2005 and I can definitely say that we are now late in the cycle with the Fed intending to continue their rate increases. We are now in a pronounced downtrend, and the Fed is not on the bulls' side anymore. The mantra of "Don't fight the Fed" is now especially true - given that the actions of the Fed is also now in harmony with the market's current trend. For readers who are going to play the upcoming bounce (however strong it may be), please be careful. That being said, let's now discuss what I see in the current market.
Over the last week or so, I have discussed the fact that while a significant amount of my technical indicators were screaming oversold (such as the McClellan Oscillator, the put/call ratio, and the AAII Survey) other technical indicators that I have followed were actually at neutral or even moderately overbought levels (such as the 10-day MA of the ARMS Index, the percentage of stocks on the NYSE above its 20/50/200 EMA, the Market Vane's Bullish Consensus, and the Investors Intelligence Survey). Given the action of the last two days, however, more of my indicators have now gotten oversold, and I will now go ahead and discuss them and what the potential implications may be.
Let's first discuss the percentage of stocks in the NYSE above their 20/50/200 EMAs. The following chart courtesy of Decisionpoint.com charts out the action of this indicator (along with the NYSE Composite Index) over the last three years:
As indicated by the percentage of stocks on the NYSE above their 20/50/200 EMAs, the market (specifically, the NYSE Composite) is starting to get pretty oversold - definitely good enough for a bounce here if you look at the very ST 20 EMA indicator. At the same time, however, the 50 EMA indicator is only comparable to the January 2005 level, with the longest-term 200 EMA indicator even at neutral to slightly overbought levels. Please keep in mind that the very ST 20 EMA indicator has always led the stock market (that is, it has always bottomed first before the general market bottomed), while the 50 and the 200 EMA indicator has been more of a coincident indicator. At this point, I will not go long here (even for a bounce) until the 200 EMA indicator has reached a more reasonable level - say, the 50% level.
Let's now talk about the Bulls-Bears% Differential in the Investors Intelligence Survey. The most recent readings have been updated, and following is the weekly chart of the Bulls-Bears% Differential readings vs. the DJIA from January 2003 to the present:
The latest decline of this reading from 30.2% to 25.8% is encouraging to the bulls from a contrarian standpoint. This latest reading is the lowest reading since mid September - and another decline of 5% or so would take this indicator to below that of the March bottom reading. However, like I have said before, we are now late in the cycle. If we were still in 2004, I would be looking for a buy point here, but in the grand scheme of things, a reading of 25.8% is actually a moderately overbought reading - especially given that we are now so late in the cycle (okay, did I just say that again?). That being said, courageous readers may want to look for a bounce once this reading reaches or declines below the late March 2004 level of 21.0%.
Another indicator which I have been keeping track of but which I have not consistently discussed is the daily high-low differential ratio of the NASDAQ - another breadth indicator and which also can be used as an overbought/oversold indicator (readers who have just recently subscribed can surf to our original August 8, 2004 commentary to read a more thorough description of this indicator and why we liked to use this over the analogous NYSE indicator). Following is a daily chart of high-low differential ratio of the NASDAQ vs. the level of the NASDAQ Composite:
While the current reading of negative 2.30% makes the current market as oversold as the March 2004, October 2004, and late January 2005 periods, it is not a slam dunk by any means, considering what I have said earlier. A "better" oversold reading would be a reading similar to the August reading when this ratio hit a low of negative 7.81%. In a more substantial break within a bull market, however, this ratio can hit a low of anywhere from negative 8% (April 1997) to negative 14% (July 1995). In a serious decline, however, this ratio can reach a level of less than negative 20% (October 1998). Please keep in mind that the NASDAQ Composite is also very close to its ST support level of approximately 1,975. Again, our more courageous readers can probably try to scalp a trade on the long side once the NASDAQ reaches around that level or if the high-low differential ratio of the NASDAQ reaches a more oversold level of negative 5% (similar to the May 2004 bottom reading).
The one surprise has been the readings coming out of the NYSE ARMS Index. Over the last few years, we have always seen a spike in both the 10-day and 21-day moving average of the NYSE ARMS Index whenever we experience a bottom in prices (even a temporary one that is good enough for a trade). So far in the latest decline, we have not seen such a spike:
Not only is the ARMS Index still at an overbought level, both the 10-day and the 21-day moving average of the NYSE ARMS Index actually declined over the last six trading days even as the market declined as well! I have not seen such a situation in the action of the ARMS Index before, and I would be happy if any of my readers can provide an explanation. For now, I think the weird action of the ARMS Index is trying to tell us something - and I don't think it has a pretty story to tell.
Conclusion: Given the fact that some my other indicators are also starting to get oversold, there may be an opportunity to play a bounce for some of my more courageous readers sometime in the next few days. However, I believe any bounce from current levels will only be temporary. We definitely need a much more oversold market before I can comfortably advise my readers to initiate longer-term long positions. I am also not happy with the action of the NYSE ARMS Index, as it has historically been very reliable with calling a bottom in the stock market. Given that the NYSE ARMS Index is actually at an overbought level and given that we are still in a defined downtrend (and given that we are now late in the liquidity cycle!), I am very wary with establishing any long positions here.
Please participate in our new poll: Are investors taking too much risk in today's market? Again, you will need to register as a poster on our discussion forum in order to be able to cast your vote. Thank you for participating!
Henry K. To, CFA