Overbought, overvalued, overbullish, elevated bond yields: Hussman’s sell signal is active

In my book, the best long-term market statistician is mutual fund manager John Hussman, whose free weekly column is more valuable than any high-priced newsletter.

Using a century of data, there is a very strong pattern of declines from a simple set of conditions. I’ll let Hussman explain them:

 In the chart below, the bars indicate points in the past 20 years where the following conditions were true.

 

1. NYSE 52-week highs and lows both greater than 2.5% of total issues traded (composite highs work better than equity-only, because dispersion of interest-sensitive issues is often meaningful);
2. New highs no greater than twice the number of new lows;
3. S&P 500 greater than its level of 10-weeks earlier (some versions use the NYSE composite, but our index of interest is generally the SPX, and we are less interested in signals that might occur when the market is already down substantially);
4. McClellan Oscillator (the 19-day minus the 39-day smoothing of daily advances minus declines on the NYSE) below zero, which is another indication of dispersion;
5. Two signals within 36 trading sessions, which is helpful for reducing one-off noise.

Ominous? Not necessarily. Worth considering in the context of a much more troubling syndrome of overvalued, overbought, overbullish, rising-yield conditions? Sure.

 

 

Furthermore, the extreme in valuation (Shiller PE over 23 on record margins – Shiller PE on normalized margins would be closer to 29) means that regardless of the near-term outcomes, the returns of future years have been cannibalized. Because earnings grow remarkably steadily over the long-term (6% nominal is the average) stock market returns depend overwhelmingly on the price paid for a claim on these earnings. With the brief exception of the mid 1990s, 10-year returns have never been favorable when the S&P500 trades over 20x 10-year average earnings.

Furthermore, the Shiller PE appears to still be correcting from the late-90s bubble. We should welcome this trend, since valuations have in the past overshot to the downside. By the way, the previous examples of seriously undervalued markets all occurred after high inflation during the later years of secular bears (1917-1920, 1940s, 1977-1982).

A Shiller PE of 10 within a few years would fit nicely in this chart, though it would not be a pleasant experience getting there. Today, Shiller earnings are about $70.

Where are we in the secular (post-2000) bear?

Mish Shedlock’s investment management company, Sitka Pacific, provided this chart in their September letter (as a non-client, I only get delayed copies):

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One lesson to be learned here, which they get into in the letter, is that prices bottom before valuation multiples. In the bears of the 1910s, ’29-early 40s and ’66-82, inflation appeared late in the game. BTW, this meshes with Kondratieff theory, where inflation leads to disinflation to deflation then inflation again, with asset values moving in tandem.

So, be prepared to buy in this coming wave down, if we get a nice drop over the next year or so, because select equities could be a nice hard asset to own through the turmoil in the currency and sovereign debt markets, which is likely to spread to the US, UK, Germany and Japan by later this decade.

Europe’s dead stock markets

There is a huge range of performance among European bourses since the 2008-2009 crash. In the previous boom, all markets went up together, but these charts show that investors are now much more discriminating, and that there is a huge range of optimism among these countries.  Here is a series of 5-year charts from Bloomberg (you can browse lots more charts here):

Greece:

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Iceland (I’ve never seen a stock index that looks like this – it’s more like the aftermath of a penny stock pump-and-dump):

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Ireland:

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Italy:

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Portugal:

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France:

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Luxembourg:

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Switzerland:(I’m surprised that this is not higher, since the economy here is strong, but the Swiss are very conservative and becoming more so, preferring cash and gold to stocks):

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Denmark:

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Germany (DAX):

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United Kingdom (FTSE 100):

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The FTSE and DAX typically trade like the S&P500, shown below for reference:

These higher-quality markets are now very expensive and technically weak, and if they enter into another bear market the lower-quality markets should follow, quickly breaking their 2009 lows. Bottom feeding value investors may then be able to find a few odds and ends in the rubble.

One year later, a real head and shoulders?

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Solid deflation trade on today: bonds, yen, dollar up and everything else down. This is hard selling, so it looks like we’re completing the top of the great dead cat bounce of ’09-’10. Once stocks and commodities break May’s lows, they could fall very quickly towards the levels of winter ’09.

Here’s crude oil, continuous contract futures. This is a beautiful short right now. How quickly the phrase “demand destruction” disappeared from discourse, along with all the other reasons why $35 was a perfectly reasonable price for oil.

Bounce or crash, that’s the question.

Here’s the latest chart of the 5-day average equity put:call ratio. Option markets have done a lot to correct the historic extreme in complacency that we saw in April.

Indexindicators.com

Stocks are still only moderately oversold on a daily scale. RSI has made a sort of double dip into oversold territory, and MACD has also turned down to almost reach a downsloping support line formed by declines over the last 12 months. At some point this year all support should be smashed, but it would be rare to crash right from the very top. A relief rally would clear things up a lot and offer a great chance to get short.

Stockcharts.com

In contrast to the US markets, look at the extreme oversold condition in several major global stock indexes.

6-month Nikkei chart:

Bloomberg

The Eurostoxx 50 index:

Bloomberg

And here’s a 2-year view of a bunch of emerging markets ETFs. These I suppose could keep rolling over into a waterfall, but I’m not sure we’re at that stage yet.

Yahoo! Finance

Rosenberg concurs: 400 point rallies are bearish

From Tea with Dave (free sign-up here):

The obvious question is: how can the bull market possibly be over considering that we enjoyed that amazing 405-point rally on the Dow just three days ago (Monday, May 10)? Wasn’t that an exclamation mark that the bull is alive and well?

Far from it. There have been no fewer than 16 such rallies of 400 points or more in the past, and 12 of them occurred during the brutal burst of the credit bubble and the other four took place around the tech wreck a decade ago. See Chart 2 below.

Blame the computers? Bah humbug.

Did the computers drive the Dow down 25% in a week in May 1940 (no, there was no major war news that would have justified such a move):

TD Ameritrade

Here’s the Dow for the duration of the last depression. Quite a few crashes in there:

TD Ameritrade

The fact is, markets just fall out of bed sometimes. It’s normal, and they don’t need the kind of reasons you can read about in the paper. Greece had nothing to do with it.

A move like this off a top does not mark the end. If we had plunged hard and reversed like this after we were already reading oversold on sentiment and momentum gauges, it could mark a bottom, but not right off the top — that is what should scare people today. This was not like Black Monday ’87 — it’s more like the Black Thursdays of ’29 and ’08 (huge intraday crashes with recoveries, followed the next week by the real crashes), or the Friday before the ’87 crash (down 5%). It’s likely a kickoff to more downside. New highs are possible, but looking less and less likely, and we doomsayers might be right after all these months…

You can’t predict a crash, but you can tell probabilities, and the probability of a decline was high as of last week. We had an extremely, extremely depressed put:call ratio, momentum was rolling over, mutual funds were all-in, and just about every measure of sentiment showed that complacency and bullishness were off the charts.

All this in the face of a depression. Yes, we are still in a depression — that’s what steady 17% unemployment is. Obama and friends conjured up some positive GDP by abusing the Treasury market’s generosity, and that spending is counted as “product,” but tax revenue, real estate prices, rental property vacancies, and unemployment tell the real story: this is a fragile environment. Dow 1500 is still on the table.

And how about gold? I gave up shorting it and suspected a rally after it failed to follow through on that drop from $1200 and sentiment got really bleak. Maybe real money will win sooner than I thought, or maybe this is a 2008 replay and gold will turn once the waterfall gets underway. Anyway, it gives me some hope that the companies in my mining stock database might not all go broke.

How long until Greece’s Athex index makes new lows?

wsj.com

Take this week’s equity drop seriously.

Longs are playing with fire here. This market is at least as dangerous as 2007 or 2000. What happens when this multi-decadal asset mania fizzles out, like they all do? The last 12 months show that it won’t give up the ghost without a fight, but it is very long in the tooth, as is this huge rally. Also, the short-term action of smooth rallies followed by sudden drops is uncannily similar to 2007.

Stocks left the atmosphere in 1995, but since 2000 gravity has been re-asserting itself. After extreme overvaluation comes extreme undervaluation. On today’s earnings and dividends, even average or “fair” multiples would put the Dow near 4000, right back to 1995.

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Charts from Stockcharts.com

A note on gold and the dollar:

I suspected a few weeks ago that gold had a rally coming, and now that we’ve seen it I’d be careful to use stops and not get too confident.

I still like gold for preservation of purchasing power through this secular bear market in real estate and stocks, but when financial markets turn down again in earnest it won’t be spared. Remember, it kept going to new highs in late 2007 and early 2008 after stocks had peaked, but then tanked with everything else when panic hit. Cash is still king, especially in US dollars and Treasury bonds. We may have only seen the start of this deflation.

The myth of the evil short-seller lives on

Bloomberg’s Jonathan Weil writes a good column. Here he digs into the falacy often cited by executives of failing companies and politicians that short-sellers are responsible for drops in price:

Still Believing

So I asked a Morgan Stanley spokesman, Mark Lake, this week if the company’s executives still believed what Mack said in September 2008 about short sellers to be true. And if so, based on what evidence? No comment, he said. Mack wouldn’t talk either.

I got the same response at a conference in Phoenix last weekend when I posed similar questions to the SEC’s enforcement- division director, Robert Khuzami, who joined the agency about a year ago from Deutsche Bank AG. How are his staff’s short-seller investigations going? Found anything significant yet? No comment, he said. Cuomo’s office didn’t comment either.

My guess for why they have nothing to say is that the whole thing was a farce to begin with. Yet this same urban legend — that mysterious, unnamed short sellers and speculators somehow are to blame whenever markets plunge — still lives on.

In Greece, Prime Minister George Papandreou has tried to blame his country’s budget crisis on speculators who profited by buying credit-default swaps on Greece’s sovereign debt. Actually, it turns out Greece was shorting itself.

Paulson’s Evidence

One of the largest buyers of such swaps was the state- controlled Hellenic Postbank SA, which made a $47 million profit last year after it sold its $1.2 billion position, the Athens newspaper Kathimerini reported a few days ago. The bank’s former chairman later said Hellenic was just protecting Greek bonds it owns against a possible default, not speculating, though that doesn’t change the economics of the trade.

In his memoir, “On the Brink,” Paulson writes like a true believer. “Short sellers were laying the bank low,” he said, describing Mack’s plight a year and a half ago. “But John and his team weren’t about to go down without a fight.” What facts did Paulson cite in support of the notion that short sellers were harming Morgan Stanley, or that they had the capability to do so? None, of course.

Paulson mentioned only one short seller by name in his book, David Einhorn of Greenlight Capital, who shorted Lehman’s stock and warned other investors that the bank’s books were probably cooked. In that instance, however, Paulson said Einhorn was proven right, a point echoed in the findings of this month’s report by Lehman bankruptcy examiner Anton Valukas. (Paulson’s book didn’t name anyone who had shorted Morgan Stanley.)

Wrong Target

Einhorn also was right when he tried to warn the SEC in 2002 about the accounting practices of a business-development company called Allied Capital Corp. The SEC responded by turning around and investigating him, at Allied’s urging, without any basis for believing he’d done anything improper, as SEC Inspector General David Kotz’s office chronicled in a report released this week. Eventually, the SEC let the company off without any penalty, in spite of what the report called “specific, detailed allegations and evidence of wrongdoing by Allied.”

Here’s another idea for Kotz. How about investigating whether the SEC had any reasonable basis for believing Mack’s short-seller story in September 2008 when it acted on his pleas, and whether Mack had any plausible grounds to believe the story himself? Now there’s a probe that might turn up something.

Read the whole article here.

More here on how CDS traders are being used as a scapegoat for a well-deserved decline in Greek debt.

Manuel Asensio’s Sold Short tells the story of a small hedge fund that sought out frauds to short and was eventually pushed out of the business by high-priced lawyers paid for with cash from pump-and-dumps.