This is a very expensive and overbought market which few participants believe can decline meaningfully. That alone is dangerous, but now we see signs of technical exhaustion, such as the downtrend in RSI on the daily chart (credit futures.tradingcharts.com):
Gold and the yen each worked still lower this week on highly depressed sentiment readings. Each of these has had a negative relationship with the “risk trade” lately, falling as stocks have rebounded from their oversold and overbearish condition of mid-November. Now, stock sentiment has recovered to neutral territory, and traders are afraid of these sometime “safety trades.”
Trader opinion gold has been very low since late October, a full eight weeks ago. Every similar instance in the past several years has been followed by a substantial multi-week rally. That said, if the bull markets in precious metals and the yen are indeed over, we should expect downtrends to become more protracted, with sentiment remaining low for longer.
Here’s a 1-year daily chart of gold:
1-year daily JPYUSD:
I’m holding to a thesis that the risk trade is topping out here as the US slides into a recession that remains largely unrecognised. Tops are rarely sharp peaks, but consist of several months of choppy sideways action during which sentiment deteriorates from giddy to nervous and the VIX picks up even before prices have fallen substantially. I view the rebound since mid-November with that context, akin to the action of April-July 2011 or pretty much all of 2007. Last nights mini flash crash in stock futures fits into that context of a increasingly jittery market.
We’re three months from the 4-year birthday of the (presumably) cyclical bull market. It is now older than most cyclical bulls within secular bears, though the last bull phase lasted from March 2003 to October 2007, 4.5 years.
Another cyclical bear and a recession and drop in corporate earnings may finally compress multiples to the investable levels required to build a solid base for another bear market. I don’t expect this to happen quickly, though, since prices have a long way to go before we see anything that can be called historically cheap. I wouldn’t be surprised to see stocks hold at or beneath current levels for the rest of this decade as inflation creeps in towards the end and boosts earnings, as happened during the latter stages of the last three secular bear markets (roughly the 1910s, ’30s, ’70s).
We finally have the classic syndrome that indicates an intermediate-term top. Upward momentum has stalled, as sentiment has remained elevated for several weeks. The combination of sideways prices on high bullish readings becomes very bearish when it has been sustained for a month or longer.
Here is the RSI and price picture (note declining trend in the momemtum indicator RSI since late August, and its resemblance to the topping pattern last spring):
Charts from Yahoo
A quick glance at sentiment shows sustained optimism:
Source: http://www.naaim.org/naaimadsenttrend.aspx
Looking at the headlines, it is nice to see good news that results in a bump with no follow-through. We saw that in mid-September with QE Infinity, and last Friday with the jobs report. Rallies end on good news and declines end on bad news.
It would not be unusual to see another test of the highs, and for prices to linger at these elevated levels for another month or so, but the odds of a sharp decline are now elevated, and any further gains should be quickly erased.
The global economy is clearly on the downswing, with the US likely having entered a recession this summer (watch for revisions in GDP and employment data in the coming months). However, as in Sept-Oct 2007, the equity market has bounced from a brief oversold interlude to a new high.
Here is the NAAIM survey. This is a relatively new dataset, but it has proved high-correlated with proven sentiment indicators like DSI and Rydex fund activity). The survey is updated each Thursday with data from Wednesday.
Sentiment has been elevated for a month, which is sufficient for a significant decline, though the likelihood of a setback and the expected magnitude thereof grows with each week that it remains elevated. This, coupled with sideways price action for few weeks (we don’t have this yet) and a declining trend in daily RSI (possibly developing) would virtually lock in the case for an intermediate-term top.
EDIT: To clarify, this is not a screaming short-term sell yet, since the market has had a habit of creaping slightly higher over a few weeks from conditions like this. However, things can reverse at any time, and it is highly likely that any further gains will be quickly erased once the turn comes.
The macro picture of deteriorating economic data bolsters the case that a bull market top is near, so if this is an intermediate-term top it could prove to be the final top prior to a bear market. This cyclical bull is now 3.5 years old. This is long in comparison to the cyclical bulls of the 1910s and 1970s secular bear markets (18-36 months was typical), but short in comparison to the last cyclical bull (spring 2003 – fall 2007, 4.5 years).
Sentiment is still very anti-dollar (though not as extreme as last February-April), but the index is no lower than a few months ago, nor even a few years ago. Despite all of the dollar-crash and hyperinflation hysteria in recent years, early 2008 still marks the bottom.
MACD and RSI also seem to back up the case that the next big move is more likely up than down:
3 year daily chart:
stockcharts.com
5-year weekly chart:
bigcharts.com
10-year monthly:
futures.tradingcharts.com
The 10-year chart says it all: the dollar has already crashed, and as is typical in the financial markets, few noticed or attempted to take action until the move was already over.
John Hussman is the rare mutual fund manager who uses technicals and hedging to minimize risk and maximize returns during a full bull-bear cycle. He hedged up in 2000 and 2007 to preserve his fund’s equity during the ensuing bear markets, and is again tightly-hedged in preparation for another downturn.
His weekly market comment is a must-read (if you just read this and Mish’s blog regularly, you’re all set). He uses a set of indicators to identify periods during which risk is elevated based on historical statistical analysis. They are: 1) stock market investor sentiment, 2) Case-Shiller PE ratio, 3) Treasury yield trends, and 4) price action (to indicate whether stocks are overbought or oversold using moving averages).
He concludes each market comment (in which he puts on his academic cap to discuss market statistics, Fed policy, etc in geeky detail), with a quick summary of where his funds are positioned according to the prevailing risk profile. When he starts his conclusion like this, you better not be long stocks:
Market Climate
As of last week, the Market Climate for equities was characterized by an unusually extreme profile of overvalued, overbought, overbullish, rising-yield conditions. Both Strategic Growth and Strategic International Equity remain tightly hedged here.
Here is a chart showing where these market conditions have existed in the past:
World stock markets are oversold, and now that the US markets have taken a dip under the May 6 lows we have a stronger case for some near-term strength. The put:call ratio is also advising shorts not to press their luck, though there is still plenty of room on the upside, especially considering that this is indicator tends to oscillate from extreme lows to extreme highs:
Indexindicators.com
I’ve eased up on my short risk portfolio today by selling some puts, closing some ultralong ETF shorts, selling Yen and buying SPX and Nikkei futures. I’ll view any bounce as a shorting opportunity, since unlike most of the people on TV this week I don’t view this sell-off as a correction but the likely start of another leg down in a multi-year bear market.
I tend to be early on closing and easing up shorts, so take note that we don’t have much in the way of bullish action out there yet.
–
Very high sentiment readings last week, up to 20:1 bulls:bears. Quite a change from a few weeks ago, when traders were bearish by 4 or 5 to 1.
If the tide is turning back to the deflation trade, expect a rout in commodities like the second half of 2008. Yes, gold rose as stocks and other commodities fell last week, but it did the same thing when it first broke $1000 in early 2008 as stocks fell into the Bear Stearns crisis. The corellation with stocks could easily switch positive again as it did in ’08.
The Russell 2000 rocketed up this morning, just when it looked like it might roll over:
Prophet.net
–
With no confirmation from the Dow and unimpressive short-term internals, plus a stubbornly strong dollar and bid on bonds, I’m not too concerned here.
If it so chooses:
,
.
The VIX has reset nicely:
prophet.net
Sovereign Speculator 