Are Stocks Similar To 2008?

October 24, 2014

Wild swings in stocks similar to 2008? Did we see real improvement this week?

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Unprecedented Fear Reset: What Does It Mean For Stocks?

October 23, 2014

This Has Never Occurred Before

While reading earlier this week, the sentence below, from Bloomberg, seemed to jump off the page:

The VIX has dropped more than 10 percent in each of the past three days, the first time that’s ever happened.

Think about that…the VIX has been around for almost 25 years. The VIX has lived through the Asian financial crisis, Russian financial crisis, downfall of Long-Term Capital Management, the dot-com boom and bust, housing and mortgage boom and bust, 2008 stock market meltdown, and European financial crisis. Therefore, an unprecedented move in the VIX begs the question…what happened in the stock market the last time we saw something similar?

Sharpest VIX Drop Since 2009

According to Bloomberg, the VIX just experienced its sharpest drop since 2009:

After surging to a 28-month high last week, the Chicago Board Options Exchange Volatility Index (VIX) has fallen at least a point a day starting Oct. 16, reflecting a dissipation of investor concern that hasn’t occurred in five years (2009).

If you are unfamiliar with the VIX, in general terms it tends to go up as the “fear of bad things happening” increases. As we know, there was quite a bit of fear floating around in 2008-2009. As shown below, after a spike in fear in late February 2009, the VIX plunged 31% in three sessions, indicating a rapid reduction in investor concerns.

What happened after the VIX dropped rapidly in March 2009? The S&P took off like a rocket.

Recent Fear Reset Was Bigger Than 2009

The recent unprecedented plunge in investor fear (concerns about future market volatility) was even larger than the plunge in 2009 that preceded a 26% rise in the S&P 500.

If investors were concerned about the possibility of “really bad things happening” last week and now those concerns have dropped in a manner never seen before, then it stands to reason that many raised cash when fear was high and may be looking to redeploy cash now that fear has dropped, which is exactly what happened in 2009 as stocks gained 26%. This is not a prediction; it is simply an educational exercise to understand possibilities and probabilities. It may also serve to balance many of the “a new bear market has started” articles. Our approach, as always, is to see how things unfold and adjust as needed, rather than predict.

Similar Equity Pop Occurred In 2011

When the VIX plunged recently stocks also experienced a rare and extremely sharp reversal. From Reuters/Yahoo Finance:

With the session’s advance [October 22], the S&P 500 is on track for the biggest five-day rally since December 2011.

While it is true that sharp rallies in stocks can occur within the context of a correction (see flash crash period) and bear markets (2008), they can also occur at the early stages of a new and sustained rally. What happened after the two big multiple-day rallies in 2011? See below - Note: One more scare occurred between the 9% rally and 13% multiple-month rally, telling us to remain open to another scare in 2014.

Long-Term Retest Aligns With Bullish Possibilities

Is there anything else that aligns with the “keep an open mind about gains in the weeks ahead” case? Yes, the bullish breakout and retest described on October 14 is still holding as of Thursday’s close.

Fibonacci Also Keeps Bullish Door Open

Fibonacci was born around 1170 and used what we now call “Fibonacci numbers” as an example in the Liber Abaci. In the stock market, it is common for corrections to experience countertrend rallies that retrace 38.2%, 50.0%, or 61.8% of the recent decline and then resume the downtrend and go on to make a lower low. On October 23, the S&P 500 closed above all three major retracement levels shown below, which tells us the odds of stocks going on to make a lower low are lower today than they were a week ago. Said another way, the current move looks more like a new uptrend today than it did last week (odds-wise). Keep in mind, even under that scenario stocks could “retest” and remain above the recent low.

Investment Implications – The Weight Of The Evidence

Does all this mean stocks are out of the correction woods? No, the evidence (some anecdotal) simply tells us to keep an open mind about better than expected outcomes in the stock market over the coming weeks and months. Even under the most bullish scenario, another scare (decline) is well within historical and market norms. Our market model has called for two incremental adds to the equity side (SPY) of our portfolios in recent sessions, based on the improvement in the hard and observable evidence. The market’s mixed profile still warrants our cash and bond holdings as risk offsets.

How Does All This Impact The Model?

The direct impact inside the model is minimal. How will we use it? If (emphasis on IF) the markets continue to improve over the coming days and weeks, the recent unprecedented move in the VIX, clearing of the FIBS, and successful retest of the long-term NYSE breakout (if it holds), will allow us to consider continuing to ratchet up our equity exposure at the maximum rate allowable based on the rules and hard data. The model, evidence, and rules always and still will govern our decisions, but external evidence can assist with intraweek moves and moves within the model’s allowable bounds.

Bearish Outcomes Remain On Scenario Table

Under the lower low, failed breakout, “give back the FIBS” scenario, the rules/model/evidence will guide us just as they did during the recent correction. We will enter Friday’s session with an unbiased, flexible, and open mind.

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October 23, 2014

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Is The Fed Altering Asset Prices?

October 22, 2014

Fed Is One Of Many Elements In Market’s Structure

Markets are never driven by any single factor at any moment in time. Asset prices are impacted by an almost limitless amount of inputs including Fed policy, earnings, valuations, geopolitical events, supply, demand, conviction, greed, and fear.

The Fed And ECB Are Important Factors

Central banks, including the Fed and European Central Bank (ECB), can alter the supply of money, provide loans to struggling banks, and even pick winners and losers (see 2008). Therefore, central bank policy represents one of the most important factors impacting markets and the prices of all assets, goods, and services.

This Is Nothing Particularly New

When you are new to the markets and begin to understand what the Fed can do (print money, buy assets, inject new funds into the financial system, etc.), there is a certain shock value along the lines of “do people understand what is going on here?” While the concept of central banking is odd in the context of free markets, central banks have been impacting, altering, skewing, goosing, and/or propping up asset prices long before most of us were born and they will most likely be doing so long after we are dead.

Blaming The Fed Is Not The Answer

Any successful trader or investor will tell you a key point in the market’s cruel learning process is accepting that we are 100% responsible for our own actions and results. It is easy to blame the Fed when things go wrong in trading and investing. Rather than blaming, it is better to understand the Fed is an important part of the markets, the U.S. central bank is not going away anytime soon, and we must account for Fed policy when making investment decisions.

Many Ways To Skin The Market Cat

A great thing about the financial markets is there are an almost infinite number of ways to skin the risk management and market cat. One way is to focus on price or the markets themselves, based on the premise that “price captures everything”, including the impact of central banks.

Are Central Banks In Full Control?

One of the biggest misconceptions held by some investors is that the Fed can always bail out the markets. If that were true, why did the Fed let stocks fall over 50% in both the dot-com (2000-2002) and financial crisis (2007-2009) bear markets? If they lost control then, then it seems reasonable they can lose control again.

The Next Inevitable Bear Market

The Fed is one of many factors impacting asset prices…not the only factor. At some point the economy, earnings, inflation, deflation, geopolitical events, or the next crisis will overshadow the attempts by central bankers to keep everything propped up, which is when the next inevitable bear market will arrive. When that will be is the million dollar question, but we know one thing with 100% certainty; price and the charts will not miss the turn from bull to bear. If that sounds crazy to you, watch this video which explores the question 2008: Was There Anything Investors Could Have Done?

There Is No Magic Moving Average Or Indicator

The video above uses moving averages to illustrate basic concepts. Are moving averages a perfect way to manage risk? No, there is no such thing as a perfect moving average or indicator. Since moving averages have some known drawbacks (whipsaws, lag-effect), it is important to diversify our risk management inputs and make decisions based on the weight of the evidence. We would never manage risk using a single moving average or moving average pair on a single chart…it is not that simple. There are many methods that can improve our probability of success. Unfortunately, the term probability also speaks to the limitations of any method used in isolation, including moving averages. This table shows an example of using diversified inputs across multiple timeframes (moving averages are only one of the inputs).

Investment Implications – The Weight Of The Evidence

As noted Tuesday, the weight of the evidence has been improving, but many markets around the globe remain below areas of possible resistance. Therefore, we will be using two levels as guideposts in the coming days:

  1. 1943 on the S&P 500
  2. 10,301 on the NYSE Composite

The rationale for 10,301 was covered on October 21. The rationale for 1943 was covered via this tweet. We have already started to redeploy some of our cash, but have done so in modest amounts given the S&P has not closed above 1943. It will be easier to add to the equity side at a faster rate if the S&P 500 can hold above 1943 and the NYSE Composite can close above 10,301 this week.

Molecule image from net_efekt via Flicker (image altered).

Stocks: Is It Time To Get Back In?

October 21, 2014

On October 13 we referred to the chart below as the most important chart on Wall Street. The gains in stocks over the past four sessions have allowed the broad NYSE Composite Index to push back above the important 10,301 level.

Why Is The Chart Helpful?

Between mid-2007 and early 2014, the stock market made no progress. The NYSE Composite was trading at 10,301 in 2007 and it hit 10,301 again in early 2014. The lack of progress, or period of consolidation, speaks to investor confusion/indecisiveness about the economy, earnings, valuations, stability of the financial system, and Fed policy. The break above 10,301 in early 2014 occurred when bullish conviction was strong enough to surpass a previously insurmountable level.

A Successful Retest Would Be Bullish

It is common for a “breakout” to be followed by a “retest”. The blue arrow in the chart above can be classified as a “successful retest” as long as the NYSE Composite stays above 10,301. It closed Tuesday at 10,500.

We Learn Something Either Way

If the market fails to hold the key 10,301 level, it puts us back into the “failed breakout” category, which would be a yellow flag for equities.

The Longer The Consolidation…

Experienced money managers know the longer a market consolidates (investors remain indecisive), the bigger the move you typically see after a breakout. The broad stock market has been “basing” or consolidating for six years. A bullish breakout, followed by a successful retest, is difficult to ignore.

Can You Make A Fundamental Case?

Ultimately, the market makes that call, but we can review a few questions. Does the economy appear to be on the cusp of a recession? With real gross domestic product (the output of goods and services produced by labor and property located in the United States) having increased at an annual rate of 4.6 percent in the second quarter of 2014, a recession does not appear imminent. How about earnings? Bloomberg estimates that profits for S&P 500 companies rose 5.9 percent in the third quarter – that is not bear market-like earnings growth. How about central bank policy? The Fed is likely to keep rates low, even after ending QE, and the ECB is currently adding, not reducing, stimulative measures.

Investment Implications – The Weight Of The Evidence

During Tuesday’s session, we noted the rationale for a measured approach when adding to equity holdings until the S&P 500 is able to hold above 1943. The S&P 500 closed just under that level at 1941 on Tuesday. Therefore, we have two good bull/bear reference points:

  • 10,301 on the NYSE Composite
  • 1,943 on the S&P 500
  • Is It Time To Get Back In?

    Many investors have been sitting in cash waiting for a better entry point. Have we reached a better entry point? Only time will tell, but the odds of the answer being yes will start to improve if the S&P 500 can close above 1,943 and the NYSE Composite finishes the week above 10,301. The longer they remain above the levels, the higher the probability of good things happening.

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    October 21, 2014

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    Stock Rally Faces Important Test

    October 20, 2014

    Earnings Help Revive Equity Interest

    The market has been looking for some good news. While IBM had a big miss Monday, the overall picture for earnings has been encouraging. From Bloomberg:

    Profit for S&P 500 companies probably rose 5.9 percent in the third quarter — a forecast that’s been revised upward from an increase of 4.8 percent as of Oct. 10 — and sales increased 4 percent, according to analysts’ projections compiled by Bloomberg.

    Rally Still Has Work To Do

    This week’s stock market video examines the question:

    Is the current rally in stocks sustainable or will stocks eventually make a lower low?

    After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.



    Europe Still A Drag

    While stocks popped Monday in the United States, the news continued to be troubling across the pond. In the first session of the week, the German DAX dropped 1.50% and the Stoxx 50 Index shed 1.18%. European stocks are highly correlated to the S&P 500, which is why U.S. investors would prefer to see some stability in that region of the globe. From Bloomberg:

    “This correction might be the symptom for something larger,” Benedict Goette, founder of asset-management firm Compass Capital AG in Zurich, said in an interview. “I do not expect a big positive impulse from the current earnings season in Europe. Unless a multi-day upmove develops, people will remain nervous. We’re now in the highly volatile phase of attempting to bottom, but I would expect a final bottom only by the end of October or mid-November.”

    Investment Implications – The Weight Of The Evidence

    If the concept of a countertrend rally is new to you, this video clip provides two specific examples from 2010. On our investment timeframe (longer), it is important to see evidence of a sustainable turn in stocks, rather than hope the rally will continue. As the market was finding at least a temporary bottom on October 15, we hypothesized stocks might hold at the lower support line in the chart below.

    Possible Resistance Ahead

    If the market continues to “care about” the blue lines in the chart above, then a good bull/bear test may be coming near points A, B, and C (or between 1920 and 1960ish). Other levels that can be used as guideposts are the Fibonacci retracements near 1920 and 1943. As of Monday’s close, our current mix of stocks (SPY), bonds (TLT) and cash remained in line with the market’s risk reward profile. Should the rally push the S&P 500 above 1943, the improvement would most likely allow for an increase in our equity exposure. The market will guide us if we are willing to listen.

    False Rally Or New Bull Trend For Stocks?

    October 17, 2014

    For reference purposes, the S&P 500 gained 24 points Friday and closed at 1,886, but down 19 points for the week.

    After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.



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    October 16, 2014

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    Could The S&P 500 Fall To 1,625?

    October 15, 2014

    A Trip Down Correction Memory Lane

    Since the correction-less market theory has been dropping transmission parts over the last three weeks, it is prudent to revisit some topics we have touched on in the past. We will focus on two questions:

    1. How far can stocks drop?
    2. How long can corrections last?

    History Says Corrections Can Be Very Painful

    Our objective here is not to create fear, but rather to better understand what is in the realm of historical possibility. If we understand the magnitude and duration of some of the sharper corrections (1983-2011), we can better prepare for all possible market outcomes.

    S&P 500 At 1,625…Is That Possible?

    In the seven historical cases below, the average correction in the S&P 500 was 19.5%. The average length of the seven cases was 114 calendar days (top to bottom). The S&P 500 peaked on September 19, 2014 at 2,019. A 19.5% drop would be 394 points, which would take the S&P 500 to 1,625. A correction of 114 days would end on January 11, 2015. Regular readers know we are not fans of forecasting (rationale here). Therefore, this is not a forecast…it is simply an educational exercise regarding some of the more painful stock market corrections. Admittedly, this is anecdotal evidence, but we can still learn from it.

    Sample of Corrections 1982-2014

    In 1984, stocks dropped 14.63%. Unlike the multiple-day pullbacks in 2013 and 2014, this correction lasted two hundred eighty-eight calendar days (288).

    The 1987 stock market crash occurred within the context of a bull market, and the bull market resumed relatively quickly. Therefore, it is relevant to our correction study and 2014.

    In 1990, stocks corrected sharply, dropping 20% over eighty-seven calendar days.

    We have covered the importance of the investment landscape in 1994 numerous times, including this March 21 article. Stocks slid just under 10%.

    In 1998, the correction may have felt like a bear market based on the sharp declines witnessed on brokerage and 401k statements. The 1998 correction was outlined in more detail on April 2.

    The 2010 Flash Crash was quite a bit more than a one-day media event. Stocks dropped 16.71% over sixty-seven calendar days.

    A political stalemate in Washington and escalating fears of the end of the euro, helped push stocks down over 21% in 2011.

    Corrections Can Be Harmful To Your Portfolio’s Health

    The details on the seven cases are shown in the table below. Can corrections be less painful? Sure, there are countless examples of more shallow pullbacks. However, understanding what is possible helps with investment contingency planning.

    Investment Implications - The Weight Of The Evidence

    Did the evidence in recent weeks suggest something was changing from a risk-tolerance perspective? The tweet below is from September 22. Since noting “the math (evidence) is vulnerable here”, the S&P 500 has dropped 131 points.

    As noted in an October 10 video, this is a high risk market until proven otherwise, markets can turn at anytime; therefore, objectivity and flexibility are requirements. When emotions are running high, market levels can assist with decision making. Our market model came into today’s session with a heavy cash position paired with bonds (TLT). We still have some stocks (XLK) left on the books. If the S&P 500 fails to hold Wednesday’s low of 1,820, we will consider cutting the already depleted equity side of our portfolios (again).

    Book image (altered) from Chris via Flickr