Bad breadth, but we're all bears

With the recent decline in stock prices, breadth has once again turned bearish.  Have a look at the charts below to see just how bad things have become.  

The S&P 500 has formed an ominous head-and-shoulders formation.  Two big days of selling could easily take us below support levels and from there it's a long ways down to the next support level. 

The NYSE BPI is bearish again, but at least it is above the lows from the past few months.

The Advance-Decline index continues to look stronger than the price action would have you believe.  However, after a short rally the High-Low index has once again stalled out as the number of stocks hitting new 52-week lows spikes to levels last seen during the flash crash.

From the charts above and the near daily release of worse-than-expected economic statistics, you wouldn't think there's much of a reason to be bullish.  But then you would have forgotten about the beast lurking in the corner.  And that beast is sentiment.

This week's AAII Investor Sentiment poll showed a dramatic shift in bearishness.  Couple that with a relatively low allocation to stocks and you've got yourself a bundle of dynamite just waiting to be ignited, "real" arguments and statistics be damned.  

Bearish prints like these don't necessarily mean that we've seen the ultimate lows.  They're just warning signs that the market has become a bit too one-sided and it'll soon be time for the weak hands to be shaken out.  Mr Market's not a fan of easy profits.  

If you've got some gambling money and feel like doing some betting, you might want to have a look at the December 100 calls on the SPY (if you this god-awful economy has blessed you with some cash to spare, consider the 115s or 120s).  The rest of you should stay hedged and hold on tight.  There'll likely be a few more rapids we have to get through before we reach the other side.

From bad to worse

Initial unemployment claims were released today and they were ugly.  Back above 500K on clearly violating any last possible argument of unemployment claims being in a downtrend.

With all-bark-no-bite bulls (why we rally sharply to resistance and then can't seem to squeeze out even just a few more points to push us through resistance is beyond me) and with claims breaking out to the upside, it's time to bring that hedge back up in size again.  We're now roughly 70% hedged and will go full once we see breadth confirm the recent weakness in price action.  Sometimes high volatility on its own warrants a significant hedge and this has definitely been a meat-grinder market the past two months.

The only bullish argument one can draw from the increase in claims and poor price action is that it's becoming even more evident the Fed will have to act to stave off deflation and a double dip recession.  The pain is getting worse and the patient is in critical condition.  All we need is a week or two of relentless selling to quiet the cries of inflation and the Fed will have the ammo it needs to act.  Ironically, the best thing a bull can do to drive the market upward is to stop buying for a week or two.  Correct or not, most economists (the Fed included) see the market as a confirming indicator.  If the market is finding the strength to rally and stage strong late-day reversals, then there's hope that what's been done is working.  If the market is tanking a few percent a day with no relief in sight it's hard to justify sitting on your hands much longer.

Also of note, sentiment shifted bearish this week but not enough to offer up any kind of extreme sentiment induced rally.  Maybe next week if we break to fresh lows.

This time Rosie's right

As I said, most of the time I agree whole-heartedly with David Rosenberg.  In today's Breakfast with Dave he made the following remark:

Almost half of the ranks of the unemployed have been looking for a job fruitlessly for at least six months. Let’s get these people re-engaged in the labour market, get them re-tooled and retrained for the skill set that businesses need now and in the future. Give these folks a shovel from 8 to 12 and engineering courses from 1 to 5 in return for their jobless insurance check.

Why isn't the government doing this already?  What better way to get people motivated than force them to work a shitty job for Uncle Sam until they find one on their own?  Don't want to do manual labor?  That's fine, just don't expect to see anymore of those cush unemployment checks in the mail.

Two months should be enough time for anyone to get back on their feet and get a new income stream going.  Can't cover all the bills?  Time to start cutting back on whatever luxuries you're still affording yourself.  Any longer than two months and you're either A) not looking hard enough, B) barely have the skills to earn the title of "employable", or C) both.  Either way, why should tax payers be paying you to do nothing when no one is willing to pay you to do something?

Right now, with unemployment benefits being extended as far as they have, there is little incentive to get off your ass and get a job if the unemployment checks are already covering your bills.  Might as well enjoy the extended paid vacation for as long as you can...

Cheer up little babies

With two tantrum-esque selloffs in the past three days, the bulls just aren't quite ready for battle even though they are so close to reaching safe grounds.  Thankfully the bears aren't either, as they seem to be happy locking in their quick intraday gains.  

The Fed meeting release at 2:15 later today will likely catalyze the next leg of the market.  Whether that be down or up we will know shortly.  One thing we know for certain is that the economy is not stable enough to walk on its own just yet, as evidenced by the endless number of below-expectations economic reports over the past two months.  Better-than-expected earnings are the only thing the bulls have really had to get excited about. 

Come on Fed, move the wobbler away from the cliff already!  At this point the inflation threat is no more than the imaginary monster living under the bed.  Deflation is the imminent threat and needs to be dealt with promptly.

We're happy to see the market go either way from here -- it's these whiny little panics that bother the hell out of us.  WIth any luck the market's next move will be decisive and extended, giving us a break from these summer doldrums.

It's been a while since we recapped market breadth, so let's do so quickly before the rush is on at 2:15.

The NYSE BPI looks great and is climbing higher despite the bulls' recent lack of conviction.

Advance-Decline and High-Low indicators look excellent as well.  Move along bears, there's nothing to see here.

The number of stocks hitting new highs was looking great until just a few days ago.  Recently it has collapsed but we have yet to see a meaningful rise in the number of stocks hitting new lows.

That's it!  Breadth looks pretty supportive at this point.  If the market likes the Fed's decision we will see new highs shortly.  If not, we're likely to continue seeing choppy trading until breadth deteriorates enough to let the bears push the market around as they please.

The tail that wags the dog?

I'm a huge fan of David Rosenberg.  His timely and thorough analysis of the latest economic releases around the globe is excellent and much more pleasurable than digging through the trash yourself.  

Sometimes I disagree with him though.  Like today, regarding his call on the 10-year note in today's Breakfast with Dave (if you haven't subscribed already I highly recommend it -- it's free):

 

The yield on the 10-year note hit its nearby peak on April 5, at 4.01%, and has since plunged nearly 120 basis points.

Declines of this magnitude very often presage the onset of bear markets and recessions. Typically, equities and then economists are late to the game. Nothing we are seeing is any different from the past, at least on this score.

 

I'm a huge fan of silver bullets, especially in a world like the stock market where they are very few and far between.  But instead of taking Rosie's word for it I wanted to see it myself.  Time to hit the charts.

I'm a visual thinker.  If you can't show me a chart or a diagram that validates your argument, I don't really care how much data you claim supports it.  If it's there I'll see it.  So when I first threw the 10-year on top of the S&P and saw the correlation Rosenberg described, I was excited.  

But then I kept digging. 

What I found was a disappointing history of reliability, swinging slowly between highly accurate and timely bear market warnings and inconsequential smoke signals.  

Here's the chart so you can draw your own conclusions.  I've marked each peak in 10-year yields prior to a sizable decline along with a circle highlighting where the S&P was at the time when yields bottomed.  By looking at the price action of the S&P (yellow) between the preceding vertical line and the circle, you can observe how the stock market behaved throughout the course of the decline.  (This is a huge chart so you'll probably want to click on it to view the original.)

Since the 2000 top in yield, the correlation has been excellent.  Before that it would have sidelined you during some of the market's strongest rallies.

But what about Rosenberg's general claim that we should "take Mr. Bond very seriously"?  When you look at the bond market as a whole instead of squinting at a single piece of it, things change dramatically.  In the following charts you'll see the yield curve presented above the S&P.  You will also hopefully see how timely an inverted yield curve signals an impending slow down within the next year or so.  (I've had to split it into two separate charts to cover the entire date range, and again, these are big charts so click on them to see the originals.)

So do I agree with Rosie that the bond market is the tail that wags the dog?  Of course I do.  The inverted yield curve evidence presented above is strong enough for me to be a firm believer.  However I don't agree that every 120 basis point plunge in the 10-year is cause for concern.  Instead it is the relationship between yields of various durations within the bond market that is the smoking gun.

If the long end of the curve sold off enough to invert the yield curve, I would quickly move entirely into cash and likely throw a small position on out-of-the-money LEAPS puts awaiting the likely decline.  But with the Fed holding rates at zero and ready to perform additional quantitative easing if necessary, I don't foresee this happening.  

These are unique times and therefore require unique tools.  Successful indicators of the past aren't likely to be as accurate in these strange times as they were before.  John Mauldin is one of the biggest fans of the inverted yield curve I know of, and even he has said that the next recession won't be so easily forewarned by inverted yields.

Instead we have to stick to absolute truths and forego our previous assumptions no matter how much we believe in them.  Here are two key ones for you:

• A market trending downward is not setting new highs (tools: 50/200 day moving averages, new 20/50 day highs and lows, support and resistance)
• A market supported by only a few large stocks is a hollow and delicate market (tools: BPIs, advancing - declining, and new highs - new lows)

Technical analysis and market breadth will serve as much better guides than fundamental arguments over the next few years.  There are simply too many contradicting data points to reconcile at this moment.

Right now the ball is the in the bull's court and they are handling it miserably.  One good high volume breakout above the recent consolidation levels will suck risk capital back into the markets and establish a solid level of support.  However a fumble this close to the end zone could also result in a severe selloff given the market's jitteriness.  

Until conviction returns we will continue to experience wide swings in both price action and sentiment.  Keep a small portion of your hedge in place to dampen the volatility but wait for the market's next move to decide the proper course of action for your portfolio.