THE BOTTOM LINE
A series of strategic and tactical supply and demand indicators are signaling that in spite of new all-time price highs potentially not all is well with the bull. Yawning negative divergences are warning that in this historically negative seasonal time for the stock market, investors should expect rising volatility, perhaps dramatically rising volatility. And, contrary to some notions in the media, risks remain elevated.
IRRATIONAL BEHAVIOR
John Maynard Keynes, a British mathematician and economist, is credited with having coined the phrase: “The Stock market can stay irrational longer than you can stay solvent”. In another era, Keynes was vilified by conservative economists, because he also advocated stimulating the economy during times of recession, or depression, through government spending, even if that meant that the national government had to borrow the money for the various stimulus programs. This became known as Keynesian economics, or deficit spending, terms that only a few years ago would cause members of a certain political party to almost set their hair on fire with disdain, faux or otherwise. The irrational spike to a new all-time high in the S&P-500 on Wednesday in the face of huge global uncertainties brought to mind Mr. Keynes famous observation about the stock market, and the irrational behavior of the investing “herd”, when it stampedes.
The amount of debt taken on since March by the United States, the various state governments, corporations and institutions reminded me recently of the craggy voiced late Republican Senator from Illinois, Everett Dirksen, who coined the phrase: “A million here, and a million there, and pretty soon you are talking real money”. How things have changed in the years since these two gentlemen were in the public eye, as reports leaked out this week that the Democrats and Republicans were “only” a trillion dollars apart on a new economic stimulus plan in response to the ongoing Pandemic’s negative economic consequences. Democrats long ago embraced Keynesian economics, and these days among the many norms shattered by the current occupant of 1600 Pennsylvania Avenue, and his party, is the application of Keynesian economics, or deficit spending, like never before in my lifetime. Not so long ago the national debt stood in the high teens or low twenties of trillions of dollars depending on which Google number you can wrestle to the ground, and if the current trajectory does not change that number will soon approach thirty trillion!
Friends and colleagues of mine in this business, including Alexander, a former bond hedge fund manager, can make you a very good case that interests rates have likely completed a thirty plus year declining rate cycle, and a new rising rate cycle is beginning, or perhaps has already begun. If you are good enough at math to do powers of ten math operations, because your calculator does not register enough numerals for calculations in the trillions of dollars, then calculate the annual debt service on thirty trillion should nominal rates move 200-250 basis points higher from recent all-time lows, then divide by the number of taxpayers in this country, which is a relatively small fraction of the nation’s 330 million population.
The Nasdaq went parabolic in its rise during the last several months, ditto for the amount of money that will be required to service the national debt as a percentage of the total budget. I am growing more and more concerned that the currently under the radar growing debt levels in governments, corporations and institutions may collide with an accelerating swoon in the stock market. All economic expansions, and bull stock markets, tend to grow to excess, and then are followed by a period of contraction, and correction of the previous excesses. These periods can be mitigated, or on the contrary, made more severe by the trend in interest rates. Given that some economists say this is the longest economic recovery in the history of the country, logic implies it is closer to an end than it’s continuation, and that ending may arrive as the interest rate trend has turned higher.
On Wednesday the NASDAQ and S&P-500 touched new all-time highs, as both indexes surged higher in climatic like behavior. On Thursday there was a sharp break in the market, as some of the market darlings suddenly fell out of favor, causing the Dow, S&P-500 and NASDAQ to decline sharply and persistently. The selling continued into Friday before some buying appeared late in the day. Alexander anticipated the Fed would support the market before the close going into a long holiday weekend. Traders tend to not like to own risks over holiday weekends, so we are suspicious the Fed was doing some buying, even though technically that would be illegal if they did it overtly.
I expected the rally off the March 23 low to expire before touching new all-time highs for a multitude of reasons detailed in previous updates. However, the NASDAQ and S&P-500 found a bid almost immediately every time the bears attempted to take charge at important support and resistance levels, and obvious Fibonacci targets. The market yielded pauses, but failed to reverse the recovery rally. However, after selling into strength at some of these key levels, we elected to not chase the market higher as it approached new highs not because of an opinion, but because of hard market generated evidence that the unrelenting rally may become a trap.
The current weakness may just be a routine pullback to re-invigorate demand in a new bull market leg up, but the attached exhibits argue that the risks implied by the rising volatility index (VIX) registering above 30, bullish sentiment at extremes where previous significant reversals have happened, the fourth highest P/E (over 30) in the S&P over the last 140 years (according to Schiller), which in the previous iterations preceded significant bear markets, and evidence of institutions crowding into only a half dozen or so big cap stocks, which in the aggregate exceed the market cap of the two thousand stocks in the Russell 2000, or alternately the value of all the stocks on the European stock exchanges! I could go on about unemployment, rising rental and mortgage defaults (40 million people currently at peril of eviction according to one source), and a host of other global uncertainties among which is an election. What could possibly go wrong?
Please note that Schiller used the term S&P-500 in his 140 year P/E chart, but the Dow is the senior NYSE index with the S&P-500 a relative new comer. I can only guess that Schiller used some kind of re-constituted surrogate index for his P/E chart comparison. I do not have the link at home where this is being written, but if you request it I’ll send you the document from the office.
However, beyond the concerns being detailed on the evening news is the market generated evidence, which has concerned me the most about the implied risks in this market. That evidence is shown in the charts above, which I’ll explain in the next section. These charts are not normally shown in these weekly updates to keep them succinct and relatively simple for clients, but the extreme they are depicting, and the level of risks they are implying, has caused me to want me to share them. The magnitude of the negative divergences between the level of the price, and the supply and demand indicators deserve to be respected.
TATY — A REPRESENTATIVE OF A FAMILY OF STRATEGIC SUPPLY AND DEMAND INDICATORS
TATY is shown above in yellow with the S&P-500 overlaid in red and blue candle chart format. TATY finished the week at an oversold 116 level without ever reaching the red zone surrounding the 140 level. It has been a source of constant concern to me that TATY atypically never led the price higher after the March 23 bottom. And, now TATY has failed to reach the red zone as the price touched new all-time highs. This is unprecedented abnormal behavior for this usually reliable as a clock indicator, and I have been compelled to grade it as a warning that not all was well with the rally, the new all-time price high notwithstanding. Now TATY is breaking down, and at peril of declining below the bottom of the caution zone, which continues the indicator’s streak of atypical behavior.
Please note the down sloping magenta line on the TATY chart. This depicts a negative divergence with the price touching new all-time highs. This kind of divergence on a shorter time span was in place before the February high, and was almost the only warning to precede the plunge in the price on the way to the March bottom. That divergence remains in place, except for a longer time span, and now TATY is showing signs of breaking lower in a zone where it usually bottoms!
Now take a look at Screenshot-145 (above), which is the tactical supply and demand indicator “SAMMY” in weekly format. SAMMY is shown in yellow with the S&P-500 overlaid in red and blue candle chart format. You can see instantly the negative divergence, which developed prior to the February high, shown by the down sloping aqua colored short line. As SAMMY faded the price continued to touch new all-time highs. At the time I thought SAMMY was telling us to get ready for a “Big Chill” warning, which almost always precedes significant tops. So, I took no defensive action given the reliability of all the previous “Big Chill” warning signals, which had always given us a timely exit near highs. I’m suspicious the normally reliable “Big Chill” warning to sober up giddy animal spirits may have morphed this time around into a “Big Freeze” during the record setting plunge post the February all-time high, by definition a statistical outlier type event.
After TATY failed to stop near the caution zone it became evident that the short negative divergence in place at the top was not going to yield a normal “Big Chill” type decline into the caution zone to sober giddy investor animal spirits, but something else was afoot. SAMMY has more derivative based components than TATY, and its recovery has been even more impotent than TATY, shown by the steeper angle of decline in the magenta down sloping negative divergence line. Sharp eyed investors will notice that SAMMY, like TATY, is now declining again. Seeing this huge negative divergence caused me to overrule my urge to chase the rally near all-time highs, which has now cracked in an environment of objective measurements registering significant extremes. A negative divergence of that magnitude was crying out to be respected.
Now take a look at Screenshot-146 (above), another tactical supply and demand indicator. ROLLINS is shown first in daily format to illustrate that the indicator was not fooled by the stampede into the Wednesday all-time high. The daily chart was signaling the irrational and stampeding price rally was likely a trap, and for those that bought the top as the animal sprits were high there are likely some uncomfortable days ahead. ROLLINS is shown in this format with the S&P-500 in the lower panel as opposed to being overlaid. This family of mostly derivative based indicators are superb futures trading tools on shorter time intervals, hence the term “tactical” indicators. The green up sloping lines on the chart illustrate how this indicator often leads the price at bottoms, and it is even more accurate on shorter intervals.
Please look at ROLLINS now in Snapshot-147 (above), which is shown in weekly format. Once again the negative divergence at the February top is shown with an aqua down sloping line, and like SAMMY the magenta line shows that in terms of the indicator the price rally has never been confirmed by the derivative universe of risk management tools, a universe which is constantly evolving and growing. So TATY, SAMMY, ROLLINS and other indicators not shown have been warning that perhaps not all is well with the price rally. If the bull market died on Wednesday on an irrational parabolic rise into the high, then these indicators will have served us well by warning us not to chase the rally. If the bull still lives, and is just taking a break to recover from fatigue, and re-invigorate demand, then we will likely be served up a less risky entry to put some cash to work. September and October are traditionally the worst months in the calendar, and with an election looming, and these supply and demand indicators not confirming the new all-time highs, then investors should expect an environment with a potential for rising volatility, perhaps extreme volatility, given that the VIX punched over 30 already this past week.
Please stay safe!
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