THE BOTTOM LINE
A decline began last week, which may only be destined to reinvigorate demand in an ongoing bull market, or it may morph into something which causes us to not be comfortable with the rising risks of owning equities. It is tough to break a Santa Claus rally and It is too soon to tell, but it is not too soon to reacquaint clients with the “herding” (read below) psychology in our DNA, which drives bull and bear markets. We are carefully monitoring the stock market for signs of rising risks, which may be become beyond our comfort level. If those signs continue to appear, then we will be compelled to act more defensively in the near term.
The stock market does not like uncertainty, and recently the number of items for investors to fret over has grown to a virtual laundry list of uncertainties from geo-political stress over 94,000 Russian troops on the Ukrainian border, to China feeling it’s oats in the South China Sea, and speaking of China, recent articles have detailed that the real estate crisis there has larger financial implications than the real estate debacle here in 2007-2009. Then there is the new COVID variant, which apparently is highly infectious, but little else is known this early in the discovery process, so It may take a while for the markets to “discount” the potential economic impact. And, then there is the Fed and inflation, about which the stories revolving around inflation are tending to be a moving target, and these are just a few of a growing list of uncertainties.
Unfortunately, we do not have a crystal ball in working order, so we do not know how the stock market may adjust prices to reflect all these uncertainties, but we do have many supply and demand based indicators, which do a really fine job of objectively measuring the shifts global variables can cause on the ever changing balance of supply and demand for stocks. Lowry Research began tracking the balance of supply and demand in 1937, and their approach has proved effective at keeping investors astride the stock market’s primary trend over the decades since. Our own work builds on their notions of how to calculate the balance of supply and demand, but we add an update to include modules, which account for the impact of modern-day derivatives on the over all balance of supply and demand, since the utilization of derivatives to manage risks has grown dramatically in recent years.
The budding decline continued this past week, and the popular stock indexes finished the week near, or on new lows since the decline began. Given the current status of an array of indicators, the decline is likely to continue, but interspersed with some intervening powerful rallies, which will likely be short lived, until the arrival of some evidence of resurging demand. We recently observed that 90% downside days occurring near all-time highs are usually viewed in the context of a kickoff to a correction, as opposed to an element of a panic bottom in the making. That appears to be the case now that the price has made new lows after a brief relief rally following the 90% downside day.
At this point we do not know if the stock market is just taking a breather to reinvigorate demand after driving historic norms of bullish sentiment and valuation to absurd levels never seen, or if this budding decline may turn into a more serious correction, or worse, to counter the outlier levels of bullish sentiment and valuation. However, the weight of the evidence currently favors more decline, and rising volatility. And, the deeper the potential decline, the more favorable the probabilities are for the occurrence of powerful, and perhaps violent relief rallies, short lived though they may be. Volatility as measured by the VIX has already moved from the mid-teens to nearly thirty, and that number is likely to rise, as we have warned investors frequently in these weekly updates.
Herd Mentality of Markets Explained
Bull markets have aspects of self-reinforcing mechanisms, as they seem to never stop going up. As they develop, a fear of missing out on the rally builds to a crescendo, even as valuations reach more and more expensive levels. However, the dips along the way tend to keep getting more brief, and often more shallow, and the rally continues, and with it bullish sentiment extremes are reached, and then exceeded. Buying becomes like a viral fever, and the market becomes even more expensive, but the psychology of missing out overrules historic definitions of expensive, because as everyone comes to believe “it’s different this time”. Then comes a nasty and deeper break in the market, but it is doubted, and after a while the market appears to steady itself, and then gives way to a powerful rally, sometimes a violent rally, but alas it does not have legs, and then falters as it approaches the previous high. By now the bullish sentiment fever has returned, and all appears well, but it is often a trap.
The rally stalls, and begins to roll over, even though the news, and the economy are still good. The decline becomes more persistent, and at some point the “herd” recognizes that “the party is over”, and by now interest rates have likely risen, giving rise to what is billed as a “safe” place to park wealth. Now the bull has a viable competitor, and bonds rally as money leaves stocks going into bonds in a “flight to safety”. The decline accelerates into panic selling, as the weak hands are now not the only victims being purged from the stock market. Stocks begin to gap down on the open, and orders come in to “just get me out at any price”, and the selling becomes a panic driven rout, as the last holdout bulls finally begin to capitulate.
A dead cat bounce rally develops, but it fizzles, and the price begins to probe new lows, but under the radar some brave souls begin to scoop up perceived bargains, even as the price continues lower. Then the market becomes relatively quiet, volatility subsides, and eventually a rally develops only to fade into another decline, which stops above the previous low, and then begins to rally again in an environment where valuations have now become “cheap”, and bearish sentiment is as dark as midnight. The rally persists and grows more vigorous, perhaps even including a 90% upside day(s) then the “herd” recognizes it’s a new bull market, and the psychological trip from bull to bear back to bull has been completed, as a newly minted bull is just getting underway.
This description, or most of the elements of it, have been happening ever since freely traded markets have existed. The psychology driving it is in our “flight or fight” DNA, so we will collectively “herd” in our behavior, and the “herd” will always play out its role the same way over and over, from generation to generation. The key is to have the tools to know where one is on the psychological financial journey, and the courage to not run with the “herd” at the turns, when the sentiment, bull or bear, is most extreme.
If you read the above carefully, then you will probably have at least some fuzzy notions about where we may be in the never-ending market psychological journey. Here is a hint: valuations and bullish sentiment have never been higher, nor the sovereign debt of nations, and many corporations! The challenge ahead is to objectively measure the ever-changing balance of supply and demand for stocks in order to properly evaluate the risks associated with the stock market.
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 marginally below the caution zone at 114.
The down sloping magenta lines on the TATY chart, and on the Premium/Discount part of the indicator in the lower panel, did accurately warn of the current decline, as the price was still touching new all-time highs. With the Premium/Discount part of the indicator so far below the minus eight level (horizontal red line), the implication is that the decline likely has more to go. The Premium/Discount portion of the chart often develops a huge positive divergence to the still declining price before the price turns up. The price often continues to decline until the Premium/Discount indicator approaches and/or touches the green horizontal line at the minus three level. Given that both TATY, and the Premium/Discount indicator are both still declining, then it is likely that the budding correction has more to go, which may disappoint the “buy the dip” crowd, which has become conditioned to buying brief and shallow declines.
TATY rarely declines below the 90-100 level, but if it does, then it would be a sign that this budding correction may turn into something more dangerous.
SAMMY — A REPRESENTATIVE OF A FAMILY OF TACTICAL SUPPLY AND DEMAND INDICATORS
SAMMY is shown above in yellow with the S&P-500 overlaid in red and blue candle chart format.
After negatively diverging with the all-time high achieving price, and persistently negatively diverging with its all-time high made at the February 2020 high (not shown), SAMMY did correctly foreshadow the current decline in the price (down sloping dashed magenta line). The subsequent swift decline in SAMMY has been nothing less than breath taking, suggesting underlying weakness in the forces guiding the price. Until there is evidence of resurging demand across a number of indicators, and possibly a developing positive divergence in SAMMY, then the benefit of the doubt will go to potentially more price decline in the offing.
STERLING — A PROTOTYPE REPRESENTATIVE OF A NEW FAMILY OF SHORT TO INTERMEDIATE TERM TRADING INDICATORS
STERLING is shown above in the top panel with the S&P-500 eMini futures contract in the lower panel. This prototype is among over two dozen being tested for their trading effectiveness, and may not be among the survivor indicators, but so far is doing very well at painting out “island” buy signals, and/or positive divergences at tradable bottoms, and more importantly significant negative divergences at tradable tops. Tops of any degree are extremely difficult to diagnose in real time, hence the real value of the STERLING family of indicators.
STERLING did a good job of negatively diverging with the price as the price approached its most recent all-time high (down sloping dashed magenta line), and please notice that STERLING even struggled to get back to its middle Bollinger Band as the price touched it’s high to date. Also, please notice in Screenshot-468, a weekly chart of a different version of STERLING, that the negative divergence was even more pronounced, and the red down bar crossed the middle Bollinger Band as the price was peaking out. If the price is in the early phase of a new bear market, then these two charts will have called the top as it was happening, which is potentially very profitable information going forward.
At this time there are no positive divergences under construction, which implies the decline remains in its early innings. Screenshots-469, 470 and 471 are the S&P-500 cash index on a daily and weekly basis for your additional information. Please observe Screenshot-471 gives a longer perspective on the S&P-500 going back to before the important March 23, 2020 low. A close below the up sloping red trend line would be a big negative, and would suggest a change in trend was likely underway. Investors should expect the bulls and bears to fight out a “Gettysburg” like pivotal battle over this important support line for the rising bull trend. So, the zone between the all-time high at S&P-500 4743.83 made on November 22nd , and the rising red support line will be important in determining, if the bull market is to remain intact, or a new emerging bear market is in its early stages.
Please be safe!