The Real Selling Has Not Started…Yet

May 29, 2010

After a rollercoaster-like ride, the S&P500 finished the week essentially unchanged.  Volume was heavy.  The VIX (or fear) index fell off, but still closed the week at an elevated level that suggests that traders and investors are worried.

Last week’s economic data were not strong–further implying that the consensus V-shaped rebound in the US economy is not only failing to materialize, but also that there is now a growing chance that the economy will slip back into recession. 

Existing and new home sales were higher than expected, but only because of the government tax credit, which has now expired.  More ominous for the housing industry, inventories of existing homes soared; this will now put even more downward pressure on home prices going forward.  Durable goods orders were stronger than forecast, but without transportation orders, they were weaker than anticipated.  Inital jobless claims were worse than expected.  Q1 GDP was revised down to 3.0%; economists had expected it to be revised up to 3.5%.  Personal spending came in flat; it was expected to rise 0.2%.  Personal income also disappointed.  Chicago PMI was loser than forecast, but consumer sentiment was better.

The technical story for the S&P is very interesting now.  Since the beginning of May, the charts–on a daily basis–have drawn out a bearish cascading pattern.  Not only are prices pointing downward, they look like they are falling off a cliff. 

And the spiking VIX together with the surging volume only add validity to the price drops.

But counterintuitively, prices are likely due to bounce back for a while–at least to their 200 day moving average, and even to their 50 day moving average.  This means that the S&P can crawl back up to 1100 and even to about 1150 without breaking the newly established downtrend.

How long will this rebound take?  It can easily consume much of June, which begins next week. 

But then–later this summer and into the fall–the real fun begins.  These 50 day and 200 day moving averages will now act as a ceiling, or resistance, to price rises.  If and when the S&P moves toward them, new selling will likely kick in and push prices back down away from these critical levels.

And once the rebound runs out of steam, the move back down will slow when it reaches about 1,050 on the S&P–the lows hit in May.  If these lows are broken, then the next move down will likely break 1,000.

All of these down drafts can be accelerated if more unanticipated bad news breaks in Euroland or anywhere else in the world.  And given how overbought equity prices were over the last three months, the rush to sell could be dramatic.

Owners of equities, seeking to preserve recent gains, and speculators seeking to benefit from a sell-off by shorting, will rush to sell.  This rush could turn into a stampede, reminiscent of the May 6 flash crash.

The difference this time?  It’s very possible that prices will not snap back.  They could plunge–in a day or two–and stay there. 

Technical analysis is sounding an alarm.  Be prepared.

Two Legendary Investors, One Piece of Advice

May 23, 2010

Equity markets stumbled badly last week.  The S&P500 lost 4.2% and it could have been worse.  Volume was high–confirming the validity of the sell-off.  And the VIX (or fear) index soared to late 2008 and early 2009 crisis levels.  Investors (and traders) are running for the hills, and they may not be done selling.

While it wasn’t the primary reason behind the selling, most of the economic news was poor.  The Empire State manufacturing survey came in well below expectations.  Housing starts were solid (but only because of the now expired tax credit); but housing permits–providing a clue of what lies beyond the tax credit stimulus–were dismal.  Producer prices and consumer prices were generally lower than expected, suggesting that inflation (in goods and services, as opposed to financial assets) is showing no signs of strengthening.  Initial jobless claims severely disappointed by rising to 471,000, when they were expected to fall to 440,000.  Leading indicators and the Philly Fed survey both missed to the weak side. 

The economy is showing signs of slipping, precisely when the inventory boost to GDP is waning and the fiscal stimulus is fading.  It does not seem that economic growth is poised to increase as many forecasters had hoped by this stage in the so-called “recovery”.

Technically, the S&P500 is somewhat oversold on a daily basis.  It would not be surprising to see a bounce back next week or the week after.  But the S&P is still overbought on a monthly basis.  The breakdown that began three weeks ago looks like it has barely begun.  On the monthly charts, there appears to be much more downside risk over the next one to two months.

Legendary investors Seth Klarman, the founder of the Baupost Group, and Mohamed El-Erian, the CEO of PIMCO, recently updated their outlooks on the global economy and markets. 

Mr. Klarman, who expressed an extremely bearish viewpoint in The Atlantic almost two years ago, told a group of CFA’s at a conference in Boston that he is “more worried about the world, more broadly, than [he has] ever been in [his] career”. 

Mr. El-Erian, in an interview on CNBC last week, asserted that the world’s leaders, especially in Europe today, are still not comprehending the fact that the core problem for many nations is a solvency crisis, not a liquidity crisis.  Many nations are at risk of going bankrupt due to overspending and overborrowing; they are not merely short of cash–temporarily.

But remarkably, both said something very similar about what investors should “actually do” now to prepare for the upcoming turmoil.  Both said that investors should do nothing today, except prepare a list of companies they’d wish to buy–at much lower prices. 

They both said that the challenge will be to remain patient, for a while.  But when the panic sets in, having the carefully prepared wish-list ready will allow investors to do what almost no other investors will be able to do–BUY when everyone else will SELL. 

Have you prepared your wish-list?

Technically Speaking

May 15, 2010

The S&P500 rebounded 2.2% last week, but most of the bounce came on Monday (on low volume), while losses resumed on Thursday and Friday (on higher volume).

Last week’s economic data were mixed.  The US Treasury budget for April came in well below expectations.  In fact, at -83 billion dollars, this was the worst April in the history of the US.  Even in 2009, during the depths of the recession, the April deficit was only 21 billion dollars.  Jobless claims remain at the recessionary mid-400,000 range.  The 30 year Treasury auction was a little scary–rates were higher than anticipated and Direct Bidders were at a record high level.  If the Federal Reserve wants to “support” prices while massive supply continues to pour into the market, then this would most likely show up in a higher Direct Bidder take down.  Retail sales were better than expected, but when auto sales were stripped out, they were worse than expected.  Industrial production rose more than economists had forecast.  And consumer sentiment was lower than anticipated.

Let’s review some technical data in more depth than usual.

First, as mentioned already, there’s been a persistent pattern–over the last year–with volume.  When prices rise, volume falls.  When prices fall, volume surges.  This is not at bullish sign; it certainly does not fit the pattern seen in most bull markets.  It does, however, make sense when one considers the Fed-fueled liquidity injection boosting all asset prices over the last year. 

The VIX (or fear) index has made a decisive turn over the last three weeks.  Volatility is surging, and this also does not bode well for stock prices.  As investors increase hedging and pay more for the privilege of doing so, they will help cause the very thing they’re buying insurance against:  lower stock prices.

The basic price charts in the S&P are also pointing to the strong possibility of a major turning point.  Prices literally collapsed the week ending May 7–slicing through both the 50 day and 200 day moving averages, which is a bearish development.  And last week, as valiantly as they tried to rally, the recovery reversed course–badly–by the end of the week.  This suggests that the price breakdown that began at the end of April is strong and fully intact.  More worrisome is the amount of “open air” still left beneath current prices and longer term support levels.  Prices rose to such overbought levels since February that they–like an overstretched rubber band–can snap back much more severely than they have over the last three weeks.

A sentiment indicator–the S&P500 Bullish Percentage Index–is still at generally optimistic levels, closer to levels we saw in mid 2007.  It is nowhere near the lower levels generally associated with a scared, pessimistic and oversold market.  This also suggests that prices have more room to fall.

How about the broader distribution of stocks within the S&P500?  The percent of firms above their 200 day moving average (a very common indicator of long-term trends) quickly jumped above 80% by July 2009–and stayed there essentially until last week’s crash shoved it down below 80%.  This implies that stocks across the board are breaking down and could be poised for more price drops.

Putting it all together, it’s easy to conclude that a major caution signal has lit up.  While these technical data do not–yet–sound the red alert warning, they do suggest that anyone who’s been riding the rally for the last year ought to be careful.

If this breakdown continues, the charts are signalling that there’s a lot of room for prices to fall.  And over the next two to three weeks, we’ll learn how accurate these warning signals actually were.

Uh, oh….a Crash

May 8, 2010

Last week, the S&P500 suffered the inevitable downturn.  While it fell 6.4% for the week, it fell about 9% for a few moments during one trading day–May 6.  Volume shot up, confirming the price drop.  And the VIX (or fear) index exploded up 86%.  The world rushed to get out of risk assets, and the selling may not be over.

The macro data were mixed, as usual.  While personal spending rose more than experts had estimated, personal income rose by less than they had forecast.  Average earnings were flat for the month of April; they were expected to rise.  It’s becoming clear than consumer spending over the last few months rose because people reduced saving rates and spent government refunds and unemployment checks.  Clearly this is not sustainable.  ISM Manufacturing was weaker than expected.  Factory orders were stronger.  ISM Services was weaker than the consensus forecast.  Initial claims remain in the mid-400,000 range.  Non-farm payrolls rose 290,000, BUT what the mainstream media will not tell you is that 188,000 of these jobs were assumed into existence via the BLS birth/death model and that 66,000 of these jobs came from census hires which will soon disappear.  The headline unemployment rate rose to 9.9%.  The broader U-6 unemployment rate rose to 17.1%.  And the number of people unemployed over 27 weeks rose to another post-WWII record high.

So what caused the stock market to crash on May 6?

No, it wasn’t a fat finger–a trading error where someone mistakenly sold a billion shares of something rather than a million shares.

And it wasn’t computerized high frequency trading in the way that everyone believes:  prices were OK, until some rogue programs went nuts and caused selling to explode and shove prices downward.

Instead, the WAY in which computerized trading caused the crash has to do with their forcing prices UP over the last 12 months (and before that, from 2005 to 2007) to unrealistic levels.

How did they do this?

Let’s use an analogy.  Imagine a housing market comprised of 100 identical homes in a small self-contained community.  Let’s assume that there are virtually no commissions or other costs that make the buying and selling of homes more costly.

Let’s assume that most owners in this community aren’t selling their homes; they’re owners who want to hold on to them.  So the price of all of these homes gets set on the margin; one very recent sale, sets the price for all the other, 99, homes.  And the last selling price (the comp) was $100,000.

One day, a computerized buyer (Machine A) enters the market by acquiring one home for $100,000.  If the next week, another computer, Machine B, bids $110,000 for this same house, Machine A sells and books a profit of $10,000 (or 10%).  In the following week, Machine A returns to bid on the SAME house for $120,000.  Machine B sells; now it books a $10,000 profit.

This back-and-forth continues until the last sale price hits $200,000.  And voila, it looks like ALL the houses in this community are now worth DOUBLE the original $100,000.  In fact, the non-participating neighbors are ecstatic; at the very least, they have no reason to complain.

Then one day, a new prospective owner decides to move into the neighborhood.  And this owner buys the SAME house from the last machine for $200,000.  After all, the market is “hot” and that’s what homes are going for.  And there are plenty of comparable sales to “prove” it. 

The machines have left–each having booked profits of $50,000.  But the new owner is left holding the bag.


Because some day–and nobody can predict exactly when–one or more of the other 99 owners in the community will also try to sell.  And believing that the prices of their homes have now doubled, they will “ask” at least $200,000. 

But there will be no machines anymore to artificially prop up the price.  Some owners may actually sell for $200,000.  But other homes will sit on the market unsold, as outside buyers worry that homes are being offered at prices above their intrinsic value. 

Sale volumes will fall.  Other owners, worrying that the new high prices may not last, will rush to place their homes on the market, until finally a desperate seller capitulates and accepts “only” $180,000. 

Then all hell will break loose.  Sellers will feel the pressure to lower their asking prices to say, $180,000.  Buyers, smelling blood, will bid even less than $180,000, until eventually the prices return to $100,000, or even LESS because prices tend to over-correct.

Who wins?  The machines. 

Who loses?  All of the owners who bought at prices above $100,000.  Arguably, the owners who did nothing through the run up and the crash also lose, because their “market” will be perceived as unstable, rigged and unfair.  So future buyers will tend to stay away for many years after the crash.

Welcome to the current American stock market.  And brace yourselves for more “Uh, Oh” moments.  Make no mistake, they will happen again.

Greece Will Default

May 1, 2010

Finally, the S&P500 showed some signs of stress.  The index fell 2.5% last week on rising–and thus confirming–volume.  Also confirming the move was a 33% surge in the VIX index.  Market traders suddenly bought a lot of insurance to protect against a further downside move in equity prices.

The economic data were mixed.  Consumer confidence rose, even though most of the reason behind the rise was the increase in stock prices.  Initial jobless claims were slightly worse than expected; and at 448,000 they are stubbornly remaining in a range that is associated with recessions–anything above 400,000.  First quarter 2010 GDP (the first of several readings), at 3.2%,was slightly below expectations; and half of this growth came from inventory building, not final demand growth.  Also, it is significantly lower than Q409’s final reading of 5.6%, suggesting that the government-generated economic rebound is rapidly slowing.  Both the Chicago PMI and Consumer Sentiment came in above expectations.

Technically, the S&P is still in extremely overbought territory–despite the 2.5% retreat.  This is especially the case on the weekly charts.  On the daily charts, the S&P has turned bearish.  It’s pointing down and a total pullback of 5%-10% is the least that can be expected to unfold over the next several weeks.  Such a correction would only bring down the overbought indicators to a more neutral level.

What was the spark that led to last week’s decline?

Simple.  Greece will default on its sovereign debt.

To be polite, politicians may not call it a default; a restructuring would be a less distasteful term.  And Greece may not default next week or even next month; still, at some point in the future, it will.

Last week, the inevitability of a Greek default started–and only started–to sink in.  Harvard economist and Ronald Reagan’s Council of Economic Advisors Chairman Martin Feldstein stated the obvious:  “there simply is no way around the arithmetic implied by the scale of deficit reduction and the accompanying economic decline; Greece’s default on its debt is inevitable.  In the end, Greece, the eurozone’s other members, and Greece’s creditors will have to accept that the country is insolvent and cannot service its existing debt.  At that point, Greece will default.”

But the real source of concern isn’t merely the issue of Greece’s credit risk; Greece, after all, makes up only about 2% of the Eurozone’s total GDP. 

The real source of concern–and eventual source of panic–is the threat of contagion.  Even before Greece actually defaults, the risk that other PIIGS (and their banks) could also default will grow.  In fact, judging by their surging interest rates, the risk of contagion is already growing.

This means that as Greece topples, Portugal, Spain, Italy, Ireland, and then eventually the UK will also face the strong possibility of “restructuring” their debts. 

This could be the next Lehman moment.  Markets–in almost all asset classes–would sell off sharply.  The US dollar and US government debt would probably rally. 

Time to order the popcorn and enjoy the show.