What Is Not Seen

Well, almost.

Im currently on vacation in Paris, with limited internet connection I thought it be appropriate to comment on the recent market development.

The Dow Jones Industrial Average is by many seen as the back bone of the U.S economy. Looking at the “leading” blue-chip stocks today, they all seem quite tired. With the Dow down 9.4 % so far this month, we have to go back as long as to the Great Depression for a larger intra-month drop in June.

I have on many occasions mentioned the Bullish percent indicator, an indicator (contrarian) that gauges the current level of risk in the market, and has a great track record. On the 19th of May I wrote in “A Stock Market Correction” that we were in for a correction. The same date the Dow Jones index peaked at 13136.69 and the bear market rally was clearly over. Since then the index has plunged13,63 % to 11346,51 today.

Soon after the peak, the Bullish percent indicator switched to a column of “O’s, indicating that demand, once more had weakened and supply was taking over. At the moment we see the NYSE Bullish percent stands at 38 %, meaning that only 38 % of the stocks in the index is experiencing some positive momentum.

This development was also captured by the VIX index that some market analysts like to keep an eye on. The VIX index measures investors risk appetite by deriving 30 days expectations on market volatility from option prices. Since the middle of May we have seen a steady increase in the index, moving almost inversely to the broader market indices.

According to the often cited maxim, we are in a official bear market when stocks have fallen by 20 %. Even if we technically are not there yet, its only one tick away. Since the absolute bull market peak in October 9th last year when the Dow hit 14164.53 stocks are down 19.9 % of today.

However, official or not, there should be no doubt that both the U.S economy and the stock market both has been in a clear bear market for some time now.

Kieran Kelly, a derivatives expert, has done some very interesting work regarding the workings of the law of large numbers, and its implications for financial theory. By studying the impact of the reverse of the law of large numbers, he delivers a devastating blow to the almost omnipresent efficient market theory. From a FT article we read that:

The reverse of the law of large numbers, as its name suggests, describes the reverse effect of the law of large numbers, which crops up everywhere in the fields of mathematics, physics, engineering and the social sciences. Put simply, the law of large numbers, or LLN, says that the larger the sample, the closer the average will approach to the expected average. Rolls of a die, for example, fluctuate wildly around the expected average of 3.5 in a small sample, but converge on the average as the sample size increases…

…In his work Mr Kelly addresses what happens to the balance of expectations when so-called rational independent entities start copying each other. Since copying reduces the independence of individual entities, Mr Kelly designed an experiment to see what happens to the balance of expectations when the LLN goes into reverse and individual behaviour starts to merge into group behaviour.

The experiment focuses on a number of individual entities who are faced with a choice between two equally likely options – the market will go up or the market will go down. Given that the future is unknown, in an unbiased market, the likelihood of the next move should be a 50-50 bet.

“We first examined what was the most probable outcome of expectations when a large sample was all acting/choosing independently,” says Mr Kelly.

“Then, we gradually reduced the number of individual entities by allowing first one individual to copy another, then two individuals to copy a third (or one to copy another and a second to copy a different other) and so on. This progressed step by step to the ultimate extreme of everyone copying everyone else, so the market as a whole is acting as one.”

They found that as individuals move toward herd behaviour, the probability distribution changes from the normal bell curve, with expectations clustered around the 50/50 level, through a tipping point, where there is an equal likelihood of a balanced or unbalanced market of expectations, to a position where a market is almost certain to be unbalanced in its expectations. At this extreme, the whole market has the same view, so the balance of expectations is polarised one way or the other.

Austrian economists have already provided lots of counterexamples and, economic reasons why the efficient market hypothesis is deeply flawed (read more).

The work of Mr Kelly adds an additional dimension to this criticism. The idea of the reverse law of large numbers, provides insight how real market agents act and interact, contrary to the efficient market theory. By themselves, recent market bubbles should be evidence enough, that phenomenon such as herding- and crowd behaviour is present in determining asset prices.

Mark Faber in a Bloomberg video today, says that the Friday market sell-off was not over done, but was merely a delayed reaction to the fact that the U.S. economy is already in a recession. The rally since mid March has been baptized a “Sucker Rally”. I agree with Mark that equities are over valued (both from a technical point and a fundamental point ).

Also, recently, Relative Strength for stocks over bonds, measured by S&P 500 and Dow Jones Corporate Bond Index, have turned south for stocks, signaling weakness ahead.

My good friend Stefan Karlsson has a great post on current stock market valuations, where he cites my recent post on Stock market corrections. From an earning perspective, Stefan refers to the historical high levels of earnings relative to stock market prices, that we see today.

Take a look at this chart, which show the same chart as in Gregory Mankiw’s original post: the 10 year P/E moving average, together with the Dow Jones Industrial Average, over the last 100 years!

This chart can also be seen in Fari Hamzei’s book: Master Traders, and found on Tuttle Asset Management LLC website.

We see that over the last 100 years, the Dow Jones Index has experienced 3 major consolidation periods, with each lasted on average about 16 years. Historically, the length of the these periods have been in direct relationship to the length of the preceding bull markets. Before each consolidation period ended, the 10 year P/E ratio had fallen below 10. Not until the 10 year P/E once agian reached higher levels, above 10, would a new bull market begin.

The latest bull market lasted more than 17 years, from Oct. 1982 to Jan. 2000. Currently, the 10 P/E has been decreasing for 5 years, ever since the dot-com crash. With current levels above 25, it should be safe to say that the stock market, also from a fundamental perspective, is over valued. Do the math!

On March 10, major U.S. stock market indices like S&P 500, Dow Jones Industrial Average, and Nasdaq, all reached there respective lows after the last stock market sell off. Since then, stocks have rallied, with S&P 500 up 11.94 %, Dow Jones up 10.62 % and Nasdaq up 16.57 % .

While some people seem to believe that we now are “out of the woods”, I strongly think that the economic troubles so far are only getting started.

For the stock market, we should expect a correction soon. For guidance, I turn to my favorite contrarian indicator, the Bullish Percent indicator. This indicator tells us how many percent of the underlying stocks of an index that are showing there first Point & Figures buy signal. At present, this gives us a way of gauging if stocks at given prices are over bought, and hence are likely to correct.

A reading above 70 is red alert for stocks, should they start declining. A reading below 30 in the Bullish percent is a good opportunity to buy, as only a small amount of additional money entering the market will push up prices.

Since the stock market started to increase, investors and asset managers have successively increased their exposure to stocks. This was captured by the bullish percent. Looking at Bullish percent for New York Stock Exchange, and for S&P 500, we see that the index reversed up into a column of X’s in the final weeks of March.

Now 40 days into the bear market rally, the Bullish percent indicators have all begun reaching higher levels. NYSE Bullish percent are currently showing that 58 % of the index stocks are displaying buy signals, and are still rising. S&P 500 shows that 62 % of the stocks are experiencing positive demand. Dow Jones on the other hand have recently reversed down from 66 % to 60 %. Suffice to say, current levels should start to raise some concern.

Given the present economic conditions, many managers and investors are still cautious. This can be interpreted that a Bullish percent reversal at present levels could be as serious as a reversal above 70 in the past when over all economic conditions were better.

When it comes to the Bullish percent indicators i don’t like trying to predict the predictors. As likely as a reversal, more capital may enter the stock market pushing prices and Bullish percent even higher. Personally I look at the indicator, and only afterwards take the apropriate action.

Although, should we see further gain, let say NYSE Bullish percent goes to 65 or even 70, we can expect the correction to be more severe and longer lasting, when it eventually comes.

Relative strength (RS), the indicator of relative outperformance have been negative for stocks since early 2007. During this time, yields have headed lower, resulting in favorable conditions for bonds. Compared to the Dow Jones Corporate Bond Index, RS for S&P 500 turned positive in the last weak of mars continuing it’s up trend so far in April. Other recent market movers have been mixed. VIX, the volatility index has dropped from it highs of 35 in mars to under 23 on 7/4. At the same time conditions have worsen in the credit market with TED-spread at 1.29 and the paper-spread at 1.22, signaling caution.

An interesting fact is that, in James P. O’Shaughnessy popular book, What Works on Wall Street (1996), relative strength is found to be the only reliable indicator for growth. How this will play out for stocks in the near future, still remains to see.