Over the past 7 weeks, stocks have moved lower in a relatively calm, and controlled manner with small daily losses and the occasional oversold bounce higher. These oversold “dead cat bounce” rallies usually begin with a gap up in morning trade following higher overnight futures prices, but so far during this correction each and every short lived counter trend rally has been reversed in short order. Financials have been particularly hard hit and many of the banking stocks have entered into bear market territory. The overall markets are now well below their 100 day and 50 day moving averages.
This type of market action can be obviously be quite difficult for many investors and traders looking for a bottom to the interim down trend in equities because there are several factors at work which make “buying the dip” an ill advised strategy at present in my view. Volatile and violent “snapback” rallies are even more frustrating for short sellers who find themselves covering positions at a loss only to see their favourite short move lower during the following day’s trading.
In my opinion, there are three main factors at play currently in the equity markets. The first is valuation. Stocks are said to be cheap by most Wall Street banking houses who are more or less fully invested in all market climates from the long side for their wealth management and mutual fund clients. To brokers pitching clients a long only approach, there is always a bull market just over the horizon as these managers have the luxury of relative performance benchmarking against the index funds. If the market drops, the goal of these managers is to lose less than the index. In the long only manager’s view, the market always rises over the long term, so determining the absolute valuation of the stock market is futile and the main concern to these investors is buying stocks that are attractive relative to other stocks in the market.
For the rest of us, we don’t have the luxury of earning money whether the market rises or falls — if the market falls, we lose money. In the hedge fund industry, when the market falls we must preserve capital or we get fired. The basic idea for most investors is to “never lose money” and to be on the right side of the tape at all times. Valuations of the overall market are absolutely key because most stocks are at least 70% correlated to the movements of the overall stock market averages. During market corrections, most stocks fall regardless of valuations by about the same percentage as the overall market. This trend was evident in 2008, as liquidity driven margin selling forced people to sell stocks regardless of PE ratios, liquidation values, or growth rates — with margin debt returning to the mania levels of 2007, this type of forced selling may be happening again already to some extent. When looking at the valuation of today’s market, it is clear that on a longer term PE 10 (cyclically adjusted PE ratio averaging today’s price over 10 years of earnings) basis that the market is quite expensive presently at 23X 10 year average earnings. Robert Shiller argued this point quite eloquently on Tech Ticker, stating that the market is 40% overvalued and that it’s “not different this time.” So for the first main factor driving equity prices, we have to score one for the bears — most stocks are expensive on an absolute valuation basis.
The second factor that will decide the direction of equity markets in the coming weeks is the technical picture of the major index funds. Traders and hedge fund managers pay particular attention to the 200 day moving averages. Many famous trend followers use only the 200 day moving average system to invest in the equity markets. When the market crosses below the 200 day, these managers and traders sell out of the market entirely and go short the stock market in a mechanical fashion. Trend followers and systems traders like Bill Dunn, Paul Tudor Junes, Monroe Trout, and many others will be looking closely at the 200 day moving averages which was breached on Wednesday by the NASDAQ 100. The S&P 500 held the 200 day, however, so we have conflicting signals on the technical front for stock prices going forward but the market looks like it wants to break below these levels in short order. In other words the markets could easily crash if we finally do get a break below the 200 day as many HFT and systems traders will be unloading their long books completely and going net short on stocks here. Even if you don’t think technical analysis works, you should study the discipline because many other investors believe religiously in a technical or trend following approach and their actions will drive the prices in the markets over the near and medium term. So for the second factor driving equity prices, namely technical analysis, we are very close to receiving a major bearish confirmation on stock prices which we have not seen in over a year — the stock markets look to be heading below the 200 day which is resolutely bearish for equities. With that said, many other technical indicators are short term bullish because the markets are oversold on the RSI, MACD, and Stochastics. We are truly at a crossroads and I expect more whipsaw action in the days to come but in the end for stocks to head lower from here. Curiously, gold and silver look to be technically strong here so I would think a long gold and short stock trade would be advisable provided that the stock market breaks under that 200 day moving average of around $1254 or so on the S&P 500 — just about one per cent below Wednesday’s close. In the meantime, many investors will be buying stocks here as they are preparing for a major bounce from these technically important levels — we are truly at a crossroads.
Finally, the third factor that affects the direction of stock prices is the Federal Reserve. Since August of last year, the stock market has glided higher on a wave of easy money stimulus. Short sellers have been all but bankrupted, and there are very few bears left in the equity market. This is worrisome to me because the FED is winding up their QE program in less than two weeks and the backstop of stimulus will be gone from the market altogether. Many investors have argued that the Fed’s low interest rates and reinvestment of Treasury proceeds will result in a de facto QE3, but the bottom line is that without more Quantitative Easing, the Bernanke Put will be almost entirely out of the market. This is very bearish for equity prices over the medium term. Remember, however, that the FED will be in the market for the next two weeks and that we may see a sharp bounce from oversold levels before resuming a larger correction later this summer.
In conclusion, I believe that equities are fairly expensive, are flirting with a major technical sell signal, and are losing the “Bernanke Put” which has pushed stocks up some 26% from last year’s lows. I feel playing defence here will be very important and that value investors would be well served holding a higher percentage of cash than normal.
Business Insider Emails & Alerts
Site highlights each day to your inbox.