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April 30, 2010

Thoughts on the Intermediate Trend

“It’s different this time.”…. those famous last words carved into the headstones of thousands of lost investors of decades past. While we desire never to be caught with those wordsleaving our lips, in truth every market cycle has something different than the previous. Equallyimportant, each market cycle shares similarities to one or more past bull or bear markets. Underthat pretext, to best understand the current market we should consistently ask ourselves; how isthis market environment similar to past markets and how is it different?I thought it prudent to step back and re quiz myself on the above when I came to realizefrom current readings that, after sixty weeks of advance resulting in a gain of over 80% in thebroad market, almost every market strategist and technician I know is bullish. In some caseswildly bullish with comments like “…any market correction must be at least a year away” and “themarket is nowhere near a top”. …Wow. Now, I like bull markets, especially this one, and I hope itwill continue. But, I am at heart a contrarian. So when I see a crowd leaning too far in any onedirection, with growing enthusiasm, I cannot help but search for a counter argument to forewarnand forearm myself against the surprised stampeding herd.Many of the arguments for further market gains rest in historical norms of indicators used bystrategists for decades to measure the health of a bull market.Traders Narrativeproduced a wellwritten article that encompasses most of these indictors. In brief, the bullish arguments include:1.The AdvanceDecline Line is at new highs, and it always declines before a Bull market high.2.The percentage of stocks above their 50 day and 150 day averages is high, showing fullmarket participation in the rally.3.The number of new 52-week highs continues to expand and is stronger than any time since1982! Here, too, this indicator should begin to contract months before a market high.4.As long as small cap stocks are leading, the market is in fully bullish mode.5.Historical measures of supply and demand are too bullishfor a market to peak.6.Breadth is more bullish than at any time in the last twenty years.For the most part, the above are different measures of breadth. It is true that historicallymany, if not most bull markets peak after a prolonged period of breadtherosion. However, not allbull markets end so gracefully. What I will present in these pages is a basis for why it may beunwise to expect a graceful end to the current rally, and why market strategists should not beenthusiastically expecting the market to continue higher until sometime after their indicators havewarned of its potential demise.

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9How is this market different than past markets?

When I first spoke of the coming secular bear market in the very late 1990’s, a period whenan investor’s idea of diversification was owning Intel, Cisco, AOL and Akamai in three differentaccounts, I was greeted with the verbal equivalent of tomatoes. I believe by now we can all agreethat the current environment is very different than a secular bull market. Oureconomic growth isfragile and our markets are not experiencing a prolonged period of earnings and P/E expansion,driven from an historical low base, as required for a multi decade advance.Our current market is also not driven by typical business growth. Yes, the percent returnsof fundamental valuations are up from last year’s very deep trough, but still far shy of past yearsand the levels needed to support employment growth. (The Fed is not keeping rates low forentertainment purposes.)The gorilla in the room is the Federal Reserve. We all know this cyclical bull market isliquidity driven. Theunprecedentedlevel of U.S. and global liquidity pumped into the economymake this cyclical bull market “different” than the bull markets that ended in 1929, 1968, 1987,2000 or even 2007. As the dissenting FOMC Governor Thomas Hoenig is trying to warn,somehow somewhere, excess liquidity always finds its way into the markets. We have seenthis inJapan since 1993as each cyclical bull market is fueled by a new round of quantitative easing, thencomes to an abrupt halt. The same can said for China’s Shanghai Index,which advanced 108%from October ’08 to August ’09.

As a side note

: After a 108.76% return off its October ‘08low, the Shanghai Index is off about 18% from its August ’09 high and has struggled in a roughly sideways pattern sincethen.While many investors view the weak performance as a leading economic indicator for the US,another possibility is that China’s equity market is enduring the same “investor rotation” as did theUS market in 2000. Readers may remember that US equities peaked in 2000 as the internetbubble burst,and the investment of choice switched from equities to real estate. Money flowingfrom the equity market drove the real estate bubble higher for another five to seven years(depending on your local). Although the US economy did experience a relatively minor recessionfrom March through November 2001, it wasn’t until the real estate bubble burst that the economyfell into the current Great Recession. With China’s rising real estate pricesand declining equities,it appears to me that a similar scenario is unfolding; money is simply moving from equities intoreal estate. But, that is a discussion we can detailat another time.

How is this market similar to past markets?

If wedefine the current environment as a cyclical bull market within a secular bear trend,what are the similar time periods with which we can compare?Certainly, Japan’s equity market from 1992 is filled with liquidity driven cyclical bullmarkets to which we might compare the current market rally. Unfortunately, we have very littledata other than price and volume. Thus, almost all we can say is Japan’s bull marketsduring the

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90’s averaged about 50 weeks with 50% returns. But here, I would note that the tops of theserallies were consistently an inverted “V”, not the rounded tops of which most current marketparticipants expect. The inverted “V” tops suggest there was very little warning, if any, of thechange in trend.Nikkei 225 1990-2003 WeeklyWe might also look at the US market during the previous secular bear from 1968-1982.Here, a simple examination of the Advance Decline line shows an environment nothing like whatcurrentmarket participants expect. Remember the Nifty Fifty? Market breadth peaked in 1959and fell precipitously from January, 1966 to January, 1975. It should also be noted that the cyclicalbull market peak of September, 1976 was not preceded by a top in the Advance Decline Line. Tothe contrary, the Advance Decline Line peaked in July, 1977, ten months later. Since the AdvanceDecline Line is a measure of breadth, we can conclude that breadth did not behave in a “typical”manner for an entire decade of the last secular bear market, and could not have forewarnedinvestors of the cyclical changes in trend. That alone should question what we currently perceiveas normal behavior for some indicators. But, this empirical evidence of “abnormal behavior” is just a side note compared to more recent and pertinent data.