Blackers Blog

At the Edge of the Cliff

In my first posting on this blog-site – To Buy or Not to Buy (May 2012), I stated that I was expecting another 2008 global financial crisis type event which would lead to a collapse in financial markets. This would trigger a ‘flight to safety’ with Investment Funds ditching ‘risky’ assets and re-investing that money into US Treasury bonds, which would push up the value of the US dollar.

 

However I also stated that at that time, many financial markets were already oversold and I therefore anticipated a rally to occur before we entered the serious collapse.

 

Three months have now passed, and during this time many markets have indeed rallied, some by over 20%. This rally has been fuelled by three main elements.

 

Firstly there has been a lull in the bad news haemorrhaging out of the Eurozone, and with last weeks announcement by ECB president Mario Draghi of a new mechanism called Outright Monetary Transactions (OMT) designed to buy unlimited amounts of the bonds of crisis-hit Eurozone countries so helping to keep their interest rates down, allied to   this weeks positive ruling by the German Supreme Court on the legality of the EU’s 500bn euro bailout fund, it has allowed sentiment to improve and once again give hope that a long term solution has been found.

The bad news is that it hasn’t! This new scheme will only help their short term liquidity problems and does nothing to solve the real issues. Although we must give the EU authorities credit for their amazing ability to keep the plates spinning whilst doing absolutely nothing to solve the underlying issues. It really is politics at its very best.

 

Secondly, the US Federal Reserve has confirmed that the stimulus will continue with its recent announcement of more quantitative easing, or QE3. This has also reinforced investor’s belief that there will be a constant stream of cheap money to fuel the increase in asset prices and get us all out of jail.

This addiction to more and more stimulus to levitate prices whilst the underlying health of the financial system deteriorates seems strikingly similar to the downward spiral of a heroin addict, taking ever increasing amounts to achieve the same hit until their system can’t take anymore. Our financial system will likely go the same way.

 

Lastly and most importantly, prices rallied because they were very oversold. This may sound simplistic but it is at the core of how all asset prices move. Basically whilst all asset prices are in a trend (either up or down), they do not move in a straight line. They oscillate around the trend, with investors at times getting over optimistic and pushing prices up too high, and at other times getting too pessimistic and selling prices down too low, swinging like the pendulum on a clock from one extreme to the other.

In May we were at one end of that extreme and so a rally was pretty easy to predict, but where do we stand currently? Do we still have blue skies ahead or are the storm clouds gathering?

 

Well, there are a few things that are cause for concern:

 ·        The strength and duration of the move.

The chart below is of the S&P 500 Index (a broad-based index of US companies) and shows how the index has moved from 1998 to the present day.

 We can see that both the major peaks in 2000 and 2007 occurred around the mid 1500 level, and that this has become a zone of resistance (It’s important to realise though that this is an area of resistance not a distinct price level, and that therefore prices can push through this level or fail to reach it entirely before ‘topping out’).

 

 

 

We also know from looking at previous cyclical bull market rallies (these are shorter term ‘multi-month’ rallies within a longer term ‘multi-year’ bear market) that on average they run for almost three years before topping out, whereafter the bear market resumes.

We are currently at 36 months and counting so this rally is wearing very thin.

 ·         The extent to which technical analysis indicators are overbought or oversold.

I use a number of technical indicators to help me gauge things such as investor sentiment, momentum and relative strength. Almost all of them are either already into overbought territory or well on their way, meaning that conditions are ripe for a correction, and although there is nothing to stop these indicators becoming even more overbought in the short term, it does tell us that we are getting close to a peak.

 ·        Seasonal Factors

Many financial markets tend to be weaker from May to August, but the September/October timeframe is often the worst time of the year for stock markets.

 ·        Commitment of Traders (COT) data.

This information gives a breakdown of investors in the Traded Options market and classifies them according to certain categories - small speculator, large speculator or commercial, for our purposes we can think of the speculators as ‘mug punters’ and the commercials as ‘the professionals’.

What tends to happen is that as a rally matures and prices rise, more and more speculators get sucked in and join the bandwagon, buying traded options that profit if the price continues to rise (known as going ‘long’) - the more the price rises, the more bullish they become and the more options they want to buy. Meanwhile the professionals, knowing that the price is overextended (see the earlier pendulum analogy) and will shortly correct, are happy to keep on selling options to the speculators knowing that once the trend changes and prices fall, they will make money (known as going ‘short’).

 Therefore as the rally continues, the ‘mugs’ get longer and the ‘pros’ get shorter, and by monitoring this dynamic, and comparing these extremes with previous examples we get a useful indicator as to when a rally has run its course.

The chart below is of the current COT data for Silver, and shows the weekly change in the open positions of the speculators and commercials.

 

 

 As the price of silver has risen, the ‘mug punters’ (represented by the combined grey and yellow bars) have become increasingly bullish and have continued to add to their long positions. If we focus on the red bars we can see the corresponding increase in the ‘pros’ short position over the same period.

Previously when we have reached these kinds of extremes the rally has been near its end, and then when prices collapse the commercials clean up by buying back their ‘short’ positions for a profit whilst the speculators panic out of their ‘long’ positions at a loss. Once again losing their shirts, crawling away to lick their wounds until the next time.

It’s not called a suckers rally for nothing!

 

So when we look at the bigger picture there are a number of warning signs.

• The rally from the 2009 lows has already gone on longer than average.
• We are nearing an area of resistance where previous rallies have terminated. 
• Many technical indicators are in overbought territory suggesting a top is near.
• We are entering the most dangerous time of the year for stock markets.
• The professionals are getting very short in a number of markets including gold and silver, in anticipation of price falls.

 We are seeing increasingly linked financial markets, with investors selling out of US Treasury bonds, selling the US dollar, and putting this cash to work in stock, commodity and currency markets. All fuelled by a diet of endless stimulus.

Unfortunately when this kind of woolly, simplistic thinking takes root, it normally means that nobody is actually thinking at all, with a very predictable result.

 The markets may trend higher for a little longer whilst investors chase the rally, basking in the warm glow of cheap money. But the fat lady is warming up.

It should be quite a show.