Let The
Trend Be Your Friend
I have long argued that the rally in equity markets we have witnessed since the lows of 2008/9 is a cyclical bull market recovery within the context of a much larger and longer secular bear market. Meaning that although these cyclical bull rallies can be extremely powerful and rewarding for those along for the ride,when the rally ends they will once again roll over and head south as a cyclical bear market takes over.
This procession of cyclical bull followed by cyclical bear and back again forms a huge, long-term trading range where equities go virtually nowhere. This is illustrated in the chart below, showing the movement of the US S&P500 index throughout its previous secular bear market period and comparing it to today's (this chart is a bit 'busy' but the point to note is the sequence of large rallies followed by collapses during the 66 to 82 timeframe, denoted in red), and although this is only comparing the current and previous secular bear market periods, the same 'pattern' exists in all secular bears to a large extent.
This procession of cyclical bull followed by cyclical bear and back again forms a huge, long-term trading range where equities go virtually nowhere. This is illustrated in the chart below, showing the movement of the US S&P500 index throughout its previous secular bear market period and comparing it to today's (this chart is a bit 'busy' but the point to note is the sequence of large rallies followed by collapses during the 66 to 82 timeframe, denoted in red), and although this is only comparing the current and previous secular bear market periods, the same 'pattern' exists in all secular bears to a large extent.
However, although the markets may be meandering their way to nowhere, one very important thing is changing, and that is valuations.
By definition, the end of a secular bull market is signified by extremely low dividend yields and extremely high valuations, these having occured as investors caught up in the euphoria have bought shares in search of capital gains, driving prices and valuations up and the corresponding yields down until they get to extremes. Although company dividends generally increase over time, prices have simply been pushed up faster than the capacity for earnings to keep pace.
It is at this point that markets roll over into both a short term cyclical bear that will take prices down, and a long term secular bear that will ultimately return valuations to 'cheap'.
This long term rollercoaster of cyclical bull to bear and back is what buys the time for earnings to catch up.
At the end of these secular bear markets, the combination of increased earnings and reduced prices make valuations 'cheap' once again, and the stage is set for a new secular bull market to take place.
It was the absence of valuations at anything like 'cheap' levels at the 2008/9 lows that strongly suggests that the secular bear market is ongoing and that what we are witnessing is a continuation, albeit a long one, of the cyclical bull rally from those lows, NOT an entirely new secular bull market.
Now whilst this sets the background picture, it does not helps us with trying to predict when this rally will end and be replaced by the next cyclical bear market. I have talked in previous posts about the nature of tops being a process not an event, and that it takes time for the rally to 'run out of steam' as sellers slowly overpower buyers, this often being reflected in a dome shaped appearance.
I have also talked about the CBOE S&P 100 Volatility Index and its use as a contrarian guide to investor complacency as to the risk of a market collapse. The process being that the more the market rallies, the more bullish investors become and the less they desire downside protection in the form of 'put' options. This lack of demand for puts is reflected in the low levels of volatility, and at extremes can be a useful indicator of a pending sell-off in the markets.
There also a number of technical analysis indicators that are used to monitor the internal health of the market and the level of participation, but some of the most indepth statistical analysis has been done by Tim Woods of www.cyclesman.net.
Through Tim's research he has discovered that there are certain similarities that occur at almost all cyclical bull rally tops, including the low correlation of certain indices and the appearance of a large number of divergences between price and supporting technical indicators (these occur when price makes a new high or low, but the indicator does not, thereby failing to confirm the price move).
According to his analysis, the pieces are not yet in place for the cyclical bear market to begin, and this along with my own analysis and the appearance of a large and growing trend in the US dollar means I am apt to agree.
Since the tribulations that started to occur in the Euro zone last year, money has been gradually flowing towards the US via the US dollar. This trickle was given a boost with the Cyprus 'bail-in' plan that made it clear to investors that their bank deposits were not safe, and become more sustained once Japan declared war by QE on its own currency in the name of rescueing its economy. These events have acted as a catalyst in driving money to the safest of havens, the US.
It seems ironic that with all the issues that currently entangle it, and the attrocious state of its finances, the US can still be considered a safe haven, however in the land of the blind the one-eyed man is king, and the US will continue to benefit from this increasing flow of funds into the US dollar as the problems in both Japan and the Euro zone worsen over the next couple of years.
This promises to have major repercussions on financial markets as this flow of funds will have two main effects, firstly driving the US dollar substantially higher, and secondly act as a major support for US equities as these funds are put to work. This really could be the dominant theme over the next couple of years and could overpower everything else, driving US equities much higher in spite of their being overextended already.
Now whilst I do not now believe we are currently close to the top, I do think we are close to a top. US equities do seem ready for a correction which has the potential to take them down between 7-10%, but in the light of what I have just said, the difference now is that at that point there is the potential for getting into the market to take advantage of the rally that will take it to new highs.
Once this rally takes hold we will have to monitor it for signs that the end is near, because this could become the longest cyclical bull rally in history, and one other point that Tim Woods has discovered is that the longer and farther the rally continues, the more painful the resultant cyclical bear.
To help with clarity here is a loose chronology of what I think will occur:
It was the absence of valuations at anything like 'cheap' levels at the 2008/9 lows that strongly suggests that the secular bear market is ongoing and that what we are witnessing is a continuation, albeit a long one, of the cyclical bull rally from those lows, NOT an entirely new secular bull market.
Now whilst this sets the background picture, it does not helps us with trying to predict when this rally will end and be replaced by the next cyclical bear market. I have talked in previous posts about the nature of tops being a process not an event, and that it takes time for the rally to 'run out of steam' as sellers slowly overpower buyers, this often being reflected in a dome shaped appearance.
I have also talked about the CBOE S&P 100 Volatility Index and its use as a contrarian guide to investor complacency as to the risk of a market collapse. The process being that the more the market rallies, the more bullish investors become and the less they desire downside protection in the form of 'put' options. This lack of demand for puts is reflected in the low levels of volatility, and at extremes can be a useful indicator of a pending sell-off in the markets.
There also a number of technical analysis indicators that are used to monitor the internal health of the market and the level of participation, but some of the most indepth statistical analysis has been done by Tim Woods of www.cyclesman.net.
Through Tim's research he has discovered that there are certain similarities that occur at almost all cyclical bull rally tops, including the low correlation of certain indices and the appearance of a large number of divergences between price and supporting technical indicators (these occur when price makes a new high or low, but the indicator does not, thereby failing to confirm the price move).
According to his analysis, the pieces are not yet in place for the cyclical bear market to begin, and this along with my own analysis and the appearance of a large and growing trend in the US dollar means I am apt to agree.
Since the tribulations that started to occur in the Euro zone last year, money has been gradually flowing towards the US via the US dollar. This trickle was given a boost with the Cyprus 'bail-in' plan that made it clear to investors that their bank deposits were not safe, and become more sustained once Japan declared war by QE on its own currency in the name of rescueing its economy. These events have acted as a catalyst in driving money to the safest of havens, the US.
It seems ironic that with all the issues that currently entangle it, and the attrocious state of its finances, the US can still be considered a safe haven, however in the land of the blind the one-eyed man is king, and the US will continue to benefit from this increasing flow of funds into the US dollar as the problems in both Japan and the Euro zone worsen over the next couple of years.
This promises to have major repercussions on financial markets as this flow of funds will have two main effects, firstly driving the US dollar substantially higher, and secondly act as a major support for US equities as these funds are put to work. This really could be the dominant theme over the next couple of years and could overpower everything else, driving US equities much higher in spite of their being overextended already.
Now whilst I do not now believe we are currently close to the top, I do think we are close to a top. US equities do seem ready for a correction which has the potential to take them down between 7-10%, but in the light of what I have just said, the difference now is that at that point there is the potential for getting into the market to take advantage of the rally that will take it to new highs.
Once this rally takes hold we will have to monitor it for signs that the end is near, because this could become the longest cyclical bull rally in history, and one other point that Tim Woods has discovered is that the longer and farther the rally continues, the more painful the resultant cyclical bear.
To help with clarity here is a loose chronology of what I think will occur:
- Equity market correction taking markets down 10% ish, possibly caused by Fed comments re QE tapering or Euro stress over the upcoming German elections.
- Correction ends to be replaced with another rally driven by increasing flow of funds into US dollar.
- Rally takes equities to new highs as money flow becomes a flood, driven by collapsing Euro zone and Japanese Yen, this inspite of equities being over-extended by most benchmarks.
- Soaring US dollar and collapsing Euro, Japanese Yen and many sovereign debt markets.
- Rally ends as the US becomes the last man standing, and the perception of it as a safe haven evaporates.
- Equity markets collapse in a cyclical bear market, taking equities down to 'cheap' valuations once again.
