Global stock markets: pop ‘n drop?

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Have global stock markets run into a cul de sac? Bulls with long and short horns alike will probably admit that the rally since August 17, 2007 (i.e. when the US Fed cut the discount window rate) was probably “too much too fast”.

The bar charts below show how global mature stock markets, as represented by the MSCI World Index, the major US stock markets and the MSCI Emerging Market Index fared since August 16 and for the year-to-date periods respectively.

16-oct-16.jpg

A cul de sac implies a U-turn. This is how Richard Russell, 83-year-old author of the Dow Theory Letters, very aptly summarizes the situation: “When you pull a rubber band out as far as it will go, the counter-force energy in that rubber band tends to pull the band back towards a state of ‘neutrality’.

“The same thing applies in a big stock move, and at this point just most of the US stock averages have been stretched to an extreme. Therefore, it would be entirely normal to see the stock market and all the major stock averages pull back, take a breather, correct.”

I alerted readers a few days ago to the fact that the so-called market internals (i.e. lack of breadth and poor volume) were diverging from the seemingly positive price trend, thereby casting doubt on the sustainability of the rally (see “Lack of stock market breadth flashes red light”). This in itself is not a timing indicator, but a warning signal of impending danger.

It would appear that danger has sneaked up over the past few days when analyzing the following graph of the Dow Jones Industrial Index (i.e. representing many large-cap companies that have been leading the broader market higher over the fast few weeks):

16-oct-2.jpg

Source: StockCharts.com

The most worrying factor of this chart is the fact that the MACD oscillator gave a short-term sell signal three days ago (see blue histograms dropping below the zero line in the bottom section of the diagram). Also notice that Thursday’s and yesterday’s declines were characterized by a pick-up in volume. Rising volumes on down-days is not a good sign.

Interest-rate-sensitive sectors in particular – REITS, financials and retailers – are looking weak, whereas another laggard on the way up – small caps – is now leading the market down.

Nervousness seems to have crept into the market over the past few days as reflected by the Volatility Index (VIX) edging up. The chart below illustrates the near-perfect inverse relationship between the VIX Index and the S&P 500 Index. Suffice to say, trend reversals are usually of larger magnitude than what we have seen over the past few days.

16-oct-3.jpg

Source: StockCharts.com

One can argue about a myriad questionable fundamental factors such as the US economic outlook and its implications for global growth, stretched valuation levels and earnings growth turning negative, but the short-term technical picture now also looks decidedly bearish.

Some stock markets are undoubtedly more overextended than others, but I would be surprised if most markets are not affected in some way by a downward correction – commonality (i.e. sentiment) should ensure that.

A “pop ‘n drop” pattern seems to be global stock markets’ fate, at least for the short term. Time will tell whether the rest of the journey will require coming all the way back from the cul de sac, or whether a longer, but more steady, route can be found.

16-oct-42.jpg

Source: Unknown

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3 comments to Global stock markets: pop ‘n drop?

  • stevo

    I think that you are right about stock market overvaluation. DJI30 earnings for Sept 07 are $830.94, and the index price at 28 Sept was 13,895.63. This results in an earnings yield of 5.98%, as compared to a ten year treasury note yield of 4.58% on the same date. Since stocks are inherently more risky than fixed income instruments, their earnings yields should be substantially higher than that of the fixed to serve as a compensation for the added risk. A comfortable risk factor is 1.5 times. The present factor is 1.31 times (5.98 / 4.58), which is less than adequate compensation.

    If we use a 1.5 times standard upon present earnings to value the Dow, we would need an earnings yield of 6.87% (4.58 x 1.5) to make the higher risk of equities attractive. Unfortunately, the maximum attractive price of the DJI would decline from its present level by 12.96% to 12,095.20 ($830.94 / 6.87%). A more fair value of the Dow is, therefore, 1800 points lower than its 28 Sept valuation. [The current value of the Dow could be justified by a 14.89% increase in index earnings to $954.63.]

    Also, comparing the broader, SP500 index to nominal GDP on a year-over-year basis, the markets have definitely entered a high risk zone. The pattern of this tracing would imply that the next general market decline will be more of the vicious, bear market variety rather than a mild, corrective mode.

    However, because IRX and TNX are still below their 40 week moving averages, the dollar’s decline is measured, the yield curve is positive, my crash indicator is neutral (it was positive from mid-July through mid-August), and my econometric indicators are still positive, I feel that the bull market will still be functional until at least November 07. Somewhere after that — TIMMMBUUUUUUUURR!

    Excursus:

    The GDP-weighted yield curve of the G7 nations is relatively flat. At 15 Oct, the spread between 2 and 10 year notes was 0.410 basis points versus 0.081 on 2 Jan 07. In Jan, both the US and UK had inverted curves, but now it is just the UK. In its current state, it will not take much further economic calamity to result in the whole works turning negative. Should the citizens of the G7 experience a sudden lack of confidence in post-Bretton Woods arrangements, we might be plunged into a deflationary maelstrom. I truly hope that we do not soon experience at first hand the sting of the ancient Chinese curse, “May you live in interesting times!”

  • stevo

    FYI.

    If time and price remain in the appropriate balance, and I believe they will, the SPX should sell at 1594.97 on Friday, 2 November 07.

  • […] my concern, namely “Lack of stock market breadth flashes red light” (October 11, 2007) and “Global stock markets: pop ‘n drop” (October 16, […]

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