Is this the end of the stock market party?

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I visited a terminally ill friend in hospital yesterday. It was not a pleasant experience as it was quite apparent that the writing was on the wall. But fading away from life does not mean a continuous deterioration – he still perks up from time to time as glimmers of hope lift his mood. After all, to hope is to be pro life.

This made me think of the complex world of investments – a world where hope unfortunately has no role. Richard Russell, 83-year old author of the Dow Theory Letters, said: “In the stock market hope gets in the way of reality, hope gets in the way of common sense. If the stock market turns bearish and you’re staying put with your whole position, and you’re hoping that what you see is not really happening, then welcome to poverty city.”

Not since buying my first stocks in 1968 have I experienced the stock market outlook to be as murky as we are experiencing today. The fears are well documented and, in short, include lingering concerns about the financial system, a US economy on the doorstep of recession, and mounting inflation worries.

For the first time since starting to write my regular weekly “Words from the Wise” blog post three months ago not a single positive item regarding the US economy/markets made its way into last week’s article. It was not surprising that Nouriel Roubini remarked that it was time to move away from the soft landing versus hard landing discussion and start concentrating on how deep the coming recession would be.

In order to gain some perspective on the outlook for equities it serves a useful purpose to study a long-term graph of the S&P 500 Index (or any other major US stock market index). This chart is based on monthly data which tends to be more helpful than daily or weekly series when trying to identify the stock market’s primary trend.

graph1.jpg

Source: StockCharts.com

There are a number of interesting observations that one can make from this graph:

The MACD indicator (bottom section of graph) has just given a sell signal as evidenced by the blue histogram bars falling below the zero line. These signals do not occur often – the last one, a buy signal, was given in May 2003 and the sell signal before that happened in September 1999.

The more sensitive RSI (internal relative strength) oscillator (top section of graph) has fallen below 70, thereby giving its first sell signal since 1998. (A buy signal was registered four years later in 2002.)

The 20- and 40-month moving averages (middle section of graph) are still intact, but these are lagging indicators and the turning down and crossing over of the two lines typically only serve as final confirmation of turning points in the index.

But what about the argument that multiple Fed rate cuts are supposed to be bullish for stocks, i.e. the maxim “Don’t fight the Fed” (as described by Martin Zweig in his book Winning On Wall Street)? John Hussman points out that in those events where multiple Fed cuts helped the market, stocks had usually firstly experienced a bear market decline of 20% to 40% prior to recovering, and the average P/E on the S&P 500 Index was typically below 14 (compared with a multiple of 19.1 at the moment).

US profit margins, inflated by super-cheap credit in early 2007 (i.e. the lowest spreads ever seen), are clearly unsustainable. As a matter of fact, profits for the Standard & Poor’s 500 companies fell almost 25% on a per-share basis in the third quarter, the biggest year-over-year decline in almost five years. David Wyss, S&P’s chief economist, expects these companies’ earnings to fall as much as 30% in the fourth quarter as companies take more writedowns for bad investments. “The earnings recession has already arrived,” adds David Rosenberg, North America economist for Merrill Lynch.

Goldman Sachs noted that the average fall in the S&P 500 Index over the last nine recessions was 13% from peak to trough. These include 1969 (-18%), 1981 (-23%) and 2001 (-52%). The Index has so far declined by 7.6% since its high of October 9, 2007.

It is no wonder that the message conveyed by the Bullish Percent Indexes, i.e. the percentage of stocks in uptrends, is not exactly comforting with a large proportion of the major indexes in fact in downtrends as indicated below.

graph2.jpg

Source: StockCharts.com

It is impossible to know to what extent stock markets may bounce from time to time, especially with the expiration of options and futures coming up on Friday. (The Dow Jones Industrial Index has rallied 20 times in the past 22 years during the week of the December expiration.) In addition to the long-term graphs looking rather gloomy, the daily chart of the Dow Jones World Stock Index (used as a proxy for global stock markets) has also just triggered a sell signal (see negative MACD histogram bars). (I remain skeptical of world markets decoupling from the US in any meaningful way.)

graph3.jpg

Source: StockCharts.com

Somebody once remarked that “risk is often lowest when it is most visible”. Why do I have a niggling suspicion that a considerable dose of bad news has yet to surface and therefore not yet been discounted by stock prices?

These are unusually treacherous times and any rally should, in general, be used to lighten holdings. And avoid hope, as so eloquently put by Richard Russell above – rather embrace the cold reality of a situation that has possibly not yet seen its darkest hour.

graph4.jpg

Hat tip: Barry Ritholtz, Big Picture, December 16, 2007.

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20 comments to Is this the end of the stock market party?

  • Göran Högberg

    verry good

    but it still could have a 10% rally in January because of bad sentiment, high put/call-ratio etc.

  • Denzil FEINBERG CFP

    cogent pointers from a veteran, dankie sê! So do we move 25% or so to MM?

    In Canada, the strong CAD$ makes for a selctive buying guide into the US$ and even Europe & UK.

  • Mr. Obvious

    Couldn’t agree with you more on the idea of hope being a bad investment strategy.

    If risk is lowest when it’s most visible, then isn’t risk lower when it’s more visible? Put simply, it’s always darkest when it’s black, which paves the way for dawn. Clearly risk has been made more visible in the last six months than before, and unless the tip of the iceberg gets considerably bigger, this could prove to be at least the opportunity for a short-term rally.

  • Göran, a short-term rally is always possible, especially as the Dow Jones Industrial Index has rallied 20 times in the past 22 years during the week of the December options and futures expiration.

  • Mr Obvious, as mentioned on Sunday the past week was characterized by an avalanche of bearish reports and for the first time since the start of “Words from the Wise” three months ago not a single positive item regarding the US economy/markets made its way into the article. This should normally start flashing a signal to contrarian investors. I am, however, reluctant to try and play potential short-term rallies too aggressively with the primary trend charts beginning to look so negative.

  • number2son

    Agreed, Prieur. And the fact that there is so much hope still lingering, witnessed by the comments above, tells me that there is still plenty of downside.

    And speaking of the BPSPX, it gave a sell signal on the daily on Monday.

  • number2son

    Also, the Dow Industrials still shows a positive MACD Hist, barely, but it will likely print negative in January.

  • N2S, yes DJIA is only just positive. One should really wait for the month-end readings on the monthly charts, but it is nonetheless fascinating to watch as the pictures unfold from day to day.

  • Do you have an opinion on the soft commodities? Specifically, sugar and cotton…

    I think we are back in the “inflate or die” situation that Richard talks so much about.

  • I am not sure why you or Russell put so much emphasis on such poor technical indicators as MACD or RSI; for example, the RSI sell signal in 1998 on the SP500, led to a 50% GAIN. So why even bother mention something that is so unreliable? As you have shown, the fundamental picture looks bleak. Technically, the process of marginal highs and marginal lows that we have seen in the major indices seen Feb, 2007 could lead to a market top significance. Furthermore, key sectors like financials, transports, and semiconductors have been in bear markets for a while. Can you really see the market higher without these sectors participating?

    Presently, and as I see it and as the data suggests, there is very little edge to being long this market –not withstanding minor bounces. And there is high likelihood of substantial loss.

  • Guy, I always try and look at both the fundamental and technical picture. As far as technicals go, I actually prefer working with the “raw” line charts rather than with any specific indicator. I am quite reluctant to base decisions on single indicators and prefer making up my mind based on various different tools, including “gut”. It perhaps doesn’t always come out that way on the blog.

  • Prieur: I would agree with your comments regarding fundamentals and technicals —as many points of light illuminating a subject is most helpful. Sorry if I come off a bit dogmatic in my view/ use of TA; I am more in the camp of “Evidence Based Technical Analysis”; that is, use stuff that works, but folks need to know what works.

  • Backing away from the minutea of filter selection and guaging the raw behavior of price and time one can observe the S&P monthly’s disturbing divergence between the 2000 and 2007 index peaks and that of the MACD values for those periods.

    Divergence = change!
    (In this case negative divergence)

  • Great post, I will mention this story on my blog.

    http://www.boldinvestors.com

    Cheers.

  • […] have I experienced the stock market outlook to be as murky as we are experiencing today,” he writes. “The fears are well documented and, in short, include lingering concerns about the financial […]

  • Thanks Yarinh (YHO) for the mention on your great blog! Keep up the good work.

  • I also share your sentiments about the current market. Well written.

  • I am a very novice investor and have just really started to pay attention to the stock market on a larger scale.

    Everyone is bringing complex Algebraic formulas and Charts showing Gains and Loses and talking about Recession. But how about Logic and Persiverance.

    Being a novice investor this might seem very ignorant on my behalf but, wouldn’t the “Darkest Hours” be the best time to invest?

  • […] on gold) during the latter months of 2007 of which the last one on December 17 was entitled “Is this the end of the stock market party?”. Mr Market has provided the answer and it is a rather discomforting one. Yes, “the trend is […]

  • Kamlesh Thaker MD

    Your case for impending recession is fairly convincing.

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