Wednesday, April 08, 2009

Long-term Potential

Because of an epic workload, this is my first post since August 5, 2008.

Watching eight months of historic market action often from a hotel room 16 time zones away has been an unforgettable experience. Water was boiling in pots I could not always see, and in hindsight this produced a more balanced market perspective than I would have gained otherwise.

Thanks to everyone for the e-mails and PMs along the way. All were much appreciated. Even though my schedule is actually more complicated now than it was last summer, recent market developments are worth a few comments.


Regardless of what the financial news, economic data, political headlines, monetary policy, pundits, bloggers, message boards, co-workers or even your own common sense is telling you, the market itself is saying that an important, long-term bottom is in.

Of course, the spectacular, short-term shenanigans in the market will continue. The global economy has serious problems, and these are complicated by a lack of consensus surrounding both patient and cure. Investors shouldn't expect a smooth ride anytime soon.

Despite the bumpiness, an increasing number of technical indicators suggest that the March 2009 bottom is an event with lasting value. These data imply that the rally – with all its imperfections – will ultimately have legs. A good way to monitor this idea is during periods of market indecisiveness. If the bias of the market has truly changed, low-volume, enigmatic market pauses will resolve upward, instead of lower as they have for the past 18 months.

However, this post concerns more long-term signals, and below are observations on eight of the more noteworthy. When considered together, these indicators provide perspective on a beleaguered market and its longer-term potential. What these indicators say is that for investors with extended time horizons, the conditions are ripe to start applying capital.

1. The Cyclical Bear Market Continues…
It’s wise to start with a word of caution. Historically, until the blue line on the chart below crosses back above the red line, stock ownership is marked by heartbreak and remorse. That said, the black line below is also printing massive positive divergence. When the stock market finally catches up with this divergence, the momentum is likely to be significant.

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2. VIX
One of the great side stories of this recession is how Robert Whaley’s obscure volatility indicator was catapulted into investing superstardom. Fueled by a populist obsession with “fear”, the VIX’s ascent was matched only by the chronic misunderstandings surrounding its meaning. As always, for maximum clarity, read Bill Luby's Vix and More and Adam Warner's Daily Options Report. Both offer hyper-informed takes on market volatility and all its implications.

The weekly chart below shows that the VIX is printing signs of a pending decline. Rather than “causing the market to go up”, a bearish VIX simply indicates that options strategies are shifting as institutional investors warm to the idea of increased long exposure.

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3. Bonds
After a 9-week climax run from Oct-Dec 2008, it appears that the historic bull market in long-dated Treasuries may finally be over. Bill Gross has been anticipating this topping event since June 2007, and laid odds it would happen before 2010. It appears he nailed it.

The weekly chart below is bearish for bonds, as institutional investors have begun the long fade out of government debt and into other investments offering better returns. Historically, this redeployment is into equities and corporate debt.

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4. NASDAQ High-Low Indicator
While not great at picking tops, the NASDAQ High-Low chart is remarkably effective at picking major bottoms. After big, sub-20 dips, crossovers by the 10-week EMA back above 35 marked key bottoms in both 1998 and 2002. After spending 18 months below, the High-Low is finally ready to cross back above 35. This 18-month submersion marks the longest the High-Low indicator has been under 35 in its 20-year history. It’s one of several market signs that sellers have grown exhausted.

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5. Tech Ratio
Another indicator pointing to seller exhaustion is the Tech Ratio. This metric compares an index of 220 pure technology stocks with the overall NASDAQ. The chart below shows that even though the NASDAQ bottomed in 2002, investors continued to loathe tech stocks long afterwards. In the summer of 2006 -- ironically as the Dow was printing new all-time highs -- the scorned Tech Ratio finally hit bottom (red circle).

But fortunes have changed. As the market imploded in late 2008, many tech stocks avoided the intense declines. As a result, over the past seven months tech has actually outperformed the indexes, and in April 2009 the Tech Ratio broke to a new 6-year high. Technology in a sustained leadership role hasn't happened in 10 years, and this is a welcome positive for the market.

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6. NDX/SPX Ratio
Another important metric of market-health-through-tech-leadership is the performance of the Nasdaq-100 vs. the S&P500. Historically, the market has always done better when the NDX outpaces the SPX. Like the Tech Ratio, in April 2009 the NDX/SPX Ratio broke to an 8-year high.

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7. Emerging Market Ratio
Like the rest of the world, emerging markets suffered withering declines in 2008. However, the slumdogs have since mounted an impressive comeback. The Emerging Market Ratio compares emerging markets with all overseas markets (Europe, Australia and Asia). Like the Tech and NDX/SPX Ratios, in April 2009 Emerging Market Ratio ratio also broke to a new all-time high. Investor appetite for the riskiest global assets is yet another encouraging sign.

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8. Contrarian Indicators
Finally, there are the current extremes in negative investor sentiment. The Investors Intelligence Bull/Bear Ratio is near a 5-year low. However, the most interesting feature of this chart is how unfazed it was by the recent 26% rally. The bulls simply don’t believe it, which is exactly what you want investors to feel after a 26% run-up, especially 18 months into a bear market.

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Below is a 30-year view of the Michigan Consumer Sentiment Survey. It’s been 29 years since this survey has recorded sentiment so negative. While the reality of this is unfortunate, it is from such despair that the most durable bottoms are born.

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These observations provide little insight into short-term market direction. For that, I encourage you to bookmark The dk Report Charts. I keep this chart library current with short-term annotations, even when I'm 16 time zones away.

Soon enough, the current rally will end in an ugly 10-15% correction, probably at the moment of maximum inconvenience. Based on broader plate tectonics, this should be a constructive event, and the odds favor the March lows holding.

Thanks for reading, and best of luck with your trades. I look forward to posting again when I can.

Until then,