A few weeks back I penned an article that discussed the “pickle” that mainline and hedge fund managers find themselves in right about now – under performing their benchmark. At the time, I suggested not being surprised at anything seen in the financial markets over the short term as the whole issue of “making your year” is front and center in the minds of the professional money management community. But time is fast running out. Additionally, I was very surprised to see so many headline soothsayers turn extremely bullish with the big European bailout plan announced a number of weeks back (a plan which has so far proven to be neither big nor an acceptable panacea). It’s never easy, is it? After all, it’s the job of the financial markets to disappoint the greatest number of participants as possible.
Having said all of this, I hope it’s helpful to keep in mind amidst all of the financial market and emotional volatility some very long-cycle equity trends that have proven themselves more than useful over time. Infallible? Nothing is infallible. These are guideposts. And to be honest, they will come across as incredibly simplistic. For years I have used the relationship of the 10 and 40-week exponential moving averages of the S&P as an important risk management tool. It’s one of many in my toolbox, but its track record over the last few decades has been spot on. When the 10-week EMA crosses down through the 40 week EMA, it’s telling us to sit up and take notice. As you’ll see in the chart below, this has occurred three times in the last 15 years – late 2000, late 2007 and a few months ago. You already know the first two dates were incredibly prescient in terms of foreshadowing the character of the longer down cycle to come. These crosses, both on the downside and upside are separated by years, not quarters or months. This is exactly why I personally deem them very useful.
In the spirit of honesty, we temporarily broke below the 40-week EMA in the summer of 2010, directly in front of QE2. Was it QE2 that saved the day for equities in the late summer of 2010? We’ll never know as free market forces were not allowed to play themselves out.
Okay, the reason I wanted to revisit this now is that with the blistering rally of October, it was starting to look like this downside cross was a huge head fake. But as of this writing (11/18), the 10-week EMA remains below the 40-week EMA suggesting a new upside trend of substance has not yet begun. And yes, after the 20% top to bottom move in equities this year that for now ended in early October, more than a number of strategists proclaimed that we’ve had our bear and we’re now onto a new bull market cycle for equities. The fact is that for now no one knows with any certainty.
But as you look at the chart above and specific to our current circumstances, we need to remember that a return of the 10-week EMA to near the 40-week EMA AFTER a major equity cycle top is not the exception, it’s the rule. You can see it happened three times after the 2000 peak and twice after the 2007 peak (noted above in the green shaded areas). Are we yet again living through this repetition in human decision-making? You already know the correct answer—time will tell.
Again, no one indicator can be called the Holy Grail in this wonderful world. For corroboration with the indicator above, I’ve historically used a “slower” version of the cross by introducing the 15-week EMA as opposed to the 10. If we get a signal from the 10-40 EMA relationship that is corroborated by the 15-40 EMA relationship, it strengthens the message of directional trend in my mind. For now, again, it’s telling us there is no new bull trend yet. Would an ECB print or QE3 change this? It could change this current message in a heartbeat, exactly as we saw in the late summer of last year, but we’re not there yet.
A final, but far from exhaustive, indicator of interest pertaining to the immediacy of the here and now...when I penned the article about money managers needing to make their year a few weeks ago, I suggested that the October move in equities was largely reflective of short covering based on the interplay of the TRIN indicator and advancing versus declining volume. What was lacking at the time was a meaningful acceleration in advancing volume. Well, quite related is the very simple variable that is new highs. I’ve put the following chart together that graphically expresses this concern.
As you look back historically, equity market moves off of major trend lows have come with an explosion in new highs. Within the context of ongoing bull markets, you can see that in post-corrective periods, we also see a very meaningful move higher in the number of new highs registered as the major averages recover. It has been an incredibly consistent pattern. This is a key fingerprint of equity bull markets.
Alternatively, have a look at the late 2007/early 2008 period. Equity rallies post the very meaningful 2007 peak never saw a coincidentally meaningful expansion in new highs. (Please be aware that I’m using a 12-week moving average of new highs to smooth out what would otherwise seem short term data noise). We even saw this snapback in new highs post the summer 2010 period.
There is one other short-term linkage here. The lack of recovery in new highs in late 2007/early 2008 also corroborated the real world event of a recession. Again, the expansion in new highs post the summer 2010 lows likewise suggested no recession. Exactly as the folks at the ECRI had predicted using their leading indicator data last summer. So here we stand today, not seeing any expansion in this moving average of new highs post the late September/early October lows AND the ECRI folks have essentially put their reputations on the line standing firm and unwavering on the recession call. We’ll just have to see how it all plays out. Are equities leading the economy via the message of new highs? Again, time will tell.
So amidst the 24/7 headline barrage of the moment, I hope it’s important to step back and have an unemotional and disciplined look at what have been very important equity market trends over the last few decades. Guideposts, not Holy Grails. Guideposts deserving of our attention and ongoing monitoring.
All the best to you and your families for the Thanksgiving holiday ahead.
