“Over the years, I’ve noted that certain subsets of market conditions – occurring together – are associated with very specific outcomes, such as oncoming recessions, abrupt market weakness, strength in precious metals, and so forth. Such indicator subsets, or Aunt Minnies, are essentially “signatures” that often have very specific implications. In medicine, an Aunt Minnie is a particular set of symptoms that is “pathognomonic” (distinctly characteristic) of a specific disease, even if each of the individual symptoms might be fairly common. Last week, we observed an Aunt Minnie featuring a collapse in market internals that has historically been associated with sharply negative market implications.
“Of the 3257 issues traded on the NYSE last week, 2955 declined and just 275 advanced. The S&P 500 has now abruptly erased nearly 8 months of progress. Moreover, we observed a “leadership reversal” with new 52-week lows flipping above the number of new 52-week highs. Our broader measures of market action deteriorated to a negative position as well. Historically, we can identify 19 instances in the past 50 years where the weekly data featured broadly negative internals, coupled with at least 3-to-1 negative breadth, and a leadership reversal. On average, the S&P 500 lost another 7% within the next 12 weeks (based on weekly closing data), widening to an average loss of nearly 20% within the next 12 months – often substantially more when the Aunt Minnie occurred with rich valuations and elevated bullish sentiment.
“The most recent instance was November 9, 2007, which was followed by a market loss of more than 50%, but the instances also include September 22, 2000, prior to a nearly two-year bear market decline; July 14, 1998 prior to the “Asian-crisis” mini-crash; July 27, 1990, at the beginning of the pre-Gulf War plunge; October 9, 1987, just prior to that market crash; July 2, 1981 at the beginning of the 1981-82 bear market and again in May 21, 1982, following a strong rally during that bear market, leading into a steep decline to the final lows; November 9, 1973 (just after a swift rally during the 1973-74 bear market, and leading into the main portion of that loss); and November 21, 1969, at the beginning of the 1969-70 bear market. The combination of unfavorable valuations and collapsing market internals is a sharp warning to examine risk exposures carefully here.”
– John P. Hussman, Weekly Market Comment
This week’s comments from Dr. Hussman are worth a close read. In addition to the excerpt above, we would also recommend reading the section from his November 12, 2007 comment, reprinted in this week’s comments.
Last time we shared our Macro Monday notes with readers was February 1st when we noted “There’s Nothing Good Here, except for the potential for a short-term bounce from oversold levels.” The market predictably marched higher from the “hammer lows” produced later on February 5th (admittedly, much higher and much longer than we would have expected), but two steep weekly declines in May, have wiped out all of that progress and them some!
Ironically, we find ourselves in an eerily similar position today with markets extremely oversold on a short term basis. To review, back in February we noted: the percent of stocks above their 200 DMA rolling over; credit spreads widening; dollar strength an indication of deflationary pressures; Euro weakness signaling sovereign debt concerns; money supply growth declining; growing red flags in the commodity space; and rampant pessimism in treasury markets. Despite the potential for an oversold bounce, we suggested that “given the massive underlying risks from a macro perspective, it is prudent to leave the last ten percent for the next guy.”
Today, we recommend investors re-read that last sentence as Mr. Market is telling us that these risks are real. The potential for policy mistakes has increased, while the consequences of any missteps are not pretty, according to Aunt Minnie. Market action last week was typical of wholesale liquidation – think Lehman. Despite the potential for another oversold bounce, the deterioration in trend, coupled with emerging cracks in credit markets are more than enough to keep us on the sidelines especially when viewed in the broader context of an extended debt deleveraging process. With that said, here is the world as we see it this Macro Monday Morning:
- Credit is a Concern. LIBOR spreads are widening . . . again. The bulls argue that spreads are nowhere near Lehman levels. We say, you gotta start somewhere. We expect more deterioration ahead, driven by an emerging crisis across European banks.
- Treasury Yields are Freaking Out! Later in the Year . . . Is Now! Note the near record foreign purchases of US Treasuries as investors flock to safety.
- CPI is rolling over despite all the yelling and screaming from the Inflationistas. Expect yields to follow lower.
LEIs are rolling over . . . globally.
Commodities are following in lockstep (with precious metals a notable exception). As we suggested in February, “When CPI rolls, run for the exits!!” Ladies and gentlemen, CPI is rolling. Take another look at the Consumer Price Index above. Again, we’d encourage China bulls to review our Cautionary Fable and Edward Chancellor’s Red Flags.
- Commodity Currencies are telling the same story as our short term, intermediate term and long term trend models are all in synch and pointing lower for the Aussie and Canadian Dollars. It should not come as a surprise that the setup for Euro and Sterling is identical. In fact, the only currencies bullish across all three durations today are the USD and the Yen. Does that concern anyone else?
We fully recognize that the simple fact that we are sharing our concerns with readers again, all but assures a powerful short covering rally that may have already begun. We’d welcome said rally as an opportunity to sell strength. The data points above, along with many others point to an important regime shift. In a bull market, corrections producing oversold conditions should be bought. Conversely, in a bear market, oversold conditions can quickly become really oversold. Short term bounces within a downtrend, should be sold. We think that advice is applicable today. While those looking to play a bounce, point to the percentage of stocks above their ten-week moving average, as proof of an oversold extreme, we are skeptical. With less than 10% of stocks trading above this mark, Mr. Market is certainly stretched to the downside. Importantly though, when combined with the percentage of stocks above their forty-week moving average, we reach a much different conclusion. In an uptrend (with most stocks above their long term trend, defined here as the forty-week moving average), short-term oversold levels (like the ten-week moving average) provide attractive entry points. But with the majority of stocks below both their ten-week and forty-week moving averages, a condition Ned Davis has observed 17.4% of the time, and one we observe today, the market has historically declined at 15.8% annual rate.
It’s interesting to note that the 1997-1998 Asian Crisis sparked a 20%-30% correction in domestic equity markets, before both indices exploded higher in 1999. We continue to think that the Asian Crisis is a good playbook for investing around today’s Global Sovereign Debt Crisis. An ugly global market sell-off in risk assets, which erodes investor optimism and rids us of complacency, may very well set the stage for Jeremy Grantham’s Third Year Presidential Cycle Rally, as the Fed keeps the pedal to the metal in an attempt to overcome the threat of Fisher’s Debt Deflation. More on this later. Right now, I’ve got to get some work done before heading to Greece later this week, where I’ll hopefully have some free time to chat with our friends in the Hellenic CFA Society. I’d imagine they’d have some interesting tidbits to share as well.
Disclosure: At the time of publication, the author was long US Government Bonds, Precious Metals and the US Dollar, and short the Euro and Australian Dollar, although positions may change at any time