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October 23, 2009

Overdue SPX Pullback
by Adam Hamilton

It's sure been an awesome year in the stock markets! By this week, the benchmark S&P 500 index (SPX) had soared 62.3% from its despair-laden March low and 21.6% year-to-date. Naturally the gains have been fantastic in this dream environment for traders, with nearly all sectors relentlessly powering higher.

Our specialty at Zeal is commodities stocks, which have been thriving in 2009. As of the end of Q3, our realized stock trades this year had average annualized gains of 45.0% in our monthly Zeal Intelligence newsletter and 80.6% in our weekly Zeal Speculator. While we've had much better past years during this secular commodities bull, the getting has still been very good this year. It's been a lot of fun.

Despite such a bountiful profits-rich environment, a vexing problem is festering below the rosy surface. Virtually all professional investors and speculators, despite doing their best to ignore this elephant hiding under the rug, are well aware of it. Quite simply, today's stock markets are very overextended. They have come too far too fast, with insufficient counter-moves to keep sentiment balanced.

Balance is supremely important in the financial markets. While core supply-demand fundamentals drive long-term price trends, short-term prices are tossed to and fro by emotions. There is an endless tug-of-war between popular greed and fear that creates tactical price action. When sentiment swings one way for too long, when too many traders accept it as a new norm, the self-balancing markets soon force it back towards the opposing extreme.

Last year's stock panic was the perfect example of this critical market truth. After watching the markets plummet for months, by December popular consensus assumed a new depression was upon us. Fear was way overdone, tremendously out of balance. Back in January I used this fear to show that "the only sound bet to make based on market history is for a massive up year in 2009. We are talking 25% up to maybe even 50% gains in the SPX!"

While most scoffed at this contrary prediction as 2009 dawned, it was really pretty easy to make. When sentiment is unbalanced, when there is too much greed or fear, the smart money bets that the sentiment pendulum will soon swing in the opposite direction. Traders would do well to remember this lesson today, when complacency runs rampant and nearly everyone assumes the SPX will power higher indefinitely.

There is certainly nothing ominous about the SPX's prevailing levels today, but the manner in which the stock markets got here was very unbalanced. Since we have run higher for so long without a meaningful pullback or correction, which are healthy and expected in even the strongest of bull markets, the risk of near-term downside action is very high. This has big implications for commodities stocks.

This year's unbalanced upside action is readily evident in an SPX chart. Here the flagship S&P 500 (blue) is superimposed over the VXO (red), the classic implied-volatility fear gauge. The manner in which this year's SPX rally unfolded was very peculiar, even considering it emerged out of an exceedingly rare stock panic. While the SPX's huge absolute gains are probably justified, the lopsided upside bias in achieving them is troubling.

All bull markets face periodic pullbacks and corrections. They are healthy and necessary, rebalancing sentiment away from greed and complacency to ensure an upleg doesn't burn itself out prematurely. The difference between a pullback and correction is simply one of degree. Classical market analysis usually places the line of demarcation at 10%. Anything less is a pullback, anything more is a correction.

To help my own trading over the years, I've clarified this definition a bit. Bull markets are made up of a series of uplegs, strong moves higher running from a few months to a year. I call the retreats in between uplegs corrections. They are often larger, tend to run for several months, and typically drag the advancing market back down to its 200-day moving average temporarily. While such a full-blown SPX correction is certainly possible today, I suspect a smaller pullback is more likely.

Pullbacks are retreats within in-progress uplegs. They are smaller, tend to run for several weeks, and typically drag the advancing market back down to its 50dma. While minor compared to corrections, the mission of pullbacks is identical. The price retreats frighten the bulls enough to temper their greed and complacency with fear and uncertainty. The longer an upleg runs without a meaningful pullback, the bigger and sharper the inevitable rebalancing pullback will be.

Since March, there have been 7 SPX pullbacks which are all noted in this chart. Some have been shorter and steeper, others longer and shallower. Both kinds of pullbacks are effective at rebalancing sentiment. A fast pullback builds fear quickly, so sentiment is rebalanced sooner. A slow pullback builds fear gradually, but eventually reaches the same neutral-sentiment result.

The first pullback in late March was certainly of the former strain. A 5.4% plunge over 2 trading days, or a 2.7% average daily rate of decline, is steep enough to shock even the most complacent bulls into a state of worry. The second pullback 3 weeks later in April, 4.3% over a single day, was equally shocking. After several more weeks, the third pullback commenced in May. Its 5.0% over 5 trading days was quite a bit slower.

As they unfolded in real-time, these first 3 pullbacks of this massive post-panic upleg were very effective. As each matured, traders were getting worried. After each steep stock-market decline, analysts and traders interviewed on CNBC were quick to bring up the specter of the W-bottom (a retest of March's brutal lows). There was great uncertainty last spring so the markets didn't need to fall too long to rekindle doubt.

Then in early June, the SPX started looking toppy in the 940s. Its blistering rate of ascent out of the March lows had run out of steam. Up a staggering 39.9% in just over 3 months, expectations for a sharp retreat ballooned. The economy looked a lot shakier then, and Q2 profits hadn't been released yet. As selling pressure mounted, fears of a double-dip recession started to dominate popular psychology.

The resulting pullback, the biggest of this entire upleg, was of the longer-and-shallower variety. Starting in mid-June, the SPX shed 7.1% over 19 trading days. While slower, this pullback certainly accomplished its mission of sowing fear and doubt. Provocatively for commodities-stock traders like me, this mid-summer general-stock-market pullback hit our sector disproportionately hard.

Over the very same span of this fourth SPX pullback, the flagship CCI commodities index fell 7.0%. Crude oil plunged 17.0% and the XOI oil-stock index was down 13.6%. Despite gold holding its own with a minor 2.8% decline, its leveraged proxies of silver and the HUI gold-stock index fared far worse with 14.6% and 10.2% losses. The 5 major base metals including copper averaged 9.0% declines.

The 500 stocks of the SPX fall into 9 sectors, each of which is independently tradable via the Select Sector SPDR (pronounced "spider") ETFs. While not a perfect match, the closest SPX sector to the commodities producers and explorers we like to trade at Zeal is the XLB Materials SPDR. While the SPX itself only fell 7.1% during this upleg's fourth pullback, the XLB lost 13.2%. Thus the SPX's own materials (commodities) stocks had downside leverage to the overall SPX approaching 2 to 1 (1.86x)!

And this downside leverage makes intuitive sense. Every time the SPX retreats, traders start worrying about the state of the global economy. The more the stock markets sell off, the worse they assume the underlying economy must be. And if the economic recovery starts to look slower than expected (whether this perception is fundamentally correct or not), traders assume commodities demand won't be as robust. So naturally they aggressively sell the commodities stocks.

That fourth pullback, which ended in mid-July, was the last meaningful pullback the SPX has witnessed. Since bouncing along its 200dma on July 10th, the SPX was up another 24.9% as of this week. And this latest run higher since mid-July has been exceedingly unbalanced on a couple key fronts.

In pullback terms, there haven't been any retreats large enough or steep enough to spark widespread uncertainty and doubt again. We had a 3.3% one over 2 trading days in mid-August, a slower 3.5% one over 4 trading days ending in early September, and a still-slower 4.3% pullback over 8 days ending in early October. Not only were these pullbacks too small and slow by spring-2009 standards, they were insufficient to counter the growing complacency in the stock markets.

Remember that a pullback's mission is to rebalance sentiment. The longer any bull-market upleg runs higher without seeing a healthy injection of fear to bleed off the greed, the more unbalanced sentiment becomes. And the farther the pendulum swings to the greed/complacency side of its arc, the greater the odds for a sharp decline to restore balance. During the last few trivial SPX pullbacks, traders generally shrugged them off and didn't grow the least bit concerned. These pullbacks were too small to do their job.

There was an additional problem in the distribution of up days and down days since July 10th. The markets tend to balance themselves out even on a day-to-day basis. No matter what the prevailing trend happens to be, up days and down days follow tight statistical averages. Over the long term, across secular bulls and bears alike, the SPX tends to rise on 54% of its trading days while falling on the other 46%.

This innate upside bias exists because monetary inflation perpetually leads to higher nominal price levels and weaker stocks are periodically culled out of the big indexes like the SPX. Between the March low and the mid-June interim high, despite being in a blisteringly-fast post-panic rally, the SPX actually held fairly close to this usual distribution with 57% up days and 43% down days. But emerging out of the subsequent July lows, the upside bias grew heavily skewed.

From mid-July to late August, a staggering 68% of the days were up days. This may not seem extreme, but it is a massive deviation in statistical terms. This heavy upside skew has moderated a bit since, but still between the mid-July interim low and the latest interim high this week fully 61% of the SPX's days were up days with only 39% being down days. This is not normal or healthy, it reflects very high complacency.

And indeed the classic VXO fear gauge rendered above in red concurs. The VXO measures options implied volatility in the elite S&P 100 stocks, the top 20% of the S&P 500. These giant and highly-liquid stocks are the ones traders are the quickest to sell to raise cash when they get scared. While the VXO has been gradually retreating from its extreme despair in early March, over the last couple weeks it broke below its support.

Just this week the VXO fell to just above 20, indicating stellar complacency (the belief there is no risk at all that stocks will fall) and virtually no fear. It was the lowest VXO read since early June 2008 when the SPX was still trading above 1400 and no one knew a once-in-a-century stock panic was looming just over the horizon. I'm certainly not arguing that we are going to see another stock panic today, far from it. My point is merely that traders are way too smug about the stock markets today, their hubris is seriously excessive.

Today's sentiment extreme cannot persist, the markets abhor such extremes and quickly work to eradicate them. The only way to bleed off all this greed and complacency is for the SPX to retreat sharply enough, or for long enough, to inject a measure of fear again. With each passing day without another meaningful pullback, the odds increase considerably for the overdue next one finally hitting. Regardless of where the SPX is ultimately heading in this upleg, and in this cyclical bull, a meaningful pullback soon is inevitable.

On a side note, this pullback may have already started this week with Wednesday's sharp late-day reversal. Between March 9th and June 12th, the initial surge of this upleg, the SPX rallied for 67 trading days before that meaningful summer pullback hit. Provocatively between July 10th and the latest interim high of Monday, the SPX has now run higher for 70 trading days in its latest surge. While this symmetry isn't conclusive when considered alone, it is certainly interesting in light of the above analysis.

And no matter how bullish you are about long-term commodities and commodities-stock fundamentals, you have to realize the overdue SPX pullback will probably again hit this sector disproportionately hard. Pullbacks breed fear, and that fear usually centers around the economic outlook. Rational or not, commodities producers tend to be sold aggressively whenever these concerns bloom.

In the SPX's latest minor pullback that just ended October 2nd, this flagship stock index fell merely 4.3% over 8 trading days. Even though commodities themselves proved fairly resilient since little fear was generated (the CCI was only off 1.7%), the commodities stocks took it in the chin. Over this span the XOI oil stocks were down 6.2%, the HUI gold stocks fell 7.7%, and the XLB SPX materials stocks lost 7.6%. This downside leverage will probably grow (with fear) in the next meaningful SPX pullback.

I'm expecting this overdue SPX pullback to shake out in the 10% to 12% range. It has to be severe enough to get traders scared, thinking about a W-bottom and a double-dip recession again. So it will probably have to drift well below the SPX's 50dma (1043 today). Off of this week's latest interim high, a major 12% pullback would take the SPX to 966 or so. And unfortunately commodities stocks have a good chance of leveraging this retreat by 2 to 1, down 20% to 25%. So make sure you and your portfolio are prepared for such an eventuality.

This final chart underscores just how overbought the SPX is today. It looks at the Relative SPX, or where the SPX is trading relative to its 200-day moving average. If you are not familiar with the power of Relativity trading in defining oversold buying opportunities and overbought selling warnings, check out the new essay on it I just published last week. The SPX is extremely overbought in relative terms.

Over the past 6 weeks or so, the SPX has exceeded 1.20x its 200dma on 4 separate trading days, and exceeded 1.18x on 19 days (out of 28 total)! To see this gigantic index stretch 20% higher than its 200dma at all, let alone for so long, is mind-boggling. During the last cyclical bull ending in late 2007, as you can see in this chart the SPX seldom climbed above 1.07x its 200dma. Even in a strong bull, 1.20x is crazy.

Now admittedly some of this extreme exists because the SPX's slowly-moving 200dma hasn't fully turned north yet after emerging out of last autumn's stock panic. But even if you adjust for that, the SPX is still absurdly overextended. There is nothing inherently wrong with today's SPX levels, but it has simply climbed up here much too rapidly without the necessary intra-upleg pullbacks to keep sentiment balanced.

No matter what technical indicators you prefer, everywhere you look the SPX is extremely overbought and ripe for an imminent pullback. Complacency is extreme, the great majority of investors and speculators are not the least bit worried about a potential price retreat. And as Q3 corporate earnings widely beat expectations, more greed is flaring up too. Such heavily unbalanced conditions never persist for long.

While such a pullback won't be much fun when it unfolds, it will create great opportunities. The post-panic recovery is far from over, the SPX still remains way too low relative to its pre-panic levels as you can see in this chart. Near 1100 the SPX is still trading at 2004 levels yet the US economy, even across the stock panic, is still over 20% larger than it was 5 years ago. This cyclical bull has plenty of room to run.

If you've been looking to buy stocks, especially commodities stocks, an ideal time to do it will come late in the approaching SPX pullback. A weaker SPX will rekindle the panic trade, fleeing stocks and buying the US dollar. The resulting surging US Dollar Index (which happens to be very oversold today) will weigh on commodities (including gold) and the miners that produce them. While a serious pullback will probably only last for a few weeks on the outside, it will drive huge discounts on the elite commodities stocks.

At Zeal we can help you prepare for this coming buying op. This year we've painstakingly researched the entire populations of publicly-traded junior-gold stocks, silver stocks, and base-metals stocks and gradually whittled each universe down to our favorites. Just last month we published a fascinating new 34-page comprehensive report detailing the fundamentals underlying our dozen favorite base-metals stocks. Buy your copy today and get ready to feast on the bargains to come!

We also publish acclaimed monthly and weekly newsletters analyzing the markets and detailing what (and why and when) we are doing in terms of actual trades. As the SPX became more and more overbought in recent months, we realized more and more trades at big gains. With tons of cash to redeploy, I am really looking forward to buying aggressively once the SPX pullback rebalances sentiment. Subscribe today and become an informed investor!

The bottom line is the US stock markets are very overbought and ripe for a serious pullback. We haven't seen such an event since June/July, so today's sentiment is very unbalanced to the greed side. Extreme complacency reigns, with most traders forgetting that stocks never move up in a straight line indefinitely. Even the most powerful uplegs within the strongest bulls cannot escape periodic pullbacks that are sharp enough or long enough to spawn significant fear and doubt.

On the bright side, if you are psychologically prepared for these inevitable pullbacks they create the best buying opportunities ever seen within uplegs. Since commodities stocks have handily outpaced the SPX's gains in this upleg, they will probably get hit disproportionately hard when the markets retreat. When this coming pullback matures, and economic fears take root again, get ready to buy aggressively.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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