The $64,000 Question
The following is an excerpt from commentary that originally appeared at Treasure Chests for the benefit of subscribers on Thursday, July 2nd, 2009.
Some might be reminded of the Abbott and Costello routine of 'Who's On First' with this line of thought, but this is not the intention. The intention behind this line of thinking is to explain why stocks can go higher from here despite negative fundamental and technical underpinnings supporting them at present. After all, this is the $64,000 question on most minds right now. So, from my perspective it makes a great deal of sense to answer it because this is what we do in attempting to divine the future - a daunting task to say the least.
In order to accomplish this, and in getting back to our Abbott and Costello routine, the question is not 'who's on first', although it could be asked that way; but instead, 'who's first'. Who's first - who leads in the markets today - the currencies? This is how it was during less stressed market conditions, and some still think this is the case. And if this is the case then, equity investors should be heading for the sidelines based on the downturn in the Canadian Dollar (C$), seen to lead turns in equities at intermediate junctures.
The logic is the C$ turns down when the demand for commodities softens (Canada being a predominant global supplier), which in turn is a barometer of general economic conditions within the world economy. Some use the Baltic Freight Index in the same manner, and are likely experiencing the same degree of frustration those who continue to use currencies in this fashion are feeling right now. Why are they feeling this frustration besides the obvious - they are losing money? Answer: Because neither currencies nor freight rates (or any other obsolete leading indicators) work in this fashion anymore, not with speculative trends morphing as the markets mature.
So again, in terms of answering 'who's first', which in turn will answer the $64,000 question, the goal is to find a leading indicator that still works - right? Here's the tricky part however. It must be a factor that not many speculators follow, and therefore do not act on, because as alluded to above, as markets mature they morph, occurring so that the appropriate numbers of winners an losers remains the way it should. You see, the market cannot pay everyone, so it must change to continually weed out the weak. This is the process of natural selection in a maturing market condition, with present condition very mature indeed.
What does this mean? It means leading indicators that still work must be able to hide in plain sight because they would be found out if otherwise were true. And as you know from our previous work on the subject, with the most recent undertaking attached here, we are talking about sentiment indications provided by open interest put / call ratios on the major US indexes and ETF's (because they influence the respective markets represented). Open interest put / call ratios still work because not many speculators follow them as closely as they should, and even fewer act on them to any appreciable degree.
In fact, you would be hard pressed to find another analyst like myself who places such importance on the sentiment related messages provided open interest put / call ratios, or a commentator who even mentions them occasionally. We are not complaining of course, because this is why our system still works so well. In this regard, it's when any system becomes widely followed by speculators it stops working. This is why other widely followed sentiment studies have increasingly little success in picking turns, because when previously successful signals are reached a bunch of speculators pile into puts or calls at the wrong time, extending the present trend.
This is exactly what is happening right now to some degree. In many respects the present move in stocks is getting tired and most of the systems used by aggressive speculators are signaling a top should be at hand, yet no reversal appears. And while we may have a more interesting break lower at some point this summer / fall, based on what we know from the above discussion one would be foolish to think stocks will crash again this year in my opinion, especially if open interest put / call ratios keep rising. Here, it should be noted that as can be seen in the attached above, speculators have already taken on increasing bearish positions in anticipating a top in stocks this summer, and that if this trend persists as summer matures, our suspicions will be crystallized.
How do US index open interest put / call ratios stack up right now? As mentioned in our most recent analysis attached above, they are 'mixed' at the moment, however increasingly the trend is higher for most of the markets now, with the holdouts being the dumb money small speculators represented by the mini-NASDAQ and QQQQ contracts. This is a common occurrence at junctures such as this though, so it's not to be unexpected. Once stocks turn lower on a decided basis, which could be starting today by the looks of things, they should be quick to follow if assumptions discussed above prove correct however, meaning open interest put / call ratios should rise across the board.
As an aside to this analysis, and the only chart that will be incorporated into the text of today's commentary due to its importance, below we find the monthly plot of the CBOE Volatility Index (VIX) from the Chart Room, where based on a preponderance of implications presently being thrown off by the indicators, a turn lower in the broads is likely close at hand. Here, we have RSI, MACD, ROC, and key Full Stochastics all hitting support simultaneously, placing a high degree of certainty on the hypothesis some degree of a turn is upon us. What's more in this regard, and the reason I am not featuring more charts in support of the message being provided by the VIX is you can look at charts of the broads all day and not get the proper 'big picture' view. (See Figure 1)
For example, if you look at this attached daily snapshot of the S&P 500 (SPX), in terms of price action from the March lows, what you see is a sharp rally up until the beginning of May, with what could be interpreted as sideways price action from then until now that could be a consolidation in an ongoing bull market, cyclical (corrective) as it may be. When looking at the VIX however, no mistake can be made in interpretation due to the move straight down to the lows you see today. This was one movement, and based on this understanding, any correction at such a turn point should be considerable or for this reason. In terms of the SPX chart then, I would take this to mean that at a minimum the head and shoulders pattern present in the trade should be traced out in coming days, meaning a trip into the vicinity of 850 is in the cards.
If we are correct in terms of how speculators should react to this however, they should push put / call ratios higher sufficiently to make declines past the measured move in this head and shoulders pattern difficult, which not uncharacteristically, would also fit with other post crash historical patterns of similar magnitude to the present sequence. Why does this occur? Answer: Because under extreme circumstances it has been proven through time that human beings will react in similar fashion because the basic metal process of delusional crowds does not change. It's that simple. What's more, and for this reason, the hypothesis no crash should occur this fall is strengthened considerably, where the basic understanding is 'if the masses are expecting it, and betting in that fashion, the market cannot pay the majority of players'.
And if we are correct in our above assessment of prospects for the broad equity complex, which again, points to weakness near-term possibly extending into fall; but no crash, then the dollar ($) should correspondingly have a modest rally here as well, with precious metals feeling the pinch initially. So, don't let yesterday's bounce (or more strength) fool you, the next move of consequence in gold for example, should be down. Remember from above however, at the same time this does not mean gold is anticipated to collapse from here as the $ is expected to have only a modest bounce to match moderate losses in equities, meaning the high to mid 800's should provide support.
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Good investing all.