War Rally Euphoria

By: Adam Hamilton | Fri, Mar 28, 2003
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My trusty Webster's dictionary tome defines the word "euphoria" as "a feeling of happiness, confidence, or well-being sometimes exaggerated in pathological states as mania."

In light of the absolutely awesome action in the US equity markets in the past couple weeks, euphoria is an appropriate description of the amazing spectacle that we have just witnessed.

In its first run of 8 consecutive winning days since December 1998, the flagship S&P 500 soared an incredible 12%! Last week the US equity markets witnessed their biggest weekly gain in two decades, since October 1982! With exciting records like these being achieved, it is no wonder that our recent monster rally captured the attention of investors and speculators worldwide.

While it is only natural for us mere mortals to want to feel happy and confident, we certainly don't want to go overboard and stray into the second part of Webster's definition of euphoria, grossly exaggerating these positive feelings in a pathological state like a mania.

In these emotional times at the advent of a dangerous foreign war, investors and speculators need to carefully consider the fine line between healthy confidence and pathological mania states reminiscent of the NASDAQ bubble in early 2000. Is the war rally euphoria that we have all marveled at in recent days healthy, or has it approached the pathological mania stage?

As an outspoken bearish speculator who is heavily short, the awesome war rally certainly moved against all of my own personal positions. After the second day of the war rally, which was then technically still a pre-war rally at the time, I wrote and published an essay called "S&P 500 Waterfall Imminent". In this essay of two weeks ago I expressed my belief that the S&P 500 was soon heading for an ugly waterfall decline culminating in a new interim low and V-bounce.

It was really interesting as within one or two days after this essay was published I was deluged with an immense number of questions and flames. Some folks wondered if I had changed my mind after a few days of rallying and others were chortling with glee over "the end of the bear market" spawned by Washington's attempted annexation of a far-off third-world foreign nation.

The euphoria waxed so intense that by last Friday the talking heads on CNBC were virtually unanimous in forecasting the end of the war in a couple days and were talking about how folks were actually scared to be short. After 8 consecutive winning days and an awesome rally I was starting to think that actual stock-market bears were even harder to find than the Bush Clan's perpetual nemesis Saddam Hussein!

Dan Basch, a speculator friend of mine who has graciously shared some of his outstanding research work with me that was featured in some past Zeal essays, coined a wonderful new word to describe the apparent extinction of the bearish operators late last week. He spoke to me of the glorious rise of a brave new species of speculator he calls the InstaBulls!

Isn't this a fantastic word? In addition to the perpetually bullish perma-bulls, the war rally euphoria caused a sea-change of sentiment among many marginally bearish players. They were almost miraculously transformed from concerned skeptics before the war rally launched to fanatically zealous bullish cheerleaders only one week later. Behold the rise of the insta-bulls!

The popular rage of insta-bulldom swept through the bearish community like the Black Death last week. Before the dust settled, the tsunami of optimism and greed over the war had crushed or drowned the vast majority of bearishly oriented speculators who existed before. While the perma-bulls brazenly proclaimed that the Great Bear was dead, killed by Washington's phalanx of cruise missiles, the few remaining bears and shorts huddled in their foxholes in fear.

Now that the war rally euphoria is finally dissipating like a chemical-weapon fog in the wind, rationality is slowly catching up with the perma-bulls and the newly minted insta-bulls. The temporarily sidelined debate over the near-term future direction of the US equity markets is beginning again. At stake are literally hundreds of billions of dollars worth of investors' and speculators' scarce capital.

Is the Great Bear dead as the perma-bulls claim and the insta-bulls wish? Did the war rally euphoria slay the fearsome beast that has viciously terrorized us for so long now? Or is the Great Bear ready to roar out of its cave with a vengeance again in the coming weeks and months?

There is almost certainly no more important question facing the financial markets today!

While it is no fun and certainly unpopular to be bearish, unfortunately I still strongly believe that the latter scenario is most probable by far. Amazingly enough, fear of Saddam Hussein wasn't the cause of the Great Bear market which began in 2000 and Washington's assassination of the Iraqi clown won't end the Great Bear market.

The overwhelming weight of fundamental and technical history powerfully suggests that the bulls are about to get slaughtered and the bears are about to feast on bull flesh in another massive barbecue.

I believe that a waterfall decline in the US equity indices is still imminent for three primary reasons. Conspiring to make this case are the current extreme equity overvaluations, the glaring lack of a technical sentiment bottoming signature before the war rally launched, and the powerful technical sentiment topping signature just witnessed this week. Considered together, this triad of evidence in favor of the bearish case is amazingly compelling.

We'll begin with valuations, the number one reason why the war rally euphoria was nothing more than that.

While the perpetually dueling emotions of greed and fear drive financial markets over the short-term, valuations are truly the ultimate driver of financial markets over the long-term. In history Great Bear markets following extreme bubbles never reach their ultimate long-term bottoms until these markets are fundamentally undervalued in price-to-earnings ratio and dividend yield terms. Period.

The last graph and final quarter of my "S&P 500 Waterfall Imminent" essay published two weeks ago explain the current equity overvaluation and resulting problems in some detail if you are interested in learning more. Since US equities haven't even been ground down to fair value yet, let alone undervalued levels, since the bubble burst in the States, the probability approaches certainty that we haven't witnessed our ultimate bottom yet.

To make matters even worse, the war rally euphoria ran valuations back up into even higher levels of overvalued extremes than I mentioned a couple weeks ago. Expecting a final long-term bottom in US equities when the markets are still extremely overvalued is like hoping for a 100-degree day in Alaska in December. Sure, maybe it could somehow happen, but the odds are overwhelmingly against it!

While the number one reason why we haven't yet seen a long-term bottom in the US equity markets is purely fundamental based on valuations, the other two reasons are technical and are based on emotional sentiment, popular fear and greed.

Interestingly, since short-term market movements within the primary trend are utterly dominated by fear and greed, distinctly recognizable sentiment signatures of both meaningful interim bottoms and meaningful interim tops emerge. By closely examining the war rally in light of these telltale signatures, we can gain a good idea of whether the war rally still has legs or if it is likely already exhausted.

First we will consider meaningful interim bottoming signatures marked by extreme fear and then we will take a look at meaningful interim topping signatures marked by extreme greed. After you carefully consider the heavy implications of these charts I think you will understand if not fully agree with my belief that a vicious waterfall decline remains imminent.

Since the S&P 500 index is the best major proxy for the US equity markets as a whole, we are using it in our graphs this week. Please bear in mind though that the exact same conclusions would be reached as well if we looked at any other major index relative to fear and greed extremes.

All meaningful interim market bottoms are carved during episodes of great fear. If you want to know if a particular market bottom is likely to hold for at least a few months, all you have to do is find out whether or not it emerged out of the depths of widespread fear and despair. If the markets appear to bounce in the absence of exceptional fear, then the bottom is false. No fear? No bottom!

Did the recent war rally erupt out of great fear?

My favorite proxy for general fear in the US equity markets today is the venerable VIX S&P 100 Implied Volatility Index. If you are unfamiliar with this powerful indicator or would like to review, I have discussed it in great depth in many past essays including "The Bust and the VIX". The VIX measures implied volatility, and extreme market volatility is most often witnessed when the majority of players are scared, near major interim bottoms.

The graph above shows the VIX relative to every major interim low in the S&P 500 in its Great Bear market to date. You will note that the VIX spikes dramatically when any major V-bounce low is achieved. Three numbered VIX spikes marking interim lows are highlighted in yellow above and they all share similar characteristics, a kind of tradable bottoming signature or fingerprint.

First, before the waterfall declines leading into the left legs of the V-bounces begin, the VIX generally trades sideways within a lower range. These zones of complacency are highlighted with the yellow ovals above. As the waterfall declines accelerate, the fear in speculators explodes and their frantic trading vaults up general volatility and the VIX with it. The VIX soars far above the immediately preceding terrain and reaches very high levels often approaching or exceeding 50. These mega-VIX spikes betray the great fear marking true interim bottoms.

If the lows before the euphoric war rally of last week were meaningful, they should have a similar bottoming signature. The VIX should have exploded above surrounding terrain to new heights as fear grew too extreme in the days immediately before the war rally launched. Remember, no meaningful bottoms are ever achieved without widespread fear!

Provocatively, the graph above reveals absolutely no bottoming signature before the war rally! The VIX had spiked from the mid-20s to 40ish at point A, but that was definitely not a major interim bottom because the US markets continued to relentlessly fall until the lower point B about a month later. Between points A and B the VIX traded sideways establishing a relatively high zone of complacency, but when the euphoric war rally suddenly erupted at point B there was no extreme VIX spike and hence no widespread fear.

If the war rally didn't launch out of extreme fear, then our most recent bottom at point B is false. That's right, no fear means no bottom!

Since the war rally didn't launch out of a fear-filled environment, the probabilities are vastly in favor of the hypothesis that the war rally will soon fail if it hasn't already and that a brand new bust-to-date interim low is approaching in the next couple months or so. If you carefully examine the entire chart above you will note that the only meaningful interim lows are carved during great fear characterized by massive VIX spikes.

In the absence of a major VIX spike, speculators have to assume that the war rally is purely emotional based on irrational euphoria and that it is probably already dead!

Besides, war is the greatest waste of scarce resources that we humans can undertake, taking valuable capital away from entrepreneurs and free enterprise in order to first build bombs to destroy expensive infrastructure and then stealing even more capital from innocent American taxpayers to rebuild from the rubble. War is a total economic loss for all sides, a catastrophic misallocation of scarce capital with fearsome inflationary consequences.

As usual, I also have a couple side notes on the graph above.

First, note the heavy resistance that the S&P 500 has faced at its 200-day moving average, especially in early 2002. Provocatively the flagship US equity index has not been able to break decisively above its 200dma in this whole bust to date! It is ominous that the war rally, exciting though it was, totally failed at the S&P 500's 200dma. This is another immensely bearish piece to place in the near-term market puzzle.

Second, serious mini-bear rallies after a bear downleg begins are not uncommon. The 12% war rally looks an awful lot like the early 2002 mini-bear rally shown on the graph above that ran up 8%. It is interesting to contrast these mini-bear rallies with the truly massive bear rallies that erupt from fear-filled interim bottoms. These authentic bear-market rallies in the S&P 500 typically run up 21% or so. The war rally, though no doubt blisteringly fast, pales in comparison to the real thing.

From a technical sentiment perspective, the awesome war rally looks to be fake, a purely emotional buying panic and short-covering bonanza spawned by a distant foreign war not even remotely related to the US stock markets.

While the distinctive bottoming signature necessary for a meaningful fear-based major bear-market rally to spawn is conspicuously absent before the war rally began, it is ominous to note that the war rally has also signaled a major interim market top!

Just as meaningful interim market bottoms are signaled by widespread popular fear among market players, meaningful interim market tops are betrayed by widespread popular greed. An outstanding technical sentiment indicator useful for quantifying greed is the 21-day moving average of the CBOE's famous Put/Call Ratio.

Options traders willingly and enthusiastically undertake one of the most risky and highly leveraged forms of speculation. When they think the markets are heading higher they buy call options, and when they see lower prices ahead they buy puts. Contrarian speculation theory states that most traders are wrong at the crucial turning points (both long-term and short-term), so prudent speculators will carefully watch the PCR and its smoothed 21dma for signs of unsustainable greed or fear on which to capitalize.

When the Put/Call Ratio is low, it signals that traders are loaded up to the gills with calls, bets for higher prices. It is provocative and sobering to note that at these very times are the optimal moments to throw short, betting against the chronically wrong majority. The PCR 21dma shorting zone in the graph above is shaded yellow and it marks the times when the PCR was too low because traders were too bullish and greedy.

Every major interim top in the whole S&P 500 bust to date coincides with a low point within the PCR 21dma's gradually rising uptrend channel! These interim S&P 500 tops are all marked above with yellow lines intersecting the PCR 21dma levels witnessed at each stock-index topping point. When the PCR falls low enough to scrape the bottom of this channel, it clearly signals that popular greed and complacency are far too great hence falling stock-index prices lie dead ahead.

It is unbelievably ominous to note that the most recent PCR 21dma shorting signal has been officially triggered at the very top of the euphoric war rally! Since the Great Bear bust began this powerful topping signature has perfectly marked 8 outstanding shorting opportunities in a row. What do you think the odds are that it will be proven right again this time?

As the PCR 21dma illustrates, the time to recognize meaningful interim tops and be short is when many more calls are being purchased than puts, signaling extreme greed and complacency. After witnessing the market action of last week, I have a hard time remembering a similar week that even rivals it in terms of raw greed. I don't know if I have ever seen more hubris than the talking heads on TV assuming that Bush's Iraq invasion would be over within 3 days after it started. Unreal!

While the greed-driven euphoric war rally was certainly exciting, three hard facts conspire against its very survival. First, the US equity markets were far too overvalued to reach a serious long-term bottom before the war rally began and they are even more overvalued today. Second, the war rally didn't emerge out of fear as no distinct interim-bottoming signature heralded its birth. Finally, when the war rally failed at the S&P 500's 200dma, a powerful topping signature was witnessed, suggesting that the markets are destined to plunge soon.

Any single component of this triad of bearish evidence alone would cause serious concern about the staying power of the euphoric war rally, but all three taken together are catastrophic for the bulls. When both long-term valuation and short-term sentiment conspire to bludgeon a market lower, no force on Earth can stand in their way.

So, to the legions of insta-bulls out there who asked me if I retracted my "S&P 500 Waterfall Imminent" prognostication after a few days of war rally euphoria, the answer is heck no! I still believe that probabilities are vastly in favor of the US equity waterfall commencing in April, soon after the standard end-of-quarter window-dressing season is over.

Although the markets may yet crush this waterfall call, I will even go so far as to say that I believe the euphoric war rally is already dead. If not dead, it is certainly dying, as the extraordinary firestorm of raw greed unleashed last week seems to have pretty much already burned itself out.

If you are interested in discussions on the crucial psychology of speculating successfully and how to avoid being fooled in the future by inconsequential fleeting events like this euphoric war rally, I am going to attack this very topic in the new April issue of Zeal Intelligence which I expect will be published on April 1st for our dear subscribers.

In addition, the new ZI will also discuss all of our outstanding options trades based on the US equity indices in light of the war rally, not to mention the current exciting gold-stock scene. Thankfully there are lots of fantastic opportunities coming up to directly profit on the silly war rally euphoria that we witnessed last week!

The bottom line is that the recent euphoric war rally in US equities was not the good kind of happiness and confidence that Webster mentioned, but the second maniacal pathological kind.

Pathological greed is an immensely dangerous emotion that always ends in catastrophic capital losses for those foolishly swept away by it. Never forget the horrific price that the NASDAQ investors have already paid for their own pathological greed that manifested itself in a bubble!

Today's insta-bulls are on the verge of learning another brutal lesson about the grave dangers of pathological euphoria.


 

Adam Hamilton

Author: Adam Hamilton

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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