We turned bearish on the stock market rally near the end of August, as a result, we’ve missed out on the last leg of the rally from 1400 to 1450 in the S&P 500. The August highs presented us with a fundamental picture that was becoming increasingly bearish and combined with the European unrest, stepping aside seemed like the appropriate action. The primary analysis simply stated that the forward returns didn’t justify the added risk necessary to capture them. The fundamental picture hasn’t changed and recent metrics suggest most of the big money is also seeking the safety of the sidelines.
Nothing has changed, fundamentally to cause me to change my mind. In fact, several measures of sentiment are becoming increasingly bearish. First of all, the general public continues to support this rally. The Market Vane bullish consensus, Investment Insiders consensus and Consensus, to which I’m a contributor, are all near or, at their highs for the year. Fortunately, it does appear that they’ve finally taken some money off of the table in the last week. In spite of this, they still hold a larger position now than they did at the beginning of the year.
Ideally, the markets would see a shift in open interest, which measures the total degree of involvement, from owning the stock market to selling stock index futures. The further the market rises, the more selling pressure small traders should put into the S&P 500 futures. This would allow them to lock in some gains while still holding their stock positions. Thus, not incurring any capital gains taxes or, missing any dividend payments. The holding pattern as it currently stands looks like it’s ready to leave the small investors holding the hot potato.
Deeper analysis from Barron’s shows that stock market insiders, those who are buying or, selling the stock of their employer has increased to its most bearish level since February of last year. Barron’s insider ratio now stands at 40 sellers to every buyer. This type of selling comes from individual employees and corporate officers understanding that their respective companies cannot continue their bull runs. Recent filings of insider transactions include sales of Allied Nevada Gold Corp., Tiffany & Co., General Mills, Capital One Financial Corp. and Franklin Resources. This type of broad based selling needs to be noted.
Barry Ritholtz published a chart this week detailing the relationships between the business cycle peak and the market peak. There were fourteen occurrences between 1929 and today. The common words of wisdom have always been, “The markets lead the economy by 6-12 months.” His research shows that the average is actually just less than four months. This means you may not have as much time to manage your finances as you thought. I’ll also throw a chart published by JP Morgan this week on market inflection points into the cycles mix. They looked at the ’97, ’02 and ’09 bottoms. All three bottoms saw the S&P 500 double from its lows followed immediately by a 50% decline. The current S&P 500 rally is 113% off the ’09 lows.
Finally, I’d like to translate the metrics we’ve used into real world trading by discussing the behavior of the commercial traders at this critical juncture. Despite the market’s rally, large traders and commercial traders are both pulling money out of the market. Money flow in the Dow Jones is negative for the month and commercial traders began exiting the market in earnest after the first week of September. In fact, commercial participation in the market is the lowest it’s been since August of 2011.
Their declining participation leads to declining market volume. Declining market volume leads to an end of the move. Home runs are hit by sticking with the trend. Clearly, the trend is up and I turned a home run into a ground rule double. Fortunately, the S&P 500 is setting up a chart pattern that may help us cross home plate. The weekly chart shows consolidation at the top accompanied by declining volume. Technically, that’s a setup for a pull back. The trade is to place a sell stop at last week’s low of 1424. This order becomes a sell order only if the market trades that low. Your profits continue to run unless the market trades down to 1424. This also allows a short entry prior to testing support at 1395.
Take heed of the fundamental and technical levels we are approaching in the S&P 500. Use it as a benchmark to compare your other holdings. Many people have been lulled into a false sense of confidence that the market always comes back. I’d like to remind you that the rallies back from the ’02 and ’09 lows were fueled by more and more economic stimulus. Whether you believe that more is on the way or, not wouldn’t you like to protect yourself from the next 50% decline?
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.