I wanted to check in on our progress along the Investor’s Cycle of Psychology.
Way back on March 11, I made the following observation:
Since I expect the renewal of the bull trend in SPY soon, two very important technical notes persuade me toward this bullishness:
- This market continues to fade the negative news, rallying on the positive. It’s a critical observation of the bullish resolve, and looking at the consolidation that’s ensued since 2/22, I find that the bullish resolve is still in tact.
- I hear a lot of noise from bulls & bears still. Each comes out of hibernation every time the trend turns in his favor. I reiterate the point I made back on 2/22: the Cycle of Psychology dictates that we’re not at a point of collapse in the markets, because with a bull/bear tug-of-war still en force, we haven’t yet transcended “Excitement” to “Thrill” nor the far reaches of “Euphoria.”
I had the right read: the market rallied another 9% from there, passing Thrill & Euphoria along the way. That Cycle of Psychology has proven a reliable guide throughout 2011’s market swoon, as always. (And I follow it, since I actually have the above illustration hanging in my office.)
So where do we stand today? Having thought about this throughout the latter half of last week, I was prepared to suggest–nay, admit–we’re at the bottom of the curve, nearing the Point of Maximum Financial Opportunity. I gathered such for two reasons.
First, I looked at the explosion of flows into safety trades as Capitulation. When I say “explosion,” I mean you have to be able to see these things from space. So, here’s a monthly view of US 10-year Treasuries:
Second, because traders are pushing their risk-hedging further out the VIX curve and institutional money is underweigh equity in general (a la Capitulation cum Despondency), the VIX is really getting suppressed, exactly as I had surmised two weeks ago:
Is a VIX print of 23 predictive of an unpcoming market rally or misrepresentative of the current atmosphere?… The question remains where & when the risk will manifest, to wit I don’t expect anything before Christmas. In a brilliant alignment of technicals & fundamentals…
- …VXX & VXZ divergence suggests more intermediate-term (VXZ) anxiety than front-month (VXX) in a kind of volatility curve contango.
- I notice a short-term Bull Pennant/Cup & Handle has developed in SPX, the inverse of which EURUSD leads by about two trading days.
- SPX also exhibits a neat bull Head & Shoulders, with neckline around 1270.
Here you can see the same kinds of explosive spikes in the VIX during crises, as with aforementioned Treasuries:
This all makes today seem like the Point of Maximum Financial Opportunity, so I’m reminded to “check your premisis.” I looked closer at those charts and noticed some false signals in certain spikes–times when the technicals seem aligned like today’s, but market conditions eventually double-dipped.
Due to its relevance as an anecdotal analogue, the only false signal I’ve included in those charts above is 1992’s Black Wednesday dissolution of the ERM I. In that instance, US Treasury markets rallied markedly in a safety-trade, but VIX and SPX hardly shuddered.
SPX seemingly faded Black Wednesday. The dissolution of ERM I was actually a boon for the UK & Italy. On the other hand, Germany’s DAX dropped -9.9% in September 1992, Spain’s IBEX -14.7%. A major European trade partner, Japan, saw its NIKKEI -12.0%. Back then, globalization and the American conglomerate had not hit their strides. Conversely, Europe today represents 21% of SPX components’ revenue* and 18% of earnings. That explains the 1992 SPX fade, but imagine the effect today, given the tight correlation between modern US & European markets. Here’s a SPX v DAX monthly chart, including correlation:
Thus, when I add context to the US/Europe 1992 analogue, today’s positioning is precarious. No surprise there, just a qualitative and quantitative justification.
Of course, I’m grounded in my outlook. It’s easy to look at a market rally as sign of repair. I know Europe herself still has not fixed anything. At the same time, American conglomerates’ sales in Europe have been deeply discounted, judging by Street expectations and management calls. The ECB has also managed to sop-up a lot of sovereign debt. While the likes of Germany are tethered to the peripheral, these recent developments all amount to more appropriately gauged U.S. expectations, not to mention lower international gross & net exposure to the EU-17. Suddenly, I’m feeling more constructive on the domestic outlook.
When I revisit my charts from a broader lens than just today’s, I do see the full sequence of Denial> Fear> Desperation> Panic> Capitulation> Despondency in SPX’s noisy channel since August.
I distinctly remember the Denial.
I can see the Fear–just ask Jeffries (JEF).
I can tell stories about the Desperation: all the meetings and rumors, culminating with a coordinated global central bank liquidity action. I have conviction in this pin-pointing of the Desperation phase, something reminiscent of the stopgap measures for Bear Sterns (March 16, 2008). The NY Fed thought it had restored confidence after rescuing Bear, but Lehman’s collapse six month later was like a wound bleeding through its bandages.
Lehman was the real panic in 2008, and I find the Panic reincarnated today in the person of MF Global. Not all Panic phases are cataclysmic. Yet, they all unveil cracks within the system, and they all yield a story for an entire generation of Wall Streeters to bestow. John Corzine’s MF Global achieved this.
Further, the market maximizes pain for the maximum amount of participants. That too has occurred–clearly evident in the non-existent NYSE trading volumes since the lows. There’s no retail participation yet, and hedge funds are still stuck with a lot of cash. Sounds like everyone Capitulated. Now, markets rally on good news and fade the bad. Sounds like we’re in a state of Despondency.
At the same time, the Cycle of Psychology reminds me that it’s not about the smart money or the guys like me (who have actually done the back-of-the-envelope math on Europe); it’s about the herd. 95% of the industry professionals I talk to daily didn’t see the Eurocrisis coming (again), they still don’t understand it, and they think it has provided a buying opportunity on Gaussian reliance. I can’t resist that right now, because they’re the market, and no catalyst stands to oppose them… yet. I referenced one such catalyst in a bullish note on earlier this month:
The next reckoning hurdle arrives with Greek bond maturities on December 29 & 30–€5.23B & €715M respectively. (Net capital outflow €2.8B.)
I’ll be quick to eat these words, but I immediately expect SPX/ES to breakout above trendline resistance at the top of this symmetrical triangle pattern:
…which suggests a move up to first resistance ~1300. Technical indicators say momentum looks strong.
Finally, I’m reminded that the half-life of every successive cycle has, well, halved. While recent liquidity provisions sidestepped the last challenge, the Jenga debt tower grows taller and wobblier with every brick, particularly with the lenders of last resort now playing the game. The only material concern I have at this point remains Greek’s next bailout installment, pending for the end of 1q2012.
–Romeo (hattip Barry Ritholtz)
*S&P only counts companies in the index that fully disclose the breakdown between U.S. and international sales and excludes utilities and telecommunications providers.