Friday, January 18, 2008

Assessing The Market

This post was originally published Jan 18, 2008 on

About one month ago with “Levels to watch for a bear market” I was writing about some technical support levels in the S&P that, if broken, would serve as confirmation for my fundamental outlook that the U.S. markets had entered a bear market earlier last summer. I listed eight indicators that I was watching, and when grouped together they amounted to quite a large level of support in the 1405-1420 area.

As of the close on Friday Jan 18th, all of those indicators have been decisively broken as the market tumbled as low as 1313. The S&P now sits nearly 10% lower than where it closed in 2007. In my years of following the markets I have never seen such despair, which is sometimes a sign that things are about to, at least temporarily, turn around. So although we are in a bear market, times like these are typically bad times to be selling stocks. Let’s take a look at the technicals.

click here for full sized chart

There is much here that suggests the S&P is in the process of forming a short term bottom. The Relative Strength Index is under 30 for the first time in nearly a year, however I don’t foresee any bounce as being much more than a function of the market working off some of it’s negativity before continuing lower in more of a panic sell-off. The increased volume thus far in the New Year is another signal that says we may need to take a breather before seeing lower prices. However, I would say that caution would be wise for those trying to time the bottom in initiating long positions. In a bear market, rallies should be used to sell existing long positions, rather than doubling down trying to recoup previous losses. The name of the game is to lose less money than the next guy. Additionally, using the RSI as a sole indicator can be dangerous, as a relatively small rally can relieve the oversold condition, allowing for large declines only days later. Last August was a good example of this. The ultimate retest of once support and now resistance indicators like the rising trendline from ‘03 and/or the 200day EMA will likely come after numerous fake-outs along the way, making it difficult to time.

I do enjoy watching the markets on a daily basis, but it is important to keep sight of multiple time frames, otherwise I find I lose sight of “the big picture.” So let’s shift to a longer term view…

Looking at the bull through a different lens
I have read many interesting articles over the past few years by well-respected writers who have been arguing that we need to be looking at the legitimacy of the recent bull market in more than the traditional metrics. For example, measuring the S&P with any currency other than U.S. dollars suggests that the bull market never even took place, and that all we are experiencing now is the continuation of major bear market that started in 2000 with the tech collapse.

This makes a lot of sense to me. I believe that stock market appreciation is ultimately a result of improvements in productivity and through innovation. There has been relatively very little of that in the last seven or eight years. The only value was created through complex financing, and that is now completely unwinding. So other than a devalued comparative metric (dollars), what legitimacy is there for the stock market to be trading 50% higher than it was five years ago? Is this a realization that could hit mainstream investors as information becomes available in the continual unwinding of our credit based economies? That possibility cannot be ignored. And the prospect of MUCH lower prices needs to be considered through the lens of a worsening credit deflation. To keep things in perspective I always refer to a long-term weekly chart from the beginning of the bull market in the early 80s, when the inflation issues were temporarily cured and globalisation and technology took the markets on a 20 year dream run.

click here for full sized chart

Also note that the index closed last week very near to the 200 week EMA.

But although we need to remain aware of the potential for an absolute collapse, there is another side to the coin that investors should keep an eye out for.

The next productivity miracle?
I have been talking about a credit deflation for a number of years now. It was one of my first observations when I became interested in the markets. Needless to say, the reception was rather sour to such an assertion. After all, notable economists had destroyed their careers over the previous decades in making similar predictions. The mistake they had made was to not recognize future productivity miracles (globalization, computers, the Internet, women in the workforce, etc.) and their effects on the demand for credit growth. So it would be foolish to be thinking credit deflation without learning from their mistakes and keeping one eye on areas of possible future investment. The western civilization has proven to be very flexible, surviving many currency crises, world wars, massive epidemics, and so on. Saying for certain that they will not solve these problems is a bit short sighted, although anything remains possible.

It is my view that there is no legitimacy in credit-based economies and fiat currencies. Their perceived success will prove to be only temporary and like many other instances over the course of western civilization, we will inevitably go back to a gold standard and learn to live with a much more reasonable (and more sustainable) level of economic growth. But regardless of those beliefs, myself and others cannot confuse long term inevitabilities with current events. There is always the possibility of postponement. What could cause something like this? I’m hoping my readers can help me identify areas that I have not yet discovered.

The obvious answer is alternative sources of energy. Energy cannot be underestimated in its importance to our economies. If we could discover a method of producing abundant sources of energy at much cheaper costs than we have with fossil fuels - and with the added benefits of improving levels of air and water pollution - we would no doubt be able to recover from a petty crisis of confidence in the asset values supporting our economy. ”If” is the keyword here. Most current solutions like wind or solar can be only partial solutions. It is going to take a major discovery, and it needs to be a market-based solution. Forced implementation of inefficient technologies will probably do more harm than good, especially if they are nothing more than politically motivated knee-jerk reactions.

Being proven correct in economic assessments, as I have been of late, can be just as humbling as being proven wrong. It very often leads to overconfidence, which can leave one worse off than they were when they began. So although we all have our long-term views, it is very wise to take note of events that can change the overall picture. We live in a fast-paced world. And if there’s anything I’ve learned in my few years of following markets, it’s that as soon as you think something ”cannot happen,” there’s a very good chance it will do just that. Always beware of people making such assertions. It can happen.

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