Monday, December 17, 2007

Levels Worth Watching For A Bear Market

This post originally appeared on Dec 18, 2007 on

Last week was a sobering one for bottom-callers in U.S. markets. Many (including myself) were expecting the Fed to bring out an axe and hack rates in an attempt to close the LIBOR gap and ease the pain for those refinancing their mortgages. But perhaps they have somewhat come to their senses in realizing what we have known for a long time: Lower Fed funds rates do little in encouraging borrowers to borrow or lenders to lend if they have shifted from a psychology of risk seeking to risk aversion. The following day was one of the most pathetic dead cat bounces I’ve ever seen. The market opened up 2.5% on news of a relatively insignificant coordination of central banks to “inject liquidity,” and then proceeded to tank 3% later in the day. Perhaps the market realized what central bankers apparently have not yet: The issue is not of liquidity; the issue is of solvency. Banks need cash, not access to long term credit. So the markets closed on Friday at their lows of the week, 4% off their pre-Fed-hype highs. Financials fared even worse finishing 11% off their weekly highs.

As was addressed in a previous article The Prime Credit Crisis, the problems generally talked about as “subprime” are really much broader than that. It doesn’t really matter much what the borrower’s FICO score is. If they are underwater on their mortgage the bank will be receiving jingle mail. And there are a lot of people that still might become underwater with rising home inventories and accelerating resets as we move on. The banks need cash to write these bad mortgages off of their balance sheets.

Thus far, the equity markets have managed to levitate in spite of such problems. I believe we entered a bear market earlier this summer and the U.S. is likely to be in a recession as of this quarter. This is what fundamentals have told me when I look forward. But in order to confirm such fundamental beliefs we need to turn to the charts. I like looking at multiple time scales to find important levels. Here are some indicators I’m using to get confirmation:

1) Bull market trendline from the lows of 2003. It was tested in August and November but both times bounced. Will it bounce a third time? Keep in mind this is a rising trend line. It was at 1375 in August, 1400 in November and will be 1425 by the end of the year. Staying above this will be important to convince people “we’re still in a bull market.”

2) Similarly, people don’t like seeing negative year-to-date returns on the stock market. It has happened three times this year, with buyers causing sharp rallies each time in rather short order. The S&P opened the year at 1418. The Dow and Nasdaq have outperformed however, so all would not be lost.

3) Like the rising trendline, the 200 day Exponential Moving Average (EMA) has not trended down since turning up in May of 2003.

4) Since crossing upward at the same time, the 50 day EMA has not crossed below the 200 day EMA. A cross below would be a signal of a bear market.

Click here to see a full sized chart

5) Looking at a weekly chart, there are many of the same conditions that have remained the same since 2003 and are now in jeopardy of changing. The 20 week EMA hasn’t crossed the 50 week EMA in over 4 ½ years.

6) Throughout the bull market, the 40 level on the Relative Strength Index (RSI) has held up. Any meaningful dip below it would be telling us that something has changed in the dynamics of the market.

Click here to see a full sized chart

7) Looking at a monthly chart (which I can’t post here according to my own charting provider - they aren’t available with, the 20 month moving average is a level that hasn’t been breached on a closing basis since the bull market started. It has touched it (or crossed by a bit) a few times on an intra-month basis, but has always produced a long tail candle (meaning buyers stepped in to prevent the occurrence). The rising EMA is at 1419 this month.

8) Closing lows from August and November at 1406 and 1407 respectively.

The combination of all of these indicators indicates a massive level of support in the 1405-1420 range. I suspect that at some point this month we’ll see that level tested. Whether it breaks or not is anyone’s guess. But I will offer that with Friday’s close, the market is approaching those levels from a daily RSI reading far higher than the previous two attempts. On July 27th the S&P closed at 1458 with an RSI reading of 31. On November 7th the S&P closed at 1475 with an RSI reading of 38. And Friday’s close at 1467 was with an RSI of 47. This means that it will take a further decline than the last to give the same oversold reading that caused the bounce.

It is easy to become complacent about the importance of these indicators. Indeed, many of the same indicators I’m describing now were very close to reversing in the summer of 2006. But with the extra 18 months they are now at all-time lengths in resisting reversals.

Anyone suggesting that the market is now at a bottom and we will go on to hit new highs soon is advocating that we throw out 100+ years of market data suggesting things like “mean-reversion always occurs.” For us to enter another phase of the bull market would mean we are in a new paradigm. I frown upon such suggestions.

There may be some wishing to wait for confirmation that the U.S. is in recession before selling stocks. I will leave those with some quotes from Alan Greenspan (note the dates):

“In the very near term there’s little evidence that I can see to suggest the economy is tilting over [into recession].” Greenspan, July 1990

“...those who argue that we are already in a recession I think are reasonably certain to be wrong.” Greenspan, August 1990

“... the economy has not yet slipped into recession.” Greenspan, October 1990

It was not confirmed until March of 1991 that, indeed, the economy was in recession in July 1990. The same mistakes are repeated every time.

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