Why the Stock Market May Be Topping

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Markets hit tops or bottoms when almost everyone shares the same opinion. Current conditions in the U.S. stock market are reaching an excess of bullishness and this indicates a top could be forming. Investors should proceed with caution.

When it comes to market opinion, the majority is usually right and investors should generally move with predominant view in the short term. However, when majority opinion starts to become overwhelming - say less than 20% of investors are bullish or bearish - then herd behavior has taken over and its time to think about stepping aside. At extremes there is no one left to buy or sell, so there is no more fuel left to propel the market in the direction that it has been going. The U.S. stock market has probably already reached that state.

News media coverage is one of the best gauges of whether or not a market has overreached. When it starts to become too positive or negative, the end of the trend is usually near. News coverage for the recent market rally has indeed become extremely positive. When the Dow Jones Industrial Average closed above 11,000 yesterday (April 12th), it got a lot of glowing press reports. This new high for the rally was hit on volume that was below average - an indication of a lack of enthusiasm from market participants. Declining volume has been a serious problem for the rally for a long time now and will eventually do it in.

The dollar has had a significant sell off from around 82 to 80 in the last few days because of the Greek bailout. Money has flowed out of Europe during the crisis and into North America, helping to drive up the U.S. stock market as well as the dollar. A resolution to the crisis will reverse this flow and be bearish for U.S. assets. In reality, the problems in Greece are not over. While a bond auction held yesterday was quite successful in terms of selling the bonds, the interest rates Greece paid were very high - more than double the rates from the January 12th auction for similar debt. Greece's problem wasn't selling its bonds, but the high rate of interest it had to pay on those bonds. So far, the bailout doesn't seem to have fixed the actual problem. While money may no longer be flowing out of Europe, it may not be quite ready to return there just yet. When it does, the U.S. stock market will drop.

Yale professor Robert Shiller has just released an updated version of his historical PE chart for the S&P500. The current level, just below 22, is around the long-term market peak in 1966 and is higher than the PE before the 1987 crash. It is well below the 30 level reached in 1929 and the 44 level reached in 2000 though. Investors should assume that the current 22 number understates the actual PE ratio. Changes in accounting rules during the Credit Crisis have made corporate earnings much higher than they would have been, especially for the financials. The New York State Comptroller's office reported that Wall Street's earnings were three times larger in 2009 than they were in 2007, which itself was an all time record year for earnings. Investors should wonder how earnings could triple from historical highs during the worse economic downturn since the Great Depression. Disneyland accounting along with the federal government transferring money from the U.S. treasury into the coffers of bailout recipients is the answer.

As always, investors should pay close attention to the VIX, the S&P volatility index. A low number indicates investors have become too complacent and the market is likely to start selling off. The VIX fell to 15.23 yesterday and is testing levels last seen in May 2008 and October 2007. The 2003 to 2007 bull market peaked in October 2007 and stocks fell off a cliff in the fall of 2008. Investors were extremely optimistic during the 2007 VIX low, as they always are during a market top.

Disclosure: Long oil.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Do Conditions Exist for a Fall Stock Market Crash?

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


Market crashes don't take place overnight. They result from excesses that build up because the market has failed to neutralize them with intermittent bouts of selling. Stock prices always correct and if they don't do so by smaller amounts every now and then, they will correct by bigger amounts later on. While crashes almost always take place in the fall, the possibility that one might occur at that time can usually be ascertained by the condition of the market in the preceding spring.

When there is going to be trouble in the fall, the market should already be showing frothiness around March and April. This condition is currently being met. U.S. stocks have been in rally mode for over a year now without any significant correction. Sentiment indicators are starting to indicate too much bullishness and too much complacency. The most recent Investor's Intelligence poll found less than 20% of investors are bearish. This is a low number. Market Harmonics put/call volume ratio for equities has fallen to multi-year lows and is well into extreme bulllish territory. The VIX (the volatility index for the S&P 500) made a new yearly low of 15.32 today, April 12th, and this is also quite low. All of the aforementioned are contrary indicators and the lower the numbers, the more bearish it is for stock prices going forward.

While the market could certainly be characterized as overbought, the technical indicators I use don't indicate that it is severely overbought just yet, especially on the intermediate-term charts. The stock market indices got to incredibly oversold levels in the fall of 2008 and spring of 2009 and they are still working off this condition. One of the most amazing aspects of the current rally is the lack of volume support for the Dow Jones Industrial Average. Volume peaked at the bottom in March 2009 and has been in a long, slow decline since then. Declining volume on a rally indicates buyers are losing interest. For a rally to hold up for more than a year given this condition is truly amazing.

Some selling in stocks could start any time in the next few weeks, but this would probably not indicate the end of the rally. A break in a market that is already frothy can be patched up and the market can then go even higher. When that happens there is risk of much greater selling a few months down the road. Abundant liquidity is always necessary for this to occur. That exists today just as it did in 1929 and 1987. Other underlying conditions are different however. While the 1987 market was supported by falling interest rates and lower commodity prices, current conditions are just the opposite. Now longer-term interest rates are changing trend and are going to higher levels. Commodity prices,with the notable exception of a number of food commodities, are also going higher. These are negatives in the long run for stock prices. There is also political risk to the markets later this year because U.S. capital gains rates will be raised in 2011. Ironically, the higher the market goes now, the bigger investors' profits will be and the more likely they will sell before the end of the year.

The easiest way for investors to check up on the rally is to watch the VIX. While anything at the 15 level is pretty low, the VIX fell slightly below 10 in late 2006 and early 2007. Macro economic and market conditions are not as supportive now as they were at that time though, so it should not be assumed that these same ultra-low levels will be reached again. The VIX tends to bottom several months before a major stock market sell off as well. It bottomed in May in 2008 for instance and the S&P 500 low for the year was in November. Investors who think the VIX has bottomed can buy the ETNs, VXX or VXZ. This is the same as shorting the market, but is a simpler way of doing it.

Disclosure: Long oil

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This article is not intended to endorse the purchase or sale of any security.

The First Stock Market Crash of 2008

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our Video Related to this Blog: http://www.youtube.com/watch?v=CCt8d6zsjQI

Monday witnessed the biggest point drop in U.S. stock market history. While the carnage was brutal, it was by no means final and the market bottom is still waiting for us somewhere in the future. Some of the worst hit stocks were the financials (down around 13% as a whole), despite the ban on shorting them - a ban that was imposed by the SEC because manipulative traders were supposedly driving their prices down artificially (so much for that theory). Gold, the ultimate safe haven in times of crisis, was up over $20, while economically sensitive oil dropped an even greater percentage than the Nasdaq.

While the point drops were the greatest ever yesterday, the largest percentage drop is still the 1987 crash when the Dow fell 22.6% in one day (the Dow dropped 23% in two days in 1929). The Nasdaq's drop of 9.1% (200 points) yesterday can't match that drop, nor can the S&P 500's drop of 8.8% (107 points) or the Dow's drop of 7.0% (778 points). Both the Dow and the S&P would have dropped more if the ban of shorting financials didn't exist and may have even exceeded the Nasdaq's losses. As has been the case for a few months now, small caps fared better than the big caps. The Russell 2000 fell only 6.7%, less than all the other major indices.

Examination of the intraday charts show that even though the market was mostly falling the entire day, there were two notable periods of sharp selling. The markets opened on a sour note because of three major bank failures here and in Europe and continued dropping gradually until it became apparent that the Wall Street bailout bill would fail. Then the floor fell out. Only five minutes later the Dow was down and additional 400 points (and the other indices a proportionate amount). Stocks quickly attempted a recovery in immensely volatile see-saw action and started drifting down again toward the end of the day. The Nasdaq hit an air pocket at the close, dropping 35 points in only a minute. The Dow, because of the market making system on the NYSE, couldn't print a final quote at 4:00 because of unresolved trades. There were huge sell-on-close orders (institutions were desperate to get rid of stocks) the last of which were processed at 4:15. The Dow fell around 200 extra points during this extended closing action.

It is not surprising that gold went up while the stock market was tanking (if you look back at what happened the day of the 1987 crash, you will see that a number of gold mining stocks actually were up on the day, there were no ETFs at that time). Not only were traders buying gold yesterday because of the crisis in the financial system, but there were also inflationary reasons as well. The U.S. Federal Reserve pumped $630 billion in liquidity into the system on Monday. This was planned before the Wall Street bailout bill failed and was being done because of the bank failures that had taken place overnight. This amount of liquidity is enormous (and possibly the most ever) and under ordinary circumstances would have resulted in a huge stock market rally. Apparently ordinary circumstances no longer apply to the U.S stock market however.

NEXT: The Next Banks and Brokers to Cash Out

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.