If a Bull Market ends and no one is around to short it, does it make a top?

The objective of this post is to discuss the phenomena which usually accompany (and thus signal) the end of a bull market. These characteristics are generally present around the top of both secular and cyclical movements, although they obviously tend to be more evident in the former case than in the latter. 

It appears to us that currently one would be hard-pressed to find them in the Yen market, whilst they abound in the stock market. We suspect that a year from now the words of the immortal Jesse Lauriston Livermore could come in handy: “It didn't require a Sherlock Holmes to size up the situation.” 

The list we are presenting below isn’t complete: we have not included other factors which, although common, might fail to appear with such unwavering regularity, or others which we deem less important or less distinctive of a top.

The usual companions of a dying bull market

1. An already-deteriorating fundamental backdrop (often accompanied by an actual disregard for fundamentals)

This is by far the most important characteristic. It almost never fails to appear and it almost never fails to signal that the top is near. When the mania is underway, the public stubbornly refuses to listen to the various Cassandra foretelling doom on the basis of sound factual analysis and actual data: this explains why the highest prices in a bull market are always reached when the fundamental drivers which fuelled the move have already disappeared or at the very least have significantly deteriorated and are about to change direction.

Let’s take Apple as a recent example: as Reggie Middleton of BoomBustBlog has pointed out many times in his excellent Google vs. Apple analysis, when it traded at 700$ per share the company had already been outclassed by its competitors and was losing competitiveness and market share day after day, as well as starting to feel the pinch of margin compression. And yet you could hear nothing but bullish calls on it, everybody knew it was certainly going to go to 1000$ and everybody was invested. But in all fairness, we can’t blame the poor saps: “This time is different”, after all! 

In fact, it is not: failure to appropriately consider the fundamental landscape on the basis of the wrongly-held belief that some magical forces are at work which will undoubtedly cause prices to rise indefinitely always leads to financial disaster. It happened in 1929, when stocks supposedly reached “a permanently high plateau”; it happened in 2000, when conventional valuation methods were to be be discarded because internet companies were somehow held to be “different” (i.e. they could apparently survive without having to generate any profits or even revenues); it will happen again whenever a similar set of conditions will manifest itself. To again quote Livermore: “Another lesson I learned early is that there is nothing new in Wall Street. There can't be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.”

2. Widespread public participation

This is an easy point to make: if everybody is already in the market, who is actually going to come in and push prices even higher?! The moment one buys an asset, one becomes a bearish force in the market, since it’s logical that at that point one can only sell what it has previously bought (of course we’re omitting the possibility that one buys even more, something many chaps like to do at precisely the wrong time). 

It’s like an overcrowded boat where everybody leans to one side to watch a whale: by the time they’re all there, the whale is gone and the boat capsizes. Apple was (and probably still is) the most widely held stock amongst large mutual funds and hedge funds (and we suspect we could include the public as well). 

It’s never nice to be in room full of people when somebody yells “Fire!”, but this inevitably happens at the end of major bull runs, as herd behaviour, euphoria, greed and the fear of missing out push the unsuspecting public in the trap.

3. A blow-off top / Euphoric rally

The last consideration we have just made above serves us well in explaining this next point: when everybody (including previous disbelievers) finally becomes bullish and jumps on the proverbial bandwagon, a powerful (oftentimes almost parabolic) rally ensues, which culminates in a so-called blow-off top, after which prices generally collapse right away. Sometimes, as a new wave of fools, enticed by the “bargain”, rushes in, prices sharply recover and even make marginal new highs: this tends to happen more frequently in the stock market (as an example see the S&P500 between July and October 2007) than in other markets (like e.g. commodities). 

Of course the quasi-vertical rate of ascent witnessed during these runs is unsustainable and a big hint that it’s time to get out, but to the excited public it means nothing but the guarantee of even higher prices to come. During the last year of its uptrend, Apple saw its price almost double: quite an impressive feat for a stock with such a large capitalization. But after all it was meant to go to 1000$…

4. Overly bullish and complacent sentiment

Daring to call a top of a bubble near its actual peak can prove detrimental to one’s health: people, excited by their own delusions, angrily and rabidly turn against all those who try to spoil their dreams of boundless wealth. Rational investors suddenly become “losers”, “haters”, “failures” and all reasoned arguments forwarded by them become irrelevant, since “this time is different” etc. Intoxicated by the artificial abundance of paper money and bank credit, the wonderfully irrational animal that man is happily engages in all sorts of unsustainable bubble activities, convinced that “no harm will befall you, no disaster will come near your tent” and that the Land of Cockaigne is just around the corner: all is needed is for the party to last a bit longer and not surprisingly party poopers are not welcome. 

Of course, this is nothing but a bitter illusion and the ensuing reality is even bitter. As Mises so aptly put it: “The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.”  

These considerations and Mises’s wise words apply to speculative excesses in financial markets as well: conventional wisdom postulates that when something has been going up for quite some time, then it logically follows that it can only continue to go up and those who refuse to acknowledge it have simply missed the boat…The reality is that whenever excessive bullishness, complacency, overconfidence and sheer euphoria abound, then it’s time to quietly take the other side of the public’s bet. And the unchanging human nature (helped along by the ministrations of the inflationists) ensures that after the bust the cycle is going to repeat.

Extraordinary Popular Delusions and the Madness of Crowds offers to the interested reader a colourful account of some of the most incredible historical episodes of collective folly. Doug French’s book Early Speculative Bubbles and Increases in the Supply of Money analyses the underlying economic causes of some of those same phenomena from an Austrian perspective. Gustave Le Bon’s and Humphrey B. Neill’s works are nice companions to the above books.

5. Extensive News coverage / Outlandish predictions

A useful rule of thumb is: whenever something has gone up so much that it makes for rosy newspaper headlines, then it’s time to sell it. 

The mainstream media are usually the last ones to jump on the aforementioned bandwagon: they need exciting stories that cater to a large audience, hence they all follow the latest fads. To make their products even more enticing, they generally add generous helpings of hype. 

It follows that the end of a bull run is usually accompanied by armies of cheerfully bullish journalists who regurgitate the most trite arguments to justify their (or some expert’s) shameless predictions, which usually prove to be just a stinky pile of rubbish. For a recent example, please watch this video (we want to warn our readers: even people with only half a brain will likely find it extremely annoying).

6. The initial trend change is met with scepticism (buy-the-dip mentality)

Since in the public’s mind a raising market can only go higher, all sell-offs and corrections are viewed as opportunities to get in. This belief has been reinforced during the course of the entire bull market, where all sell-offs and corrections were indeed opportunities. Unfortunately, this fails to hold true at the top, where distribution takes place: early participants (astute investors) sell their stakes to latecomers (your proverbial dentist). Countless investors have been ruined by buying one dip too much. 

This phenomenon is also due to the fact that the euphoric mental state that we discussed above acts as a filter that automatically prevents people’s brains from contemplating negative outcomes. Pride, the desire to be right and blind hope contribute to it as well. 

It’s important to note, however, that this generally happens only at the end of major bull runs in stocks, since commodities have the pesky attitude of crashing much more swiftly.

Conclusion

We hope to have provided our readers with a brief, to-the-point list of phenomena that usually accompany the end of a bull market. We’ll leave it to them to ascertain in which markets it is today possible to find all or most of them busily at work. 

We want to stress that these are helpful yet imprecise tools: they can’t endow an investor with the ability to spot exact tops; they can however help him in identifying approximate turning points, or at the very least moments when the risks of buying something greatly outweigh the prospective returns. 

Howard Marks’s last letter to his clients does a great job at explaining both the difficulties and the importance of being a contrarian: we suggest our readers save the PDF and peruse it every time they feel compelled to run with the herd. In investing what feels comfortable is rarely profitable and as the brilliant Ed Seykota once said “If comfort is your goal, stop trading.”

The Yen: a Contrarian’s Wet Dream

The objective of this post is to clearly delineate the reasons behind our recent Yen bullishness and to explain why we think buying it against the Australian and New Zealand dollars is likely to prove a very profitable and relatively safe speculation. We need however to immediately point out that everything we are going to write below is conditional upon the Bank of Japan continuing to do what it has always done (and what we think is likely to continue to do), namely to say one thing and then do another (or slowly do just a little of that one thing). In case the demented Abe is capable of fully enforcing his delirious inflationary views on the BoJ, then dear readers brace yourselves and prepare for the Misesian “disastrous bull market”… This is the main reason why we advocate implementing the trade with a judicious use of call options on the Yen (or put options on the Aussie and Kiwi), as they both buy us time and protect us from unwanted catastrophic scenarios that, although unlikely, could nonetheless materialize. With the above in mind, let’s begin our analysis.

The Fundamental Backdrop

A) Japan’s Money Supply growth is both modest and lower than that of other major currency blocks

Leaving aside temporary phenomena which might impact it, the long-term value of a currency is mainly determined by its supply and demand dynamics: in the end it will tend towards the level where demand and supply converge. So the main question an investor has to ask himself is: what is the current supply/demand status quo and how it is likely to be impacted by future developments?

We won’t cover here all the factors influencing the demand side, apart from briefly mentioning that during periods of economic turmoil society’s reservation demand for money (see Rothbard, “Man, Economy and State with Power and Markets” - Chap. 11) tends to sharply increase (as a reflection of the increased uncertainty market participants face). Of course such demand will tend to focus on those forms of money which, correctly or not, market participants perceive to be of highest quality. This is the formal explanation behind the safe haven trade and the reason why during the last crisis the Yen and the Dollar benefited handsomely at the expense of other, less trusted, currencies like the Euro. We will instead focus on the supply side.

Japan’s True Austrian Money Supply as calculated by Michael Pollaro at The Contrarian Take.

As can be seen in the chart above, sourced from the highly recommended blog of Michael Pollaro, Japan’s True Austrian Money Supply growth has been muted in recent years (readers interested in learning what this money supply measure contains and why, as well as in which respect it differs from commonly used metrics like M1 and M2, can do so here and here). Even more importantly, given that currencies do not trade in a vacuum but rather against each other, it has been consistently lower than those of other important currency blocks like the U.S., the Euro area and the U.K (not shown in the chart above and yet important to mention is the fact that BoJ’s credit has only recently reached its old 2005 peak, whilst other central banks have tripled, quadrupled or even quintupled their credit since the beginning of the financial crisis).

There are two main reasons as to why this has been (and may well continue to be) the case: on the one hand, the BoJ has been reluctant in injecting large doses of newly created money into the economy, notwithstanding all their posturing; on the other hand Japanese banks have been more than happy to grab the chance to engage in massive deleveraging (a.k.a. credit contraction), thus counterbalancing to a large extent the effect of money printing (it should be noted here that inflation is correctly defined as an increase in the supply of money and money substitutes). Going forward, the second factor is likely to remain unaltered, given that the sorry state of the Japanese economy and the increasing likelihood of a globalized slowdown mean that banks are probably going to be unwilling to extend new credit (please see chart below). So the question becomes whether the BoJ will truly print enough to overcome the deflationary effect of credit contraction and to outdo its competitors in the mindless race to devalue (on this last point please see our paragraph below). We are inclined to think that much of what we’ve heard so far is little more than political manoeuvring and that in the end they won’t seriously alter the status quo lest they may finally wreck the ship, given that Japan’s precarious position does not allow much if any room for “funny money” experiments. The BoJ’s meeting this week will give us some clues as to the likely direction they’ll take, although the actual implementation of their programs is what matters most.

A chart showing first the decline and then the almost non-existent growth of credit in Japan, via http://www.tradingeconomics.com/.

We recommend our readers to have a look at all of Michael Pollaro’s charts on Japan’s True Austrian Money Supply as well as his work on other currency blocks. We also suggest reading this WSJ article, in which the author points out that Abe’s inflationist policies might upset some powerful sectors of the business establishment (not to mention many other innocent people as well as the poor chaps at the bottom of the economic ladder, who always suffer the most from such insanity). Incidentally, this has so far been the only mainstream article we have been able to find which didn’t contain gloomy predictions about the Yen’s imminent demise and which didn’t simply regurgitate some expert’s opinion about why shorting the Yen is going to be the greatest thing since sliced bread…

B) Other Countries are unlikely to let themselves be outprinted by the BoJ

We have already mentioned the fact that so far the BoJ has shown remarkable temperance in its money printing (and that other central banks have not), but should they decidedly change course, what are other countries going to do? Are they going to let themselves be “outprinted” by these latecomers in the inflation game? On this topic we can do no better than pointing our readers to this excellent article written by the always excellent Pater Tenebrarum, which closely mirrors our own views and even includes a nice haiku for the discerning reader. It appears clear to us that the fallacious and highly damaging mercantilist approach is going to be embraced (or has already been embraced) by most nations, thus making any devaluation attempt on the part of the BoJ unlikely to succeed (particularly if half-hearted).

C) The influence of Capital Repatriation (i.e. carry trade and Japanese overseas investments)

This point analyses in more detail one of those temporary phenomena which might impact the value of a currency: the sudden shift of large amounts of capital from one currency block to another. As we have already witnessed during 2008, when a serious, unexpected crisis strikes, massive quantities of money, which previously headed, during the course of many months or even years, in a certain way, are quickly moved back in the opposite direction, thus causing extremely powerful trends in the currency cross involved. This can be likened to the effect that suddenly opening the floodgates of a large dam has on the underlying brook.

In the case of the Japanese Yen, we think there are at least two factors which might contribute to this phenomenon materializing: the infamous carry trade and the repatriation of foreign holdings on the part of Japanese investors.

The former is certainly no longer as large as it once used to be, both because many speculators got badly burned during its 2008 dramatic unwind and because the spread amongst yields has been steadily diminishing. However, the fact that the hunt for yield has become even more desperate and the stable if mild uptrend which many risk currencies (like the AUD or the NZD) enjoyed against the Yen since the post-crisis rebound of 2009 might have induced at least a modest resurgence of this phenomenon. A generally low level of forex volatility that reached its apex during last summer probably also played an encouraging role. It’s important to note that this is only speculation on our part, as we do not have any concrete evidence to back our claims.

The latter factor, on the other hand, has in our opinion the potential to generate the kind of outsized forex move we’re looking forward to. Japanese investors hold a staggering $3.3 trillion of foreign assets, which amounts to roughly 55% of their annual GDP. The Ministry of Finance holds approximately $1.27 trillion in exchange reserves, whilst the remaining $2 trillion are held by the private sector. During a crisis, either out of fear or out of necessity, some of these holdings are liquidated and the proceeds repatriated: this has an obvious boosting effect on the Yen. This is exactly what happened during the spring/summer of 2011: both the massive earthquake that shattered Japan in March and the mini bear market that shook global markets during the summer induced capital flight and thus generated a quite powerful rally in the Yen, which took place notwithstanding a globalized manipulative effort to the contrary on the part of the G-7 (which was capable only of producing a temporary spike in late March of 2011). We expect this to happen again, only on a much larger scale, during the coming bear market.

As to why we chose Australia and New Zealand as the main counterparties to our long Yen campaign (apart from the specific reasons outlined in the paragraph below), please consider the following: roughly 80% of Australian government bonds and 70% of Australian corporate bonds are owned by foreign investors (sources here and here); the situation in New Zealand in not much different, with 62% of government securities now held by foreigners. We suspect this is going to have a huge negative impact on their currencies in case of a global crisis. The icing on the cake is that Japan’s investments in Australia total more than $123 billion and account for 6% of all foreign investments in the country (placing Japan firmly in the third place, behind the U.S. and the U.K.). Almost half of this sum is invested in Aussie bonds, in a desperate hunt for yield. There are signs that this phenomenon is accompanied by dangerously high levels of complacency and euphoria ("If you think there's been a lot of investment from Japan in Australia so far, just you wait and see," Mr Beazley said. "The Australian economy looks and feels extremely secure."). Finally, the traditionally risk-averse Japanese individual investors have recently started to become excited about the U.S. and other foreign equity markets, exactly at a time when caution would be advised.

D) A Brief Introduction to the Australian Bubble

We will now briefly cover the main reasons which stand behind our calling Australia a bubble.

1. Brisk monetary growth, both in absolute terms and when compared to other countries:

The hallmark of all bubbles: monetary growth. M1 in Australia, the U.S. and Japan, indexed at 100 in January 2005.

A long-term chart showing the annual percentage changes in M1 for the same three countries. Australia has often led the way.

It appears clear from the charts above that there has been remarkable inflation going on in Australia for at least two full decades and we know that with inflation malinvestments and capital consumption inevitably occur. Japan on the other hand has certainly been the least bad of the group, something which we already remarked above [Ed. Note: since we do not have True Money Supply statistics for Australia, we are using M1, which acts as a decent proxy.].

2. Large amounts of debt, mainly concentrated in the household sector:

Household debt as a percentage of GDP: higher than in the U.S.

Australian households are buried in debt: if the economy barely sneezes, they’ll get pneumonia. In this context, it’s worth nothing that the latest PMI reading (December 2012) came in at 44.3, marking the 10th consecutive month of contraction, and that the overall picture painted by the report is rather bleak: interested readers can find more info here.

3. The always-present real estate bubble:

House prices in Australia, U.K., Canada, Spain, Japan and the U.S. via The Economist.

Year over Year % change in real estate prices in Australia, via Global Property Guide.

It’s quite obvious that there’s a massive property bubble in Australia. Other indicators looking at affordability (namely price to income and price to rent ratios) also signal massive overvaluation. Mortgages account for a large part of the astronomically high household debt [Ed. Note: readers can find some interesting info here. We also think that the whole blog is worth keeping an eye on.]. When will this bubble pop, as they all inevitably do? We wouldn’t rule out it’s already in the process of deflating, given that we’ve had two years in a row of declining prices (recall how in the U.S. prices topped in 2005, roughly two to three years prior to the actual bust) accompanied by declining sales in both the residential [Ed. Note: forget the mindless babbling of the article’s author and instead just focus on the chart at the top of the page.] and commercial sectors. Moreover, point 4 below might prove to be the prick that this floating balloon needs so badly.

4. Australia’s fate is highly dependent on China:

Exports to China constitute roughly 29% of all Australian exports, with Iron Ore accounting for more than half of the total, with Coal, Gold and Oil distant followers (all data sourced here). It’s not difficult to envision what would happened in case the much-talked-about Chinese hard landing materialized. As a side note, we’re highly sceptical of the Chinese boom as well, given that it’s built on the shaky foundations of money and credit inflation, coupled with massive state intervention in the economy (which all result in malinvestments and capital consumption). Curious readers could embark on their own research on the topic: we’ll just mention that ghost cities are amongst our favourite manifestations of the massive misallocations and imbalances currently plaguing China, mercantilist extraordinaire.

Technicals, Sentiment and Positioning

From a technical perspective, the Yen is severely oversold and incredibly stretched below its long-term moving averages (like e.g. the 200-day simple moving average):

A chart showing the Japanese Yen Index, via http://stockcharts.com/.

It’s important to note that the index above tracks the movements of the Yen against a basket of currencies and that the levels reached against certain currencies (like e.g. the Euro, the AUD, the MXN and the NZD) are even more extreme.

Yapanese Yen Futures Positioning, via http://www.cotpricecharts.com/.

Positioning in the futures market is also remarkably elevated, with small speculators holding a record amount of shorts and large speculators’ shorts at a multi-year high (significantly higher levels were recorded during the summer of 2007, right at the peak of an egregious bubble and at a time when the carry trade was still buoyant). It’s worth mentioning that this is accompanied by opposite extremes in AUD and MXN positioning, thus showing a propensity toward risk-taking and generalized complacency. We briefly mention here that record CoT readings in risk-on and risk-off currencies usually provide very reliable contrary signals on the stock market as well.

Finally, sentiment on the Yen lies at multi-year (possibly all-time) lows, with Sentimentrader’s Public Opinion Survey showing only 16.5% of bulls, after having spent quite some time in the below-neutrality zone. Moreover, the Yen is universally hated: we have yet to see somebody who is not bearish on it. Pundits and talking-heads as well as many self-appointed experts have all been quick to point out how the currency is doomed, how shorting it is going to be the best trade of 2013 (when in fact it most likely was one of the best trades of 2012...), how the BoJ will inflate ad infinitum etc. As the heading of one of our favourite blogs reads: "When it's obvious to the public, it's obviously wrong."

The conclusion is clear: rarely have we seen such extremes and they have never proved to be the hallmark of a sustainable trend.
Moreover, an investor has always to ask himself: what is the market already discounting? It appears to us that in this specific case the market has already priced in many negative developments, some real some most likely not, leaving ample space for positive surprises.

Conclusion

We are very bullish on the Yen and we are convinced that the best way to position ourselves is to buy it against fundamentally weak currencies like the Aussie Dollar. The important caveat is that the mental Abe could really wreak havoc on the country and consequently on its currency, given that Japan truly is just a little inflation away from total disaster. We always prompt our readers to engage in their own research. In our next post, we’ll discuss how secular bull markets generally end and which common traits they tend to share at such a juncture: as you’ll see, the Yen currently displays none of them.

Addendum

The BoJ set a 2% inflation target and embraced open-ended asset purchases: we have to confess that we are rather pleased to see this outcome, given that on the one hand it deprives the hallucinated Abe of the possibility to attack the Bank and on the other it gives the Bank itself the flexibility to decide how much and when to print (whereas a fixed monetary goal would have forced them to act and would have always elicited calls to "do more"). Moreover, there wouldn't be any additional money printing until 2014. We'll now have to watch like hawks how this new program is implemented (and whether the appointment of the new BoJ governor in April will change the landscape significantly), as this is what really matters: should the BoJ really print ad infinitum, then it would be game over; should they decide to continue to deliver only a modicum of money printing now and then, as they've always done, then the secular Yen bull market should resume its advance. So far the market's reaction gives us cause for optimism: at least a short to medium term rebound is likely in the cards, as too many jumped too quickly on the short yen boat.

A Technical Interlude

What’s better than starting the week sipping a nice cup of espresso, carefully sweetened by the addition of some sugar [Ed. Note: we actually like our coffee as it is and think that sugaring it should be made an offence punishable by death.]? Starting the week buying some coffee and sugar futures, that’s what!

With this post, we will provide a brief technical summary of these two markets, which in our opinion may be ripe for a buy. We won’t address their fundamental backdrop: suffice it to say that from a mid-to-long-term perspective we’re very bullish on sugar whilst we have mixed feelings on coffee. As a matter of fact, we’re convinced that sugar has not yet made its bull market high (i.e. we expect it to go higher than the 35c$/lb level reached at the beginning of 2011). Coffee on the other hand may have already had its blow-off top in May of 2011. Moreover the technical position of the former appears to us stronger than that of the latter. Finally, secular bear markets in equities tend to coincide with secular bull markets in the whole commodities complex (as opposed to specific, strictly supply/demand-driven cyclical bulls in single markets or sectors, which can happen at any time). You can peruse our post on stocks to better understand our perspective on this last topic.

Sugar

A daily chart of the sugar price, constructed using Stockcharts.

As we can see in the chart above, sugar has been constrained in a “falling wedge” pattern since its early 2011 top. This pattern tends to be resolved to the upside (i.e. it’s a bullish pattern). It’s important to consider that this current pattern represents a meaningful long-term development, given that sugar has been stuck in a rather brutal (-50% peak-to-current-trough) and persistent (two years and running) bear market. This fact also increases the likelihood that a significant bottom is either behind us (we are inclined to think that the 13/12/2012 wash-out low around 18.30c$ indeed marked such turning point) or just in front of us: as already stated, this is for us of utmost concern, as we always strive to enter positions at a time when we think that the actual risk is significantly smaller (and way less likely to manifest itself) than the potential return.
Zooming in on recent action, we can notice that significant momentum divergences started to emerge approximately six months ago and continued to increase during recent declines, reinforcing our view that there simply isn’t any meaningful selling pressure left in the market. Both the CFTC Commitments of Traders data and Sentimentrader’s sentiment survey seem to confirm this assumption. Except for a couple of short-lived spikes, the latter has been oscillating in the 25% to 50% zone for more than a year: this means that for a protracted period of time very few participants have been bullish on this market and the few that have have also been quick to become bearish at the first signs of trouble. Anecdotal evidence (i.e. news headlines) confirms an entrenched bearish mindset. The former (chart below) have registered a consistently low level of speculative longs (and a consequently low level of commercials’ shorts) since the end of this summer, recently reaching rather extreme readings (with small speculators’ shorts at record levels and large speculators’ and commercials’ positioning at opposite multi-year extremes). It’s worth noting that previous instances where market participants were similarly positioned gave rise at least to powerful rallies (see May 2012 as a case in point, although that period’s readings pale in comparison to the current ones). It is precisely this kind of prolonged despondency that generates new, powerful bull markets.

2012 Commitments of Traders data via http://www.cotpricecharts.com.

Finally, we can notice how price has been recently capped in its advances by the 50-day simple moving average, which also provided important support or resistance in the past. Although we’re already long sugar and are holding it as a long-term investment in our portfolio, the more technically inclined amongst our readers might want to wait for a convincing breakthrough above that level before committing to the long side. The previously mentioned low might act as a reasonable stop-loss level. A break-out above the important 20c$ level might also prove to be a good entry or adding point. However this is not really our cup of tea: we employ a different approach to risk management and to investing in general, but to each his own.

Coffee

As we already mentioned, we have a few reservations about coffee, but they’re mainly confined to the realm of the long-term. From a short-to-medium-term technical perspective this market seems to us to offer an excellent trading opportunity.

 A daily chart of coffee constructed using Stockcharts.

As can be clearly noticed, many of the considerations made for sugar apply to coffee as well: a long-term falling wedge pattern (not as nice as the previous one though) accompanied by meaningful divergences in momentum. Sentiment and positioning also paint a bullish picture: the survey on coffee has recently registered a depressed reading of 15% bulls (currently 26%), after having been stuck in the below-50% zone since late 2011 (with this summer’s rally constituting the only exception). Positioning is also at extremes, with commercials holding a record amount of longs and large speculators providing the mirror image with a record amount of shorts. Small speculators are in a no-man’s land, meaning they aren’t overly exposed to either side of the market. More details can be found in the chart below:

2012 CoT data for coffee via  http://www.cotpricecharts.com.

Again, it’s worth noting that a prolonged period of extreme readings usually produces a much more powerful and lasting trend than an episodic spike.

There is however something very important that differentiates coffee from sugar: the former has already broken above and rallied from its 50-day simple moving average and did so on a Friday (last one, to be precise) and with very convincing volume. Both of these are meaningful details: a powerful Friday break-out with a convincing close at the highs positively shapes the weekly chart and signals a strong commitment on the part of position traders (those willing to take their bets home with them for the weekend). It also signifies that all contracts that were sold during the week were actually sold at a lower price: this is bound to put significant pressure on many short-sellers and usually ensures at least a temporary follow through. And now enter volume: Friday’s volume on the March13 contract (the one currently traded) was the highest since rollover day (i.e. since the beginning of active trading). More importantly, it was higher than any previous down-day volume registered during the life of the contract (including both active and non-active periods). This not only shows the sheer buying pressure, but coupled with the surge from the 50-day SMA, over-qualifies Friday as a “pocket pivot buy point”. This is a concept developed by Chris Kacher and Gil Morales in their let’s-not-brag-about-our-successes book entitled “Trade like an O’Neil disciple (How we made 18,000% in the stock market)”: in the context of basing/bottoming patterns sudden, unexpected surges from or above important resistance levels or moving averages, accompanied by volume that is greater than the highest volume registered during the 10 previous down-days, often signal important changes in a market’s character and anticipate successful break-outs from the aforementioned patterns [Ed. Note: although we have more than a few reservations about the Authors and their work, editorial and not, and our investing style is as far removed from theirs as possible, we found this specific concept to offer value and we do have included it in our arsenal to our satisfaction.].

All of the above combines in making us think that coffee is a good buy at current levels, at least for the short-to-medium term. Technical traders might effectively manage their risk by placing their stop-losses either below Friday’s low/the 50-day SMA or somewhere around the recent 149/143c$ congestion area (the recent low at about 141.20c$ appears to distant to us).

Conclusion

We’re bullish on both sugar and coffee, although we do favor the former, at least from a long-term perspective. We’re walking the talk by actually being long both markets, but we want to stress that for us these represent rather small positions opened with the main purpose of diversifying our portfolio and keeping it well balanced. They offer good potential, but they also offer risks and more importantly plenty of volatility, hence they are not good candidates for a large exposure. Again, we recommend readers to embark on their own research and to always fully “own” their trading decisions: the best way to escape from losses is not to escape from responsibility.

A Brief Note on the Yen

We’re currently busy writing our second post, which will focus on the Japanese Yen. We can by no means be certain that the recent bout of selling has exhausted itself, but as we’ve stated we like to establish a position when we think that the long term potential of the trade trumps its short-term risks. Hence we’re buyers here. As to why this is the case, please find below a brief summary of the salient points, on which we’ll elaborate further during the course of our next post, which we expect to go live early next week.

Interesting Fundamentals

Inflation as properly defined (an increase in the supply of money and money substitutes) has been relatively tame in Japan, particularly when compared to the rates of growth achieved by the Federal Reserve and the ECB. This gives our bullishness a solid basis, at least until the Bank of Japan continues to refrain from implementing the “bold” (read reckless and ruinous) policies invoked by Abe (our contention, backed by actual facts, is that so far nothing meaningful has really happened: traders just think it has). When it comes to the next BoJ Monetary Policy Meeting, it seems to us that the market has likely discounted at least both an increase in the size of the asset-purchase program and the adoption of a 2% “inflation” (we use the term here in its common fallacious meaning) target. Imagine what could happen if they were going to disappoint… Even if the BoJ were to implement both, we think we could still witness a “sell the news” event. As for the long-term soundness of the trade, it’d need to be re-evaluated in light of the Meeting’s decisions, keeping in mind that one thing is to “adopt a 2% inflation target”  and another one is to actively print money at a high enough rate to achieve the Yen’s devaluation (keep in mind that it’s not so easy to outprint Bernanke). Moreover, we harbour more than a few doubts about the desirability of a weakening Yen (and the accompanying rising interest rates) and we suspect that these are shared by quite a few Japanese, including some powerful business leaders who could make their voices heard at the LDP’s headquarters (the fact is, if Abe is not a complete fool, like for example Hollande is, he’ll quickly reach the same conclusion without the need for any outside help).

Two different and somewhat interrelated catalysts

We suspect that in recent times there has been a resurgence of the infamous carry-trade, particularly in favour of what we like to call bubble currencies (the Aussie dollar is chief amongst them). This has likely been driven by the desperate and very risky hunt for yield, which has also produced the already mentioned collapse in the spread of risky bonds vs. treasuries [Ed. Note: we can personally attest to this fact, as we’ve witnessed many European banks peddle Aussie bonds of questionable quality to unsuspecting customers. This is moreover confirmed by the worryingly high 80% of Australian government bonds and 70% of corporate bonds currently owned by foreigners.].

The Japanese hold a massive 3.3 trillion $ in net overseas assets (of which roughly 1.3 trillion $ are foreign exchange reserves, whilst the rest is in the hands of the private sector), more than 50% of their annual GDP. What if they suddenly repatriate some of them (maybe because of a scary bear market in equities or a resurgence of the European debt crisis or a deepening recession at home)? We mention here en passant that Japanese holdings of Australian and New Zealand bonds are rather large in both absolute and relative terms. This, coupled with the very real possibility of a sudden bursting of the Australian bubble and a few other considerations, makes us think that the best way to play the Yen is via the AUD/JPY and NZD/JPY crosses. A careful accumulation of long-dated put options might prove to be a savvy speculation, as they could allow the owner to withstand any further upside there might be left in these crosses whilst at the same time limiting his losses to a predetermined amount in case the BoJ really goes nuclear.

Extremely oversold readings and one-sided Sentiment

The USD/JPY cross has not been so stretched above its 200-day simple moving average since at least 2005. This combines with many other measures and indicators into an extreme technical picture rarely seen and almost always destined to revert spectacularly. Countless pundits and self-appointed experts with a dubious track-record have been all over the news predicting nothing less than the total collapse of the Yen. Sentiment on the currency lies at multi-year (probably all-time) lows. There are also signs that Japanese investors have recently increased their exposure to foreign equities (mainly American ones): as they tend to be rather risk-averse, this may indicate an extreme degree of complacency in the markets and act as a contrary signal for stocks (reference our post on equities as well), which could in turn activate on of our hypothesized catalysts.

How Bull Markets end

We will also go through a brief list of the phenomena that usually accompany the end of secular bull runs, with the purpose of showing that none of them are currently present in this case. We’ll use Apple as a recent example of how such moves tend to end (although it’s important to note that not all of them reach the same mind-boggling extremes).

Conclusion

We are bullish on the Yen and we’re actively buying it. We cannot rule out further weakness (and in particular a test of the 90 zone against the USD), but we consider the risk/reward proposition to be good enough for us. Readers should always remember the importance of doing their own analysis and of proper position sizing and risk management strategies.

2013: The Comeback of the Stock Bear

 

A brief introduction to our secular perspective

The purpose of this first post is not to give an in-depth look at market history or to discuss at length what the long-term macro picture is likely to be, but rather to provide a sound analysis of the current market situation. However, in order to better contextualize  said analysis, we feel it’s important to make our readers aware of what our secular perspective is.

We are of the opinion that a secular bear market in equities started in March 2000 (this opinion is probably shared by anybody who has not lived under a rock during the course of the last decade). Secular bear markets tend to last on average approximately 17 years and at their secular bottoms they tend to reach certain specific and depressed valuation levels which in turn give rise to new secular bull markets. As we shall endeavour to demonstrate during the course of this post, such depressed valuations levels have not only not yet been reached, but not even approximated. This, the fact that according to historical records we still have some 5 years or so to go and certain macroeconomic considerations (a succinct summary of which you’ll find in the next paragraph) lead us to believe that we still remain mired in a secular bear market.

Secular bear markets all display certain characteristics, one of which is the alternation of cyclical bear markets with cyclical bull markets. During the current secular bear, we’ve witnessed two cyclical bears, followed by two cyclical bulls, the last of which is the current one. Historical precedent tells us that we should expect at the very least another cyclical bear market, more likely two.

With that in mind, let’s see why we think we may be on the verge of one of those nasty cyclical bears, but not before having covered some basic economic theory.

The money printing fallacy

“But the Fed will not allow the stock market to plunge”, “With all this money printing stock prices are bound to increase”, “QE(insert number) is stimulating the economy and putting it back on track”, we can almost hear the sceptics say. So let’s quickly deconstruct these arguments and show why money printing (these days euphemistically called Quantitative Easing in Newspeak) is not helpful to the economy at all and, as an obvious consequence, ultimately hurts stock prices as well (even in extreme situations, when money printing goes berserk à la Zimbabwe, stocks fail to make any real advances, i.e. they fall when measured against gold). To all the readers brave enough to venture on their own in the realm of macroeconomic theory we suggest to read the important classics of the Austrian School of Economics, like “The Theory of Money and Credit” and the intimidating “Human Action” by Ludwig Von Mises and “Man, Economy and State with Power and Market” by our beloved Murray Rothbard. We strongly encourage all the other readers, who do not have this somewhat masochistic vocation or simply lack the time to engage in such in-depth readings, to visit Pater Tenebrarum’s blog Acting Man: there he provides a very useful and always excellent commentary on the economy and markets and in our opinion does a great job at simplifying and summarizing rather complex concepts in a clear and concise way.

What is money? Money is the general medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods and services on the market (Rothbard, Austrian Definitions of the Supply of Money). Is money synonym with capital? No, capital represents the so-called “pool of real funding”, it is saved consumption (i.e. lower order goods) which can be used to fund investments in higher order goods (e.g. new plants, machinery etc.) with the goal of increasing productivity and achieving economic progress (i.e. doing more with less). All investments have to be funded with capital (that is: real resources that were saved before and that are now taken out from the economy’s pool of real funding to sustain the investments). Money alone does not suffice. However the fact that capital is often expressed in terms of money constitutes the basis for a pernicious misidentification.

What do money printing or the expansion of fractionally reserved bank credit do to the economy? Because of the public’s conflation of money with capital, they fool economic actors into believing that there is more capital available than it’s actually the case. They encourage investments in higher order goods that appear sustainable when they really aren’t (because the economy has the money/credit, but doesn’t have the actual real resources to fund such investments that this money/credit purportedly represents). The longer this shell game continues, the more capital is wasted in the process, further reducing the pool of real funding and thus undermining the economy as well as its future prospects. Sooner or later reality sets in and all the endeavours that appeared to be profitable because of this fictitious  abundance of capital are revealed for what they truly are: malinvestments that need to be liquidated. This happened many times before (inter alia 1929, 1965, 2000, 2007) and is happening again now:

The ratio of Industrial Production of Business Equipment to Industrial Production of Nondurable Consumer Goods and the S&P500 index (right scale, logarithmic). The  graphical demonstration of our point: all unsustainable fiat money-driven spikes in the ratio of higher order to lower order goods need to be painfully corrected. Notice the strong correlation of such corrections with bear markets. It is important to note that Corporate CAPEX has been extremely high as well as of recent: not really a bullish sign.

As such, money printing cannot achieve what it should supposedly achieve, namely to bring about economic prosperity. What it can achieve is to delay the inevitable and, in so doing, make it worse.

With these objections now out of the way, let’s get down to business.

Fundamental Conditions

In this section we intend to show you why in our opinion a new cyclical bear market is likely just around the corner. We will cover two main points: the current stage of the business cycle and the current level of stock valuations as well as the rationale behind them.

A) Where we are in the Business Cycle

A premise: there are plenty of indicators out there which track (or supposedly track) economic trends and we are well aware that not all of them confirm what we are about to show below. However if a recession were obvious no profit opportunity would currently exist. Moreover some of those indicators aren’t in our opinion reliable, as they’re either lagging rather than leading or they’re based on shaky theoretical foundations. Generally speaking we tend to favour indicators which track the performance of the manufacturing sector, as it represents the core of economic activity. We also tend to dislike indicators based on GDP or GDP growth, as we’re not at all fans of this specific aggregate (and of economic aggregates in general), although now and then we do employ it to calculate ratios (and will do so below). We may some day write a more theoretical post on the many weaknesses of GDP and other popular indicators, but for now this will suffice. Of course we encourage our readers to do their own research on the topic. Finally, although we’ll only show US data below, we’d like to briefly mention that the December Markit manufacturing PMIs came in as follows: JPM Global 50.2 (up from 49.6 in November: back in slightly positive territory after a few months of contraction); Eurozone 46.1 (down from 46.2 in November: still no end in sight for the 18-month-and-running contraction); Germany 46 (down from 46.8 in November: in contraction mode since March 2012 with 18 months of falling orders…anybody wants some DAX futures?); Japan 45 (down from 46.5 in November and currently sitting at a 44-month low, with investment goods demand contracting the most).

The first chart we show in this section tracks the performance of three popular indicators published by the Institute for Supply Management: the New Orders Index, the PMI Composite and the Production Index. They generally tend to be leading indicators, although to varying degrees, with the New Orders Index being our favourite one.

PMI Composite, New Orders and Production Index: their ability to anticipate recessions can be clearly gauged from this graph.

As can be seen above, all these three indicators have been flirting with contraction territory for quite some time (remember that a reading above 50 signals expansion, whilst one below indicates contraction; the same applies to the Markit PMIs further above). Sceptics may point out the undeniable fact that these aren’t infallible measures, as they often give false signals, as in the period from 1990 to 2000. However one always has to contextualize information: back then we were in the second decade of a very powerful secular bull market, whilst right now we find ourselves in the second decade of an equally powerful secular bear market. To further prove this point, let’s see how this indicator fared during the last secular bear market (1965-1982 or 1967-1982 depending on interpretations):

Same indicators as above, from 1965 to 1985.

It becomes clear that false signals become way less frequent, particularly as the economy enters the tail end of the secular  bear cycle. Our contention is that we are today in a very similar situation: we are approaching the final and always more painful years of a secular contraction which, as we must never forget, was born out of an egregious bubble of unmatched magnitude.

The second chart tracks the evolution of an indicator known as Smoothed US Recession Probabilities, which was created by economists Marcelle Chauvet and Jeremy Piger. Readers interested in exploring how this indicator is constructed and its workings can do so here. It is important to note that the indicator undoubtedly confirms a recession after it has long happened: if one wants to profit from its use one has to act in a sort of “twilight zone” of uncertainty (as is always the case in financial markets as well as in life in general). It is also worth mentioning that, given the way in which it is calculated, it is published with a delay of roughly two months (i.e. the last reading currently available refers to the month of October): this adds an element of uncertainty as well (one has to act early or risk “missing the train” as two mere months can induce a lot of change in the  markets). With that in mind, let’s see what it tells us:

Smoothed US Recession Probabilities: the last reading refers to the month of October and came in at 7.34%.

We can notice a quite unpleasant spike in recession probabilities as of late. The last readings were as follows: July 0.6%; August 4.5%; September 4.8%; October 7.3%. Clearly, the trend so far is up and the rate of change tends to be quite dramatic, i.e. we are unlikely to see a quiet and progressive increase: this stems from the fact that recessions tend to happen quite abruptly. False signals are rare: the only one worth mentioning happened during late 2005. The two spikes recorded in the  late ‘70s were soon followed by the 1980 recession. So the question becomes: is this recent increase likely to be a false signal? You decide! But we’d tend to think it’s not.

Finally we’d like to include a chart which shows Corporate Profits with Inventory Valuation Adjustment and Capital Consumption Adjustment as a percentage of GDP, with the Dow Jones Industrial Average superimposed (right scale, logarithmic) :

Corporate profits as a percentage of GDP: currently at nosebleed levels and they got there with an astonishing vertical rise to boot! Notice how during bear markets peaks in the ratio tend to anticipate important tops in the stock market.

We can make two important observations with regard to the graph above. Firstly, Corporate Profits currently are at very high levels relative to GDP, when viewed in an historical context. This makes us think that further economic expansion seems improbable at this stage, since this is exactly what we've already got for the last four years and corporations have benefited handsomely: does this look sustainable? Secondly, the correlation between this ratio and stock prices tends to be rather weak during secular bull markets and strengthens during secular bear markets: this might be explained with the fact that during secular declines profit margins as a whole tend to be more dependent on the economic cycle, as it frequently and dramatically swings from expansion to contraction, whilst during secular advances they are influenced by a wider array of factors and recessions tend to be less frequent, milder and only temporary. Not surprisingly, the ratio usually peaks before the stock market does and as of now it has apparently topped already: are we going to see this relationship continue? Keep in mind that since the start of the current cyclical bull market in 2009 Corporate Profits growth has been impressive and is unlikely to continue on this path: mean reversion appears to be a more probable outcome, hence further upside in the ratio above should be capped.

These considerations, as well as many other and maybe more conventional ones which we won’t cover here, have us thinking that a major turn for the worse in the business cycle is likely to happen fairly soon. Chances are, it may have happened already and its effects are going to become evident during the course of Q1 and Q2 2013.

B) Equities are Overvalued

Although deteriorating economic conditions are a necessary factor in provoking a bear market, they are by no means sufficient: we also need to have generous and overly optimistic stock valuations. Something we’re apparently getting as well! Before proceeding with the analysis, we’d like to acknowledge the excellent work done on this topic by HussmanFunds in their Weekly Market Comments. We were recently involved in a discussion on equity markets at one of our favourite blogs: a reader argued, somewhat bizarrely, that HussmandFunds’ lacklustre performance somehow disproves the validity of their research. As any real trader or investor knows, doing great analysis and employing it profitably are two very different things (by coincidence, their latest missive thoroughly and convincingly addresses this criticism and explains their long-term strategy as well as its basis). We are of the opinion that their work is not only interesting, but more importantly rooted in actual facts and sound arithmetic calculations. We also recommend our readers to have a look at the valuation research of Doug Short as well as at his other work: we do not always share his views, but he always makes for an interesting and thought-provoking read. We will present below a selection of charts from these two sources.

The first graph plots a number of valuation metrics against their arithmetic mean (for the record, Doug Short also shows the same metrics compared to their geometric mean) and the distance between the CPI-adjusted S&P Composite and its exponential regression line:

Crestmont P/E, Cyclically Adjusted P/E (CAPE 10) and Q Ratio compared to their arithmetic mean and the distance between the CPI-adjusted S&P Composite and its exponential  regression line. For the sake of brevity, we’ll leave it to the interested reader to investigate the details of these valuation measures and their validity or lack thereof. More information can be found here, here, here and…here!

It appears evident that a) the overvaluation levels reached in 2000 were egregious, whilst those reached both in 2007 and presently look quite scary as well(in fact the ‘60s bull market peaked at or below those levels); b) neither in 2002 nor in 2009 did we reach the levels of undervaluation usually associated with secular bear market bottoms (actually we didn’t even come close to those levels) and considering the overshooting to the upside of Y2K we wouldn’t be surprised to see an equivalent one to the downside. An important caveat is that of course such undervaluation levels do not necessarily have to be achieved by means of a collapse in nominal stock prices (1970s bear market docet).

So let’s now see what kind of nominal returns can an investor reasonably expect in the current valuation environment:

S&P500 Projected 10-year total annual return in nominal terms(details on the calculation method here) and the subsequent 10-year total annual return in nominal terms actually achieved by the index.

The same projections made using different valuations methods and the actual subsequent return. Extracted from this article.

As can be gauged from the charts above, the 10-year total nominal return a prudent investor (one who does not recklessly gamble in hope of finding the proverbial greater fool) should be expecting based on current valuations lies somewhere around 5% per annum. Historically, this is where  bull markets tended to peak, rather than bear markets bottom: the latter occurred when prospective total annual nominal returns where around 20%. Buyers beware!

It should be remembered that these generous valuations arrive at a time when earnings/corporate profit margins have likely peaked (earnings growth has already been decelerating for quite a while and has recently turned negative during Q3 2012, as reported by Factset).

Technicals, Sentiment and Positioning

The final section of this post will cover a variety of timing tools which we find useful in helping us assess the likelihood that a major market turning point is approaching. Again, this is not meant to be a comprehensive list: we just want to show some of the more interesting and maybe some of the lesser known technical and timing indicators we use.

We’ll start by including a somewhat arcane technical indicator, developed by McClellan Financial Publications: the previous year’s Eurodollar Commitments of Trader Report can be used to ascertain the likely direction of the S&P500 index. For some background on why this may be the case, please read here. We’ll present the most recent chart published by McClellan and then we’ll show you the graphical representation of the 2011 and 2012 Eurodollar Commitments of Traders Report.

Commercials’ positioning in the Eurodollar market: major tops in the S&P500 tend to occur about one year after major peaks in commercials’ net long exposure.

Traders’ positioning in the Eurodollar market during the course of 2011 according to data from the CFTC CoT reports: commercials’ net long positioning peaked around the end of November. Chart via http://www.cotpricecharts.com/

The same information conveyed for 2012: commercials’ net short positioning peaked around September. Chart via http://www.cotpricecharts.com/

We want to warn readers that this is by no means a perfect indicator: it can and does give false signals and even correct signals may be of the mark by a few months. However we’ve found it to be useful, particularly when one focuses only on extreme readings (like the opposite ones registered during November 2011 and September 2012). According to this tool, the stock market may have already peaked and is unlikely to find a major bottom before this autumn.

We will now show a very simple yet informative breadth measure: the percentage of S&P500 stocks above their 200-day simple moving average, with the S&P500 index superimposed:

The S&P500 index and the percentage of its components above their 200-day SMAs: the latter has been declining since at least the spring of 2011. Chart constructed using http://www.indexindicators.com/.

The chart above shows that the participation rate in the last major advances has been constantly declining: notwithstanding new cyclical bull market highs, today 80% of stocks are in a long-term uptrend, as opposed to more than 90% at previous major market tops. Rising prices in the face of declining participation tend to signal weakness. We are aware of the fact that other breadth measures do not support this conclusion, but we think this simple indicator does a better job at measuring the health of the market than many more complex others.

It should be noted that other important bearish divergences exist: most notably long term RSI and MACD divergences and declining volumes of trading. This all combines into a picture of deteriorating technical conditions that signals a faltering advance likely to top soon.

The Volatility Index confirms the assumption that we’re more likely near the end of a rally rather than at its beginning:

The S&P500 Index against the VIX: volatility is currently very low and during the recent correction it has failed to show the usual behaviour generally associated with major bottoms. Chart via http://www.indexindicators.com/.

A careful look at the graph above reveals that major bottoms are usually accompanied by a meaningful spike in the VIX (at least above 30 and more likely towards 40/45). Moreover after said spikes volatility tends to remain at elevated levels for quite some time, as fear and disbelief accompany the nascent rally and every correction is mistaken for a further continuation of the downtrend. None of these circumstances where present at the recent bottom: the VIX briefly surged above 20 and immediately collapsed and currently sits at 13.8 as of Friday’s close: is this the marking of a major bottom?

Sentiment and positioning tend to confirm our bearish outlook. We won’t include any charts, as many of them are copyrighted, but we’ll instead go through a quick overview.

Sentiment: NAIIM Manager Survey, Market Vane bullish percentage and Hulbert Stocks and Nasdaq readings all stand at rather elevated levels and have been there for a while (a sign of complacency); sentiment on the Japanese yen (a classic risk-off play) currently lies at multi-year lows.

Positioning: NYSE Margin Debt is at very high levels, signalling excessive speculation; Mutual Funds Cash as a percentage of total assets and Retail Money Market Funds as a percentage of market capitalization both lie at extremely low levels, signalling complacency and an active participation in the current rally on the part of dumb money; the spread between US Treasuries and risky bonds (High Yield and Emerging Market Bonds) currently sits at very low levels, rarely seen outside of the mid 2000s bubble years; traders’ positioning in the Japanese Yen and in the Mexican Peso both stand at opposite extremes (speculators are heavily short the former and equally heavily long the latter: this is an incredibly ominous sign that never fails to materialize at important market tops). [Ed. Note: one of our next posts is likely going to cover currency markets in general and the Japanese Yen in particular, as we believe it might prove to be a wonderfully performing long in the months to come.]

We show below the graphs of traders’ positioning in the Yen and Peso, to wet the appetite of the contrarians amongst our readers (a note on CoT charts: the persistence over time of very large speculative commitments, in either direction, is always more worrying than episodic spikes):

Traders’ positioning in the Yen: the last time we saw a higher commercials’ net long position was at the end of June 2007. Chart via http://www.cotpricecharts.com/.

Traders’ positioning in the Mexican Peso: as far as we know commercials never held such a large net short position, at least not after 2004. Other notable extremes regularly occurred in concomitance with major stock market tops. Chart via http://www.cotpricecharts.com/.

Conclusion

We remark once again that all of the above is simply an overview (although an extensive one we believe) of the current situation and does not constitute a complete market analysis. We have however performed such an analysis and we can confidently state that it confirms the view expressed above, namely that from both a fundamental and a technical perspective we’re fast approaching an important market top that will likely signal the beginning of a new cyclical bear market of unknown magnitude (we note however that at least a test of the important support zone around 1000/1100 on the S&P500 appears likely). We can not yet ascertain whether this top has already been reached: we shall endeavour to provide a real-time update if and when we become convinced that said top is in. We do note here that this mostly concerns active short term traders: we are long-term investors and we like to establish our positions at approximate turning points, when we become convinced that a major shift in trend either has occurred or is about to occur and that consequently the potential reward of the trade dwarfs the potential risk. In this specific case, we think that it’s highly unlikely that the S&P500 will close 2013 having gained more than 10% (this is our worst case scenario), whilst the possibility of a 30% or more peak-to-trough decline appears very real. Given the above, we have started to purchase put options on major stock indices, including the S&P500 and the Dax30. We have also opened some company-specific shorts [Ed. Note: we won’t generally comment or provide coverage on single companies. To readers interested in this field, we suggest checking out the work of Reggie Middleton of BoomBustBlog fame: we subscribe to his services and are deeply satisfied with the quality of his research.]. As always, we encourage all our readers to perform their own analysis.