A Quick One

The objective of this post (whose title is likely to ring a bell with rock enthusiasts) is to provide our readers with a brief update on the markets which we follow and in which we currently hold positions. It is not difficult to surmise that we’re not busy popping bottles of Pétrus to celebrate our winnings. As contrarians, we’re accustomed to coppering the public’s bets and we’re also used to being early and to suffering drawdowns that generally last anywhere from a few weeks to a few months. We rarely have the pleasure of picking exact tops and bottoms. We have however to admit that this time around the stubbornness with which the various markets persist in following their current trends is nothing short of amazing. This can either mean that A) we’re spectacularly wrong on all our major calls so far; B) for once in their lifetime, the herd is being granted by the market’s gods the privilege of being right in spades; C) the degree to which the current trends are being overstretched is going to guarantee equally strong and long-lasting trends in the opposite direction. We’ll let our readers make their own choices re the above.

Precious Metals

Since our analysis of the sector dated the 13th of February and our More-on trades of the 26th of February and the 6th of March, Gold experienced a crash of historical proportions and Silver did its best to keep up Gold’s pace.

As we mentioned we were alert to the possibility of a final washout of weak hands, although we must admit we weren’t expecting such an effective cleansing. However “shit happens” in the markets as well. We aren’t concerned in the slightest that the fundamental, long-term trend is over: we consider this correction to be just part and parcel of a secular bull market and the longer and more severe it is, the better. Those who sell in a panic always have the opportunity to regret it and those claiming that during the ‘70s Gold halved in price and that as such it now has to go below 1.000$/oz. forget the different dynamics of the last bull market and the fact that Gold experienced a much stronger advance in a much shorter timeframe, thanks to the fact that it had just begun to trade freely. As a basis for comparison, please consider that during the same period Silver (which was already trading freely and which of course has a higher beta than Gold) declined roughly the same percentage: a testament to how overbought gold was.

That said there are more than a few facts and factoids that point to the possibility that a major low has just been printed (or that at least a remarkable window of opportunity has opened up). [A retest of said low may or may not occur: we don’t now and, quite honestly, we don’t care. In case it does, it’s guaranteed to scare most people shitless.]

Here are some of them, in no particular order of importance:

• Record-high volume on GLD both on Friday and on Monday;
• Continued outflows from GLD notwithstanding a meaningful price recovery (those claiming that ETF selling is bearish and impacts the market need to remember that the total stock of gold roughly amounts to 170.000 tonnes vs. roughly 2.500 tonnes held by ETFs);
• Record-high volume in the GDX ETF;
• Record-high volume in the Gold futures market as well;
• Record-low readings on the Hulbert Gold Sentiment indicator and very low readings on the Sentimentrader Gold and Silver Public Opinion surveys;
• Extremely good CFTC CoT reports for both metals for the week ending on the 26th of April, with Small Specs in Gold basically erasing their Net Long position. To quote Sentimentrader: “In gold, small speculators have gone from holding a net 60,000 contracts in October of last year, to very nearly being net short now for the first time since 2001. They've reduced their positions over the past two weeks more than any other two-week period since 1988.”;
• A flood of bearish articles, reports and recommendations appearing on a variety of prominent financial sites, newspapers and magazines.

And here are some charts that highlight the severity of the decline and the sheer volume that accompanied it:

 Weekly Gold chart via Stockcharts. Notice the nice long “wick” at the bottom of the last red candle: it usually signals buying pressure and a bottoming process.

 

A daily chart of GDX via Stockcharts: notice the staggering volume.

Daily Chart of GLD via Stockchats: you can observe that just a wee spike in volume took place here as well.

Weekly chart of Silver via Stockcharts: way less inspiring than Gold and yet some support can be detected there as well.

A chart showing the outright collapse in Small Specs’ positioning, via Gotgoldreport.com.

Softs

Both Sugar and Coffee have experienced further declines since our posts dated 14 January, 1 February, 26 February and 13 March. Fundamentals continue to remain decidedly bullish, in particular for Sugar, and sentiment and positioning are extremely favourable to the bullish case as well. An interesting development is the marked reduction in volatility in Sugar, as measured by the width of its Bollinger Bands: our experience is that this usually signals that a powerful trend is the makings.

A slow bleeding accompanied by a marked reduction in volatility: a powerful trend change may be in the offing. Otherwise, hold on to your hat, as we may see a repeat of the Gold near-death experience (extremely unlikely an yet still possible).

The decline of Coffee prices from their 2011 peak now amounts to almost 60%. As Pater Tenebrarum likes to joke, there’s no need to worry, as it exists strong lateral support at 0. More seriously, we have now retraced exactly 100% of the previous advance (you can see the breakout area at the far left of the above chart).

Yen

This is the market where the most interesting changes have occurred. Soon after taking on the role of BoJ Chief, the apparently inebriated Kuroda decided to double Japan’s monetary base on the spot. This may very well turn out to have killed the bullish case. We shall see. We just mention that risks continue to exist and actually abound in various currencies like the CAD and the AUD and that at least a decently-sized correction is likely to occur, to erase the oversold readings and the sentiment excesses. We hold long-dated options that have indeed turned out to prove effective in protecting us from ruinous losses.

Kuroda cheering at the thought of destroying an entire country, right after having smoked some good stuff. He also seems to need a dentist quite badly, a sign that he may very well be addicted to Meth.

A daily chart of the horribly oversold Yen: after a 30% decline in a bit more than 6 months a rally is just par for the course, even if the bear market were to continue. A double bottom may be in place.

Stocks

This is the market that is frustrating us the most. After all, PMs have been great performers for years on end and they’re now experiencing a run-of-the-mill cyclical bear market; Softs are also in the last and hence tricky part of cyclical bear and the Yen is now managed by a band of lunatics. But the stock market is now in the late stages of an extremely powerful cyclical bull market, with money printing that does nothing but create unsustainable bubble activities, with macro data that now obviously point towards a recession (in the U.S.: the rest of the world is already deep in doo-doo), with earnings that are now clearly deteriorating and with sentiment and positioning that have now been signalling for quite some time a speculative frenzy and yet it refuses to beak down. Each and every time it tries to do so, there you have support coming in and, presto, new highs are achieved. Not even the DAX can manage a half-decent decline. The only positive development we’ve seen so far is the recent increase in volatility and in daily ranges, something that usually accompanies the distribution process that takes place at a top.

A chart of the DAX: after tagging the 200-day SMA a bounce occurred and now we’re again above the 50-day SMA. The chart doesn’t look very bullish though.

 Here we have the S&P500: it refuses to break down. Notice however how choppy the recent action has been: generally it is not a good sign when it occurs after long and powerful advances.

Conclusion

We need to exercise patience and wait for our investment theses to play out. The more the various markets keep going in the current direction, the more they’ll need to play catch up once the reversal occurs. The only notable exception may be the Yen, given that there’s now been a catalyst powerful enough to change the secular trend.

Miscellanea

The objective of this post is to provide our readers with a quick update on the markets we have covered thus far, while waiting for our next major post, which will cover the precious metals market.

Stocks

The S&P 500 has advanced less than 4% since our post on the coming bear market, but judging from the bullish noises made by various pundits and commentators you’d tell it has doubled. CNBC has even put on their screens a “countdown window” measuring the distance between the current Dow level and the all time highs.

From a fundamental perspective, the recent data releases have confirmed what we’ve long been thinking: the global economy is at best growing at a very mild pace, but most likely it is in the first phases of a contraction. Europe is undoubtedly in a recession, no matter how desperately talking heads try to positively spin the data: the recent Markit PMIs were supposedly a success, since the pace of contraction eased a little…big deal! Not to mention the fact that France is falling fast into the grave Monsieur Hollande has been so busy digging since coming to power. European retail sales were also disastrous (no surprise here for those who understand the specular concepts of overconsumption during the boom periods and forced savings during the bust). China is showing a lacklustre “recovery” (we’d prefer to call it: “short-lived rebound artificially engineered by means of inflation”), as evidenced by the latest PMI readings. Japan continues to be stuck in a recession, with the only difference being that now companies face additional pressures on their margins, given that a weaker Yen has pushed up their input costs, while their output prices continue to fall amid strong competition and a lack of demand for their products: they can of course thank Shinzo Ape (no, it’s not a typo) for this one. The US economy is also sending more than a few warning signals (and we are not referring to the meaningless GDP) and is in desperate need of a recession to correct and liquidate all the malinvestments engendered by the Mad-Hatter-in-chief Bernanke. It seems likely to us that much of the positive surprises in data recently released are due to the already high and recently accelerating rate of inflation, which furthers the aforementioned malinvestments. Moreover, earnings and revenue growth have at least stalled, but our suspicion is that they’ve started reverting to the mean: after all, many companies have issued negative guidance, either for the year or the quarter.

Technically, the stock market remains very overbought and ripe for a correction. Bullish sentiment and complacency have reached new extremes and many sentiment and positioning measures are now well into their danger zones (e.g. NAAIM Survey, Investor Intelligence, AAII, Rydex Fund flows and positioning, Hulbert Survey etc.). In short: the retail investor is back, eagerly waiting to get fleeced again.

We’re willing to make a wager here: we think that the actual top is less than 5% away (i.e. we think the S&P won’t surpass 1575, much to the chagrin of CNBC). Timing-wise, the prediction is a more difficult one to make: we may be two weeks or two months away from a top. It will all depend on how the stock market behaves: given that it’s already very overbought, if it were to rise fast towards the all-time highs, it’d probably mean a top is in; however, if it were to correct a little and then resume it’s advance, then we’d be looking at a longer topping process that could drag out until March or April. In any case these are just exercises in futility: what really matters is that we are convinced a top is near and we’re committed to the short side, as this is were the best risk/return proposition lies. To all the bulls pressing us to buy we can only say: “After you, my dear Alphonse”.

Yen

This is were things really get interesting! The Yen is as oversold as it has ever been, with e.g. the EURJPY cross stretched more than 22% above it’s 200-day simple moving average, something almost unheard of for a major currency pair like the EURJPY, which only happened before during the 2008 panic, for strong fundamental reasons to boot. But we’ve discovered a little something that might turn the bears dreams into nightmares… We’ve already commented about the usual strategy employed by the BoJ (to say a lot and then do a little) and it appears that this time they’ve really surpassed themselves!

The details are as follows: the BoJ recently announced ¥13 trillion of monthly purchases of JGBs and T-Bills starting in 2014, but what has apparently gone unnoticed to the hordes of excited bears is that these purchases are gross (i.e. they include rollovers, that is purchases made to reinvest the proceeds of redeemed securities). Net purchases (which are made with newly printed money), on the other hand, won’t amount to more than ¥10 trillion per year, that is more than 10 times less than advertised (as a basis for comparison, consider that current monthly purchases amount to ¥3 trillion).

Now this is a remarkable sleight of hand! They’ve fooled pretty much everybody into thinking they’re going kamikaze, when in reality they’re going to print one tenth of what they claimed and one third of what they already print. We think that such an achievement might warrant an entry in the Urban Dictionary: “to pull off a Japanese”. Derren Brown stands in awe.

Of course market participants can continue to ignore reality for longer than it appears humanly possible, nonetheless with sentiment in the dumps, more and more stories pointing to the resurgence of the carry trade and extreme CoT readings we remain convinced that the Yen is going to revert to the mean and then some. It appears increasingly likely, though, that this will happen in concomitance with the decline of the stock market, exactly as in 2007: patience is advised.

Softs

Sugar is behaving in a rather bullish manner: after washing out some more weak hands with a new low on 23/01, it immediately reversed up on huge volume and then proceeded to play a new trick on bulls, staging a high-volume reversal to the downside on 29/01 and then going through a very volatile range on 30/01, before resuming its march higher over the next two days before closing the week on a mixed note. Price now sits right just below the 19c$ level and the 50-day simple moving average and both have acted as strong resistance in the past. We suspect however that an upside breakout is imminent, not least because the recent CoT reports showed commercials going net long for the first time since 2007. Sentiment remains subdued, increasing the likelihood of positive surprises.

Coffee on the other hand is showing weaker behaviour: after an initial follow-through from its break out level, it plunged right back to the 50-day moving average and then after a couple of days moved below it. It now stands again just below this key average, with favourable sentiment and CoT readings. We continue to remain bullish, but this latest development forces us to consider the possibility that the bottoming process is not yet finished and that as such further volatile spikes and corrections could occur.

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.”