Jay - good to hear from you. You came right as the market appears to be rolling over again! Just wrote this today:
Since the bear market began in March of 2000 the US stock market has had 3 major rallies. One in the summer of 2000, another that lasted from April to August of 2001, and finally one that began last September and lasted until the first week of January.
Each of these rallies started once the market reached an oversold condition based on technical indicators and investor sentiment indicators such as the VIX and the Put/Call ratio. Initially these rallies were sparked by a technical bounce fueled by short covering, bottom fishing, and interest rate cuts, but as the rallies continued stocks became bought based purely on psychology.
Investors bought into the rallies in the hopes that the bear market was over and the faith that Alan Greenspan would make the market go up. Never were fundamentals the driving force behind these rallies. That’s because stocks never got cheap enough to attract true value investors. In fact if people looked at fundamentals they would have sold a long time ago and would continue to sell as the market is now at a valuation analogous to what it had at the March 2000 stock market peak.
However, since market bulls didn’t buy on a valuation basis they had to buy on the hopes of simple slogans such as “stocks always go up when interest rates or cuts,” “when they say there is a recession it is over,” “bear markets last only 6 months,” “money in money market accounts must go into the stock market,” or “Alan Greenspan will bail me out.”
The problem is slogans aren’t based on facts and rarely are aligned to reality.
But slogans are enough to cause people to buy stocks and fuel market rallies. Especially when a Fed Chairman who has been pumping money like mad into the monetary system backs them.
This current rally has been fueled by the hope that the economy will rebound sharply in the second half of the year. Bullish fund managers and TV commentators say that valuations do not matter. They say the market will pause or trade slowly up and earnings will catch up with stock prices later. The problem is, that even if this were true stocks have reached such a high valuation that the economy would have to grow faster than it did in the bubble days of 1999 for stocks to reach a sane violation. This clearly won’t happen. In reality the bullish prognosticators are saying this simply because they need a hope to hang their hat on and it is the best one they can find. If you are fully maxed out in your fund you need some reason to be long on stocks and if everyone else is saying the same thing then it must be right.
Most people don’t become bullish on the stock market until they buy stocks. Once everyone is fully invested though market rallies run out of buyers and come to an end. I was hesitant in calling the January peak the top until the market action became bearish, because we had not yet seen signs of an extreme bullish sentiment top that signals buying exhaustion.
We are seeing that now. The Investors Intelligence Survey shows 53% bulls and 24% bears. This is a level that hasn’t been seen since the summer top. The VIX has fallen to 21.93. This is important because readings in the low 20’s have historically signaled sentiment tops in the options market. In January of 2001 the VIX signaled an important market top at 22. In July it signaled a sentiment peak by falling to 20.24. Historically readings between 20 and 21 have signaled major tops.
What the VIX does is measure the premium that option traders are paying for market volatility. When the VIX goes to a low reading it means that hardly anyone believes that the market faces any risk of decline. It is a concrete measurement of sentiment and one of the most accurate ones.
To understand it another way when market declines come to an end people panic and buy high premiums for market volatility, causing the VIX to sharply rise. When people become overly bullish they no longer expect the market to decline or correct and the VIX falls into the low 20’s.
So the market and the VIX have an inverse relationship to each other. When the VIX drops the market usually rises and vice versa. However, when the VIX goes to 20-21 it eventually – and usually quickly – turns around and begins to trend up. At the same time the broad market ceases to rally.
The Chicago Board of Exchange also created the VXN, which is similar to the VIX, but uses Nasdasq options for its calculation. It has only been in existence for a year. Its lowest reading ever is 43.17. On Friday it fell 5% to close at 45.67.
The current readings of these two indicators tell us that the market cannot rally much more at the moment. Another up day or two will send the VIX down to 20 and the VXN down to all time lows. Without a significant correction the market probably could only put on a 30-50 point rally from current levels without becoming completely overbought.
So at the moment you have a potential upside of 50 points on the Nasdaq and a downside of hundreds of points.
Another factor to be concerned with is Alan Greenspan and the Federal Reserve.
Since the bear market began Greenspan has been trying to force the stock market to rally by cutting interest rates and increasing the money supply.
Little of this extra money has gone into the real economy in the form of new investments and corporate expansion, but a lot of it has gone into the stock market. What is more for the past year Fed meetings have become bullish events that have gotten stock traders and investors excited.
This is all coming to an end.
Between September 11, 2001 and January 1, 2002 Greenspan increased the M1 and M2 money supply at a faster rate than has ever before been done in history. This fact has been one of the main fuels of the stock market rally. Think back to the winter of 2000. Greenspan did the same thing in fears that the Y2K computer bug could spark bank withdrawals. When he took away the extra money the stock market collapsed.
He is now beginning to take away the extra money he put into the system last year. M1 and M2 levels have now fallen below the levels that they were at a month ago. What is more the futures market is now only pricing in a 20% chance that the Fed will cut rates when they meet this Wednesday.
What this means to you is that the whole investor excitement over the Federal Reserve and Alan Greenspan will soon come to an end. The bond market is now factoring in interest rate increases by the summer and there are signs of inflation in the economy, mainly a rising gold market and a rising Commodity Bureau Research Index.
People will still probably be a little excited about this coming Fed meeting. There will be talk on TV that the fact that the Fed probably won’t cut rates is a positive thing, because it means that the economy may be bottoming. So there is a good chance that the market will trend slightly up into the meeting.
I have shorted a basket of stocks last week in expectations of a market decline. My main objective now is to manage that basket.
Based on the charts I think the odds are that the market will decline Monday and Tuesday morning and then bounce on Tuesday close and into the Fed meeting. It should then resume the downtrend after the Fed announcement.
The other scenario is that the market rallies Monday and Tuesday into the Fed meeting and then falls afterwards.
If this happens I may buy the QQQ’s as a hedge on my short positions. If I do that I will unhedge them on the Wednesday Fed day after or right at the moment of the interest rate announcement.
The market has put on a technical bounce after falling to the 150 day moving average at 1880. Based on the market sentiment indicators, the top of this bounce should mark a major top in the DOW, Nasdaq, and S&P 500. I believe that top probably came last Thursday, but it is possible that the Nasdaq could rally 30-50 points into the Fed meeting and then drop. If the Nasdaq goes through Thursday’s high at 1960 I will become concerned that this might happen.
In the end what we are seeing this week is the last hurrah for the rally that began this past September; and not coincidently the last hurrah for Alan Greenspan. This is the last Fed meeting that people will get excited about. After this one no one will be excited about the Fed anymore, because they will no longer be cutting interest rates. In fact Fed meetings will eventually become moments of dread and fear of what higher interest rates will mean for the market and the economy. The manic deification of Alan Greenspan ends on Wednesday. |
