Sunday May 12, 2002 : Hotline Update
The Market Climate remains on a Warning condition. Once again, the hallmark of last week's action was distribution without any particular accompanying news. As I frequently note, market action conveys information held by other traders that cannot be observed directly. So despite the lack of specific bad news, the news last week was evidently bad.
Now, if all traders in the market are rational, and it is common knowledge that they are all rational, then any attempt by one trader to buy or sell can be taken as a pure information signal. The mere willingness to trade reveals privately held information. In that kind of market, prices quickly and fully reflect all information whether public or private, and the market is "efficient." But it is also true that every academic theorem asserting market efficiency is accompanied hand-in-hand by something called a "No-trade theorem." In an efficient market, no trading takes place. Price quotations change in response to new information, but no trading occurs at those prices. So when the market starts moving up and down on bid-ask changes but without volume, it's time to buy an index fund. Until then, we've got to take market action as a "noisy" signal, containing both information and uninformative noise.
This, by the way, is why a stock that looked great at $40 isn't necessarily a buy at $20. The decline from $40 to $20 may represent more attractive valuation, or it may mean that traders have new, negative information about the future prospects of the company. How one distinguishes information signals from noise is essential to interpreting such a price movement. A sharp price decline might mean one thing for say, Bristol Myers, and another for Enron, depending on the precise features of market action accompanying the decline.
The analysis of trend uniformity is one proprietary method we use to separate the signal from the noise. With respect to the overall market, we got a nice momentum signal between the September low and late December, and left as much as 20% of our holdings unhedged on that basis. But we have since observed a failure of the market to recruit any kind of favorable uniformity. That suggests that there remains an underlying aversion to risk. And in an overvalued market where risk premiums are very thin to begin with, small shifts in risk aversion can have sudden and devastating results. Accordingly, we remain fully hedged here. We will shift to a more constructive position when the market recruits favorable trend uniformity, but we have no forecast of when that will eventually occur.
In the meantime, last week's action was disturbing. On Monday, we saw the 10-day average of the trading index (TRIN) move above 1.5. The TRIN is calculated by dividing the ratio of advances to declines by the ratio of up-volume to down-volume. Often, a 10-day TRIN of 1.5 or higher occurs just before a capitulation in prices, often representing important lows. This occurred both before the March 2001 low and the September 2001 low. However, Wednesday's explosive rally served to let off the steam, so that the market was not able to develop an extreme oversold condition. This was followed by fresh weakness, in the classic style of bear market rallies - fast, furious, and prone to failure. There is a disturbing persistence in all of this distribution, as well as the ability of the market to work off oversold conditions as it declines. This behavior may make it more difficult for the market to mount a sustained recovery without yet further deterioration. Not a forecast, but certainly a concern.
Moreover, sentiment indicators remain very complacent, with the CBOE volatility index nowhere near levels typically seen near important lows, while the Investor's Intelligence figures report that investment advisory bearishness remains under the important 30% figure. Elsewhere, brokerage analysts continue to advise nearly the highest allocation to stocks on record, historically a reliable contrary indicator.
In the fixed income arena, my impression is that the yield curve is likely to flatten considerably in the weeks ahead, with short term yields pressured somewhat higher while long-term yields move down. That's a somewhat odd expectation, but it derives from expectations of oncoming economic weakness, combined with increasing (and myopic) pressure to swap long-term debt into short-term debt to relieve debt service costs. As always, we don't invest on expectations, but on the prevailing Market Climate. In the fixed income area, that climate appears favorable for medium- and long-term bonds, as it has for several weeks.
In all, we've got extreme overvaluation, particularly in the blue-chip "growth" area (as reviewed last week), unfavorable trend uniformity, persistent distribution, complacent sentiment, and important weakness in the dollar and corporate bonds suggesting fresh economic weakness. Not an environment in which we find market risk inviting. Our stock holdings remain fully hedged.
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