One more leg up for stocks?

One more leg up for stocks?

Great bull markets rarely give up the ghost easily. Just as St George found, his dragon took some time to roll over after the first stab. The vast majority of market tops are rolling affairs with the first decline being met by the army of Dip Buyers who have learned over the past nine years to just follow that simple investment rule.  That strategy has worked like a charm for so long, so why stop now?

The Dow has declined by around 300 points from the March 1 high at 21.170 and by yesterday, a goodly part (50% in fact) of that loss had been recouped.

But of course, as I have shown, bullish sentiment is off the scale – and has been for some time.  Another measure of sentiment is the amount of money borrowed to buy shares – called margin debt.  When investors borrow to invest, they are bullish of course, and they are able to leverage their purchases by 2:1 with margin debt. And after the eight year bull run they are borrowing hand over fist at a record rate.  Here is the chart

Margin debt follows the trend in stock prices with peaks pretty much corresponding to stock index peaks (and similar with the dips).  But what caught my eye was the five wave pattern in margin debt on the latest leg up from March 2009.

As all good Elliott wave students know, five waves make a completed trend with the fifth wave being the ending wave before the reversal sets in.  This chart is yet another flashing yellow light to add to all the others.

Then I came across another indicator – the One-Year Confidence Index.  A selection of wealthy private and institutional investors are asked whether they believe stocks will be higher a year from now.  Private investors, who are usually pretty bullish anyway, are now 84% certain, which is higher than average.

But what about the institutional investors?  Are you sitting down? They are an incredible 99% certain!  That is remarkable.  Complacency to the max.

Naturally, this is the highest reading ever.  Putting all of the indicators I have shown in my posts together, I can say that virtually no-one in the US institutional world expects a major decline within the year.  And that means the coming stock market top will be historic.

When 99% of institutional investors believe stocks will be higher a year from now, they must be fully invested (as is also demonstrated by the record low 3% cash-to-assets ratio of the mutual funds chart I had in my last post).  So who is left to buy?

But why do money managers herd in such an extreme manner? Because their animal spirits tells them to.  To justify this feeling, they obviously have bought into the Donald’s promise to cut taxes and bump up government spending (surely an impossibility?). Not only that, but like the Fed they watch the Leading Indicator data – and here it is from the 1950s:

A rising trend indicates a forecast for an expanding economy and vice versa.  And on the hard right, the trend still points up, so no recession is in sight (these are marked by grey bars) – based on this universally-watched data.   That is the story peddled by the bulls.  Of course, it is all pure rationalisation for their inherently bullish stance.

But using this data to forecast no recession ahead is false.  Just look at the curve as it approaches any of the marked recessions.  The curve is still going up even into the leading edge of the recession!  The LI only turns down after the economy has already entered a recession.  In reality, this is a lagging indicator! Fat lot of good to help us forecast a recession.  And well before a recession hits, stock prices have already veered southwards in any case.

No, we need a more reliable and timely set of tools to warn us of an impending market top.  And that is where the Elliott wave model enters.  We are near the end of a major wave 3 up before wave 4 down starts (it may already be in progress off the 1 March high).  This wave 4 will last several weeks and encompass many hundreds of Dow points.

Finally, does the COT data back up the idea that institutional bullish sentiment is off the scale and a major decline lies directly ahead?  Here is latest set as of 7 March

This is the mini Dow and shows the hedge funds (who are predominantly trend followers) are a massive near five-to-one bullish – and during the previous week had ramped up their long positions even more that on 28 February.  This is how the Dow performed in that week

That was the period when the market had trended down off the high.  And as I suspected, the hedgies were in there dip buying!  The commercials were taking the other side of that trade and are now three-to-one bearish. So now we have the hedgies herding to the bullish side of the boat.  I am sure much of the commercials short sales are hedging operations to protect against a sharp decline in their equity positions.  It is clear that the hedge funds’ long futures positions are naked to express their belief share prices are headed higher.

But so far, there is no sign of long liquidation – far from it.  But when the bear does strike, we shall see lots of that and the Dip Buyers will have their heads handed to them.  That event lies down the road a tad.


Beware the Ides of March!

Many have pointed to the coincidence of possible disasters awaiting stock bulls on Wednesday the 15th.  We have the Fed’s monthly intentions regarding interest rates with accompanying press conference.  There is also the US debt ceiling problem that could herald another shut-down of government as it runs out of the readies on Wednesday – until congress votes in another massive hike in the debt ceiling.  But this promises to be more than usually tortuous this time around.

Already, Treasury yields are zooming northwards. The 30-yr T-Bond has lost over five full points in the last two weeks and the short end likewise has moved down (yields up).

This week should see volatility in stocks and bonds ratchet up a few notches.



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