Tuesday, June 30, 2009

Not Throwing In The Towel!

For the past several months, I have emphatically stated that the equity rally that started in March is a bear market rally. For the most part and because I primarily look at price, it has been my belief that the technical factors normally seen at a market bottom are not present. There were no divergences; time from the last bull market bottom or from the last bull market top had been too short. To make a long story short, this is not the proper launching pad for a new bull market.

Recognizing that I could be wrong - that my indicators just aren't sensitive enough to detect a new bull market in this era of the "new normal" - I arbitrarily chose a close over the simple 10 month moving average in the S&P500 as a reason to turn bullish and embrace the rally. This is the Faber strategy, which is an easy to implement strategy that gets high marks for its aversion to risk.

As we end the month of June, price has closed above the simple 10 month moving average of the S&P500 triggering a buy signal for the Faber strategy. I am writing today that I will not be honoring that signal, and these are my reasons.

First, I want to mention Rule#2 and Rule#3 of my "11 Rules For Better Trading". Rule #2 states:

Be disciplined. The data should guide you in your decisions. This is the only way to navigate a potentially hostile and fearful environment.

Rule #3:

Be flexible. At first glance this would seem to contradict Rule #2; however, I recognize that markets change and that trading strategies cannot account for every conceivable factor. Giving yourself some wiggle room or discretion is ok, but I would not stray too far from the data or your strategies.

Suffice it to say, I am comfortable making this decision. My research still suggests that this is a bear market rally and not a new bull market. Furthermore, this is a very risky time and place to be putting new money to work. So let me give you my reasons as to why I continue to sit and wait, and I will present my reasons from the strongest to the weakest. Of note, I will focus on the things that I do best - that is analysis of price and sentiment. I assume that you don't read me for innovative and insightful fundamental analysis, so I will let others stimulate your thinking in that regard.

The Launching Pad

This is not the launching pad for a new bull market in equities. I have stated this many times over the past 3 months and so let me explain, once again, what I mean.

I asked the following question: what are the technical characteristics seen at market bottoms that lead to secular changes in trend? You have divergences between price and momentum oscillators. The price decline typically has gone on for a period of time from the prior bull market top; it isn't so much the steepness of the decline (y-axis) but how long investors and prices have been underwater (x-axis) that I measure. Of course, prolong periods of consolidation can be a good lift off for stocks too. All this is quantifiable and that's what I do. I quantify those "things" seen at market bottoms, and with the exception of the Russell 2000, none of the major equity indices (i.e., S&P500, NASDAQ 100, or Dow Jones Industrials) display those characteristics seen at past market bottoms. We are close to being in that zone, but I still think it is going to take more time. Without the proper launching pad, I don't see how we can get from here to there.

Inflation Pressures

Whether inflation is real or perceived, the strong price trends in crude oil, gold, and 10 year Treasury yields are telling us that investors are concerned about inflation. Even if they are not concerned about it, I have shown that equities tend to under perform when these trends are strong. Furthermore, I believe there is real serious risk of capital loss when these trends are strong as they are now. The data presented in the article, "Inflation Pressures Are A Legitimate Concern" was pretty clear. We can make the Faber strategy more efficient by avoiding the equity markets when the price trends of crude oil, gold and yields on the 10 Treasury are strong and rising.


The "Dumb Money" indicator is bullish to an extreme degree, and typically this is a bearish signal. Of course, if you believe this is 1995 or 2003, then by all means feel free to buy to your hearts content. After all, "It Takes Bulls To Make A Bull Market".

"Sell in May and go away" does work in a bear market; I believe we are in a bear market. This bit of market dogma does not work in bull markets.

"This Time Is Different"

Utilizing negative divergences between price and an oscillator that measures price momentum, I have defined the "this time is different" scenario. At market tops we typically see negative divergences. If prices continue to move higher despite the presence of these divergences, often times we find investors saying "this time is different" as prices accelerate much higher. Of course, I think the acceleration in prices is due to short covering. In any case, we now have negative divergences showing up in the major indices. As expected momentum has slowed. Closes over these negative divergences - essentially weekly closes over the current range - will lead investors to say that "this time is different" as none of the issues that I or others present matter. "Stocks are pricing in a recovery." No doubt a close over the current price range will likely fuel a short covering rally.

The Banking Index

I have called the Bank Index the single most important index. Have you seen it lately? Figure 1 is a weekly graph of the S&P Banking Index (symbol: $BIX.X). It hit resistance at $126.80 nine weeks ago, and it is off 16% since. I cannot see the broad market higher without the help of the financials.

Figure 1 $BIX.X/ weekly

Lastly let me state that there is nothing unique about price closing above the simple 10 month moving average. Yes, prices are less volatile above the 10 month moving average (i.e., bull markets) and they tend to be more volatile below this "key" moving average (i.e., bear markets). But a close over the simple 10 month moving average is just arbitrary. The simple 9 month moving average would work just as well. The beauty of the Faber strategy is not its ability to time entries but to limit losses. In general, you don't take the big hit with this strategy. See the MAE graph of the Faber strategy.

My real reluctance here is that it is not the time or place to put money to work. There will be better opportunities ahead. I am NOT throwing in the towel yet! I am invoking Rule #3 for now!!


Jérôme said...

Haha this is a funny post! I am not throwing the towel either Guy... but am starting to shake seriously. I have hit what I call the 'stubborn behaviour zone', which means that it looks like I am wrong but I will bet on a stubborn positionning. You would probably call it the 'flexibility zone'. In one word good luck!

Guy M. Lerner said...

Jerome: I am not sure why you think post is funny but that is ok; I thought I would explain my rational and thinking of why I am not doing what I thought I might be doing 8 weeks ago. Essentially, I will stick my research and I don't feel like I am missing anything

Anonymous said...

Not only that, the S&P is still below the May highs, so all these bulls have gone nowhere for a month. That's what bear markets do, they attract enough suckers by teasing as much as possible. Hang in there.

Dacian said...


It's always a pleasure for me to discover a new post on your blog and read it.

So by Faber's model we have a buy signal now but you won't go long because of the "perceived" inflationary headwinds hence an environment where the markets tend to under perform (and we have past data to help us here).

Even if here we don't talk fundamentals, want to point that the market had it wrong in 2008 regarding inflation. The reality is there are big deflationary forces at work no matter what the FED does (except if they manage to panic investors with huge consequences).

Coming back to your analysis, I'm not sure if your measurement is very reliable; oil won't go down or up because of inflation (even if it might do); gold behaves well in highly stressed environments (depression of hyperinflation), but it does poorly during inflation; the most reliable measure I see are the yields on 10 years - even that the market got it wrong in the spring of 2008.

Regarding the historical data you're using for filtering Faber's model it shows you what happened in the last years when we had recessions caused by big inflation (mainly the 70s & 80s). The environment we have today is a credit event and this is a very rare event. Having inflationary expectations going up today might be a welcomed event (regarding the stock market) because it shows a deflationary depression might have been avoided; I'll stop here :)


Jérôme said...

It was funny becoz traders (and I am no different) always try to find good reasons for not stopping out. That is THE usual behaviour and I find is funny coz it is so human. Even you, who are so specific and rigourous in all your comments, desciptions and trading techniques, have the same behaviour.

Your arguments are great indeed and they definitely convince me. But the risk with not respecting a former clear rule to stop out is what is going to decide the next S/L? I guess you still have the inflation criterium. But then if it proves wrong as well, what is the following S/L? And how many moving S/L shall we allow ourselves? This poses the great risk of never stopping out and end up missing important profits.

Guy M. Lerner said...


Thanks for the comments and feedback and insight

The question certainly facing the markets is inflation v. deflation; yet somehow "we" or all of us cannot agree what is going on; yes, there is no inflation today but the perception is that inflation is somewhere in our future.

But what I have tried to do is take my input or thoughts of what is going on out of the equation; so let's assume my composite indicator that looks as the trends in crude, gold and yields has nothing to do with inflation (real or perceived); so all I can say is that when these price trends are strong and rising stocks underperform -- this is all I have down; I measured the trend of something -in this case, prices on the chart - and saw how this related to price of another instrument. Whether this is inflation or something else doesn't matter.

As an aside, others (i.e., Hussman) have made similar observations utilizing the simple 13 week rate of change; I have used my own tools here.

With regards to inflation being welcomed, I have thought about this too. This relationship that I have highlighted held up particularly well from 2004 to 2008; in addition, we can say that no country has ever devalued their way to prosperity; I just don't see how a falling dollar will be good for any of us.

Guy M. Lerner said...


Got it! I would agree with that it is shared trait; I kept wondering am I just finding a reason not to get long as I know I could always find a reason to do such and such. I have had several weeks to think about this as I knew the Faber signal was coming; in the end, I reverted back to my research - those things that work well for me.

With regards to your last paragraph, I try not to be too hard on myself and two, I try to give myself wiggle room so I don't have to thread the needle to make profits. I am operating on a very long term time frame in many cases and this is so I don't have to be very precise in my entries and exits.

In sum, the headwinds or reasons I put forth in the article would suggest I am not going to more than a couple % if I am wrong.

Anonymous said...

i like your analysis on dumb/smart money and so far you were pretty accurate. Thats why i was surprised to read few weeks ago about "10 month" strategy. You know well that fundamentals beat whatever the market is doing day-to-day. Especially when it is manipulated... they can push it up certain levels hoping that people watching averages will buy... anyway, i am glad you are back to your senses :-)

Guy M. Lerner said...

Anonymous: the only caveat about the smart and dumb money indicators that I can offer is that it doesn't work all the time; in particular there were two periods where more bulls actually translated into a bull market ramp; this was 1995 and 2003; so it is not perfect; so it was difficult in the one sense to exclude this --at least for a couple of weeks. If you believed that the fundamentals supported a bull market or to put another way, that all the other stuff didn't matter, then by all means this is your bull market; but this would be ignoring the other 40 some odd times over the past 20 years that prices stalled as the dumb money got more bullish;to read more about this look for the article on sentiment called "It Takes Bulls To Make A Bull Market".

dacian said...

"I measured the trend of something -in this case, prices on the chart - and saw how this related to price of another instrument. Whether this is inflation or something else doesn't matter."

I totally agree with the above; being correct on the market doesn't mean the truth on what's happening in reality (market create its own reality). I just wanted to point that your inflation indicator might not be very reliable. That the market does poorly when your "inflation" indicator is where it is, I understand. We have historical data for us to base on.

thanks again

Jérôme said...

Hi Guy
So many comments on this post!

Hey more strong technical arguments not to throw the towel on Hussmann website. Maybe you saw this article already but if not look at that http://www.hussmanfunds.com/rsi/rallyvolume.htm

He is describing two important caracterisitics of 'normal' market bottoms: shape of the 'V' and volumes. You should see that, it looks pretty amazing and would add some other indicators to your analysis even in 'normal' market conditions, not only at bottoms.

Senta said...

Enjoyed the blog. However more and more bears are throwing in the towel. I do expect a garden variety correction of ~10% or so - but this might be a cover for capitulating bears to get in. The catalyst is going to be Q3 earning season - (which will anniversary the start of the 2008 collapse). If the earnings starts coming in - the rally would then restart.