Perceived Inflation Pressures Are High

Last week, I presented an article on real versus perceived inflationary pressures. The reality (for now) is that inflation is low; the perception is that inflation is just around the corner.

This week Dr. John Hussman, who is a must read for any serious student of the markets, essentially echoes a similar sentiment. (As an aside, I want to state that I am no Dr. Hussman, yet I like his writings and insights very much, and I thought this would be a good time to share that with my readers who are not familiar with him.) In his article, "The Destructive Implications of the Bailout - Understanding Equilibrium", Hussman writes:

"by transferring wealth from those who did not finance reckless loans to those who did – providing monetary compensation without economic production – the bureaucrats at the Treasury and Federal Reserve have crowded out more than a trillion dollars of gross investment that would have otherwise have been made by responsible people in the coming years, shifted assets to the control of those who have proven themselves to be irresponsible destroyers of capital, and have planted the seeds of inflation that will cut short any emerging recovery."

These are our percieved inflationary pressures.

Hussman goes on to state in bold print (for emphasis I presume):

The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade. As I've noted previously, the growth rate of government spending is better correlated with subsequent inflation than even growth in money supply itself, particularly at 4-year intervals. Regardless of near-term deflation pressures from a continued mortgage crisis, our present course is consistent with double digit inflation once any incipient recovery emerges.

With regards to our inflation indicator that assesses the strength of the trends in crude oil, gold, and 10 year Treasury yields that actually ticked down at the end of last week. See figure 1.

Figure 1. Inflation Pressures/ weekly

Nonetheless, with crude oil plus 5% today, with stocks up over 2.5% today, and with 10 year Treasury yields up over 2.5% today, the message is clear: whether inflationary pressures truly exist or not is another matter. The perception is that inflation does matter, and a stock market that has been pumped up on steroids (i.e., liquidity) will likely remain vulnerable to selling pressure when the trends in crude oil, Treasury yields, and gold are strong.

We Don't Have Time For Main Street

The mantra on Wall Street this past year has been how Main Street is connected to Wall Street. You know, what is good for Wall Street must be good for Main Street, so let's all chip in and fix the banks because if we don't fix Wall Street then Main Street will never recover. It sounds nice, but it is just a bunch nonsense to sell the bailouts and stimulus packages to an unknowing and ill-informed taxpayer.

Wall Street still remains disconnected from Main Street and watching this video of Maria Bartiromo interviewing car dealer, Jack Fitzgerald, this dynamic is very apparent. As we learn in the interview, Mr. Fitzgerald has 32 car dealerships under the "Fitzgerald" name. Oh, and he has 50 years of experience in the car business. He is "Main Street".

I actually saw this interview live and as it was unfolding, I kept wondering why Ms. Bartiromo couldn't interview him. Gone was the breathlessness. There was no adulation. Yet here you had a person, Mr. Fitzgerald, with a front row seat to the drama unfolding in our economy, and there were no questions that could bring out the insight that he must have from his many years of building a business.

Of course, we have the "breaking news" flash or graphic towards the end of the video where Warren Buffet is buying more shares of Johnson and Johnson and US Bancorp. From this point on, there are no more questions from Ms. Bartiromo, and she hastily sums up the interview with "geez, it must be tough out there especially with the competition to produce fuel efficient cars". Uhh, where did that come from? No doubt Ms. Bartiromo was distracted getting the "breaking news" in her ear piece. Shortly after the interview ended, the anchor sent it over to the "breaking news" desk.

Ok, Mr. Fitzgerald thanks for your time and we wish you good luck. Now we have to get back to our regular mission of "juicing" the market. We don't have time for Main Street.

Investor Sentiment: Is More Bulls A Good Thing?

Although the S&P500 lost 4.9% for the week, the bullish contingent actually grew stronger. This can be seen in the "Dumb Money" indicator shown in figure 1. The "Dumb Money" indicator looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio.

Figure 1. "Dumb Money"/ weekly

As pointed out last week, it takes bulls to make a bull market, and during a certified, bonafide bull market typically that is what you have - lots of bullish sentiment. This notion seemed to be bourne out by the strategy where you "bought" the S&P500 when the "Dumb Money" indicator was only in extreme bullish territory as it is now. As can be seen in the strategy's equity curve (which I showed last week), such a strategy only made money during a bull market. See figure 2.

Figure 2. Equity Curve

So maybe more bulls is a good thing?

But here we are one week after the initial signal and the S&P500 is down 4.99%. Does the "dumb money" have this one right? Was last week one gigantic head fake? To answer these questions, we need to look at each individual trade from our strategy.

Figure 3 is a maximum adverse excursion (MAE) graph showing each individual trade from the strategy. What does MAE measure? If you are like most traders or investors, you put on a trade and then watch as prices move adverse to your position as no one ever buys the exact low tick. MAE measures, in percentage terms, how much you had to lose before the position was closed out for a win or a loss. Look at the caret in figure 3 with the blue box around it. This caret represents one trade. This trade lost 2.25% (x-axis) before being closed out for a winner of 5.5% (y-axis). We know the trade is a winner because the caret is green.

Figure 3. MAE Graph

Now focus your attention to the right of the blue vertical line. Here we have 8 trades and they are all red carets (i.e., losing trades). The MAE for each of these trades was greater than 4.5%, and the MAE for the current trade is already 4.99%. In other words, the current trade is unlikely to be a winner as long as the "dumb money" remains this bullish. In fact, with 5 of the 8 trades losing greater than 4.5%, there is a possibility that the trade may not recover at all.

So how do we make the "dumb money" less bullish? Lower prices, of course.

Last week, I was unable to discern the significance of "too many" bulls. With this week's down draft, we have more information, and it seems unlikely that the equity markets are at the cusp of a new bull run as long as sentiment stays this bullish. Therefore, I am expecting lower prices over the next couple of weeks. This is another way of saying that the market will need to convert some of those bulls to bears before prices can move appreciably higher.

Furthermore, this view is also consistent with my belief that this is not the "technical" launching pad for a new bull market. I have summarized this research in the article "Bear Market Rally or New Bull?"

For the record, the "Smart Money" indicator is shown in figure 4. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders. There is no change in the "smart money" this week.

Figure 4. "Smart Money"/ weekly

Key Price Levels: May 14, 2009

Since April 19, 2009, I have been advocating "to sell strength and tighten up stops". I always try to provide some context that are the basis for my opinions. While the "sell call" may have seemed early, the S&P500 is now with 1% of those levels seen back on April 17, 2009, and the sell signal has not behaved any differently than past signals. It is just difficult to the nail the top.

In any case, the bear market rally continues, and the bulls are hoping that the recent weakness is nothing more than the pause that refreshes. I suspect that it will be something more as the price cycle needs to recruit more bears before heading meaningfully higher. This means we should see lower prices. I doubt we will get the weakness all at once as there are some key support areas that won't be broken too easily to the downside. I doubt we will get the weakness all at once as the Fed and Treasury will do whatever they can to juice the markets with well timed announcements as to why such and such program is now needed. Hope springs eternal that eventually one of these programs will do the trick.

Please review the methodology and the significance of the key price levels by clicking on this link.

A weekly cart of the S&P Depository Receipts (symbol: SPY) is shown in figure 1. Support is at 86.78, and resistance is the down sloping 40 week moving average. I would expect a range between these two "extremes".

Figure 1. SPY/ weekly

A weekly chart of the Diamond Trusts (symbol: DIA) is shown in figure 2. The breakout above 82.64 is still intact, and this is support. On the upside, the down sloping 40 week moving average is resistance. Like the SPY, I would expect a range, and resolution of this range should provide more clarity.

Figure 2. DIA/ weekly

Figure 3 is a weekly chart of the Power Shares QQQ Trust (symbol: QQQQ). A more significant pull back will find prices at the 30.33 support level. Resistance is at 36.50.

Figure 3. QQQQ/ weekly

Figure 4 is a weekly chart of the i-Shares Russell 2000 Index (symbol: IWM). The breakout from several weeks is still holding (just like the SPY and DIA). Support is at 47.58 with resistance being the down sloping 40 week moving average.

Figure 4. IWM/ weekly

More Headwinds To Worry About

On the way into the office this morning, I was listening to CNBC radio on Sirius Satellite. In that 7 minute drive, I think I heard the word "inflation" about 15 times. With year over year CPI virtually at zero, I am not sure what the worry is all about. This is the reality. Inflation is low.

On the other hand, with world central bankers making the cost of capital almost nil and their willingness to do "whatever it takes" to break the global slump and revive growth, the perception is that inflation is lurking around the next corner. If we can borrow the thinking of stock bulls, maybe we can say that inflation is so low that the only way it can go is up! It's a second derivative kind of thing.

All nonsense of course. But when it comes to the markets, perception always trumps reality.

However, what is worrisome from an equity perspective are the current trends in crude oil, gold, and 10 year Treasury yields. The prices in these assets are rising and gaining momentum, and this is a headwind for equities. So let's look at some data.

Figure 1 is a weekly chart of the S&P500 and the indicator in the lower panel is a composite indicator that assesses the strength of the trends in crude oil, gold, and 10 year Treasury yields. When the indicator is above the upper line (i.e., inflationary pressure line) that means that these trends are strong and inflationary pressures (real or perceived) are rising.

Figure 1. S&P500 v. Inflationary Pressures/ weekly

The question becomes: how do these inflationary pressures affect equities? So let's construct a study where we "short" the S&P500 during the time the indicator is at or above the high inflation line. The position is covered when the indicator drops below this line.

Since 1985, such a strategy has yielded 581 S&P500 points. There were 52 trades and 60% were profitable. The time spent in the market to get these 581 S&P500 points was an incredible 12%. Remember, this is a strategy that shorted the S&P500 through a bull market. Buy and hold S&P500 resulted in 736 S&P500 points. The equity curve for the strategy is shown in figure 2.

Figure 2. Equity Curve

I have tagged the equity curve with some dates, and in this age of asset bubbles, rising inflationary pressures (as measured by strong trends in crude oil, gold, and 10 year Treasury yields) is another headwind for equities. Note the rise in the equity curve since 2004. Whether inflationary pressures truly exist or not is another matter. The perception is that inflation does matter, and a stock market that has been pumped up on steroids (i.e., liquidity) will likely remain vulnerable to this dynamic for the foreseeable future.

Investor Sentiment: It Takes Bulls To Make A Bull Market

The "Dumb Money" indicator now shows that there are too many bulls. From a contrarian perspective, one would think that this is bearish for prices as there are too many believers in what pundits are calling the next bull market - "hey you, you're missing the train... you're missing a generational buying opportunity". But in reality, it takes bulls to make a bull market. So higher prices and excessive bullish sentiment have occurred together in the past, and this dynamic is generally the norm in a bull market as the data shows. On the other hand, the bulls - or newly bullish let's say - should be careful what they wish for as excessive bullish sentiment can also herald an intermediate term top in a bear market.

The "dumb money" looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investor Intelligence; 2) Market Vane; 3) American Association of Individual Investors; and 4) the put call ratio. See figure 1.

Figure 1. "Dumb Money"/ weekly

To provide some context as to the significance of too many bulls, let's construct a study. We will "buy" the SP500 when the "Dumb Money" indicator shows that there are too many bulls and we will sell when this condition is relieved. In other words, we are only in the market when the indicator is red and above the upper line. Commissions and slippage are not considered.

Since 1990, such a strategy has yielded 41 unique signals or trades. 46% of the signals were winners, and this strategy generated a paltry 72 S&P500 points; buy and hold over this time period has yielded 570 S&P500 points. Your time in the market was 23%. If this was the only strategy you traded since 1991, you would have an equity curve that looked like the one in figure 2.

Figure 2. Equity Curve/ "too many bulls"

Now let's put the notion of excessive bullish sentiment aside for a moment and go back in time about 10 weeks when there were too many bears. Let's construct another strategy where we "buy" the S&P500 only during the time when the "Dumb Money" indicator shows that investor sentiment is too bearish. I previously discussed the significance of excessive bearish sentiment in the March 8, 2009 (note the date) article, "Putting A Bullish Signal In Context". Since 1990, there have been 42 unique signals or trades; 80% have been profitable. This strategy generated 647 S&P500 points (versus 600 S&P500 points for buy and hold) with only 20% market exposure. The equity curve for this strategy is shown in figure 3.

Figure 3. Equity Curve/ "too many bears"

Comparing the two strategies and equity curves, I will leave it up to you as to what point in the price cycle you want to be invested.

But let's look a bit more closely at our current dynamic - "too many bulls" - and the equity curve in figure 2. From 1994 to 1999, the curve makes a nice 45 degree ascent; this coincides with the end of the 20 year bull market. So, during this time, it was a good idea to buy when everyone was bullish. Remember, it takes bulls to make a bull market. From 1999 to December, 2002, this strategy of buying when there are too many bulls gave back the gains from the 1990's. Then from December, 2002 to December, 2006 the strategy yielded positive results, and since 2006, the strategy has not been too kind to the bulls.

So what is the take away message? Some times it pays to play with the bulls and sometimes it doesn't. Too many bulls is a hallmark of a bull market, and at other times, it is a hallmark of a market top. I guess it all boils down to one simple question: is this a bull market? My current feelings on this topic are stated in "Bear Market Rally Or New Bull?".

For the record, the "Smart Money" indicator is shown in figure 4. The "smart money" indicator is a composite of the following data: 1) public to specialist short ratio; 2) specialist short to total short ratio; 3) SP100 option traders. The "smart money" is less bullish this week than last.

Figure 4. "Smart Money"/ weekly

The Bank Index: The Single Most Important Index

Figure 1 is a weekly chart of the S&P Banking Index (symbol: $BIX.X).

Figure 1. $BIX.X/ weekly

The red dots on the price chart are my key pivot points, and these identify support and resistance levels. This figure is a snapshot of the bear market.

In essence, the current bounce off the March 9 lows is no different than the prior 3 bounces before it as prices have only retraced back into key resistance levels or the prior breakdown point. If the market is going higher, than the S&P Banking Index will need to close above resistance at 126.80 and the down sloping 40 week moving average. This will not be an easy task.

As I try to figure out if this bear market rally will morph into a new bull market, I should probably remind myself everyday that I only need to look at this one chart to get my answer. For now, this current rally is looking no different than the preceding bear market rallies - built on lots of hope and built on lots of well timed announcements from the government.