The recent advances in the stock market have led to an explosion in articles contending that we are in a new stock market bubble or mania. Some analysts are seeing a parabolic peak already. Almost everyone seems to agree that some market decline should come any day now. The number of references to “bubble” on Twitter has also gone up significantly, as was pointed out in this article.
So, let’s have a look.
We all know how a parabolic peak, typical for speculative manias, looks like. The chart just shows a faster and faster appreciation, until it goes almost vertical.
The stock market in the 1980s and 90s shows a classic example (click for larger image):
It’s easy to see how the rate of change accelerated twice, until it became unsustainable, and then the inevitable collapse after the year 2000.
Is that the kind of picture we see in the current S&P 500 chart? Here it is (click for larger image):
This is not a parabolic peak at all. If anything the rate of change has decelerated noticeably since 2011. In fact the S&P is still near the bottom of the trend channel it has occupied since 2009. That doesn’t mean it has to keep rising within this channel forever, but unless we get a drop below the support line (currently ~1500) it can keep going for quite a while. If it does so, then I would look for the market to reach the mid line by summer, which would be around 1800. The mid line is likely to put up serious resistance, so look for a meaningful correction if the S&P gets there.
Is there any precedent for this kind of scenario? Well yes, it’s the one scenario you never see mentioned anywhere in comparison with the current times: the roaring 1920s.
Some will consider that crazy, but there are more than a few parallels with now:
1) The market bottomed out in 1921, at the end of a sharp deflationary depression, not unlike 2009
2) Investors had suffered 50% losses twice within a decade, just like investors have burned their fingers twice in the 2000 – 2010 period. When investors have recent memory of painful losses they become very skeptical of any new market advance, and this sets the stage for a long bull market.
3) By 1923, two years after the bottom, the Dow Jones had recovered most of the depression losses, and by 1925, four years after the bottom, it was pushing into new highs. The current market playbook happens to be very similar, markets have pushed into new highs four years after the bottom.
4) What fueled the market? Well, besides ongoing innovation, the Fed also increased the money supply by 60% in the mid 1920s, with the aim of keeping interest rates low, not unlike the current QE programs. That money had to go somewhere, and apparently started flowing into stocks at some point.
5) We know what happened next. Most investors had probably remained scared, scarred and skeptical, even when the market was setting new highs every day. Then they started buying stocks in 1928 and 1929, and that made for the parabolic peak, almost eight years after the bottom. A similar scenario now would point to a peak in 2016/2017.
Here is the chart Dow Jones 1920-1940. (click for larger image):
I have added the current years to line up the historic comparison. Notice how once the market moved into new record highs, there was only a brief correction and then the market kept grinding higher for almost a year without any serious pullback. Is the same happening again now? We will know by the end of the year.
Here is a chart comparing the current recovery with the post-1921 depression recovery, based on monthly Dow Jones index (click for larger image):
Up to now there has been a 0.81 correlation between them. We will see how it continues.
I think the current high levels of ongoing skepticism, and all the talk about bubbles, are actually lending credibility to this scenario. And the ongoing QE programs around the world are known to come with a high risk of igniting another stock bubble.
Bear in mind: history does not repeat, but it tends to rhyme.
The market action in the early 1920s rhymes well with what we see currently. The question becomes: when and where will the rhyming stop? Are we setting up for a great depression in the 2020s, or will the rhyming stop well before then?
Danny
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MoM indicator
Posted by Dan on September 14, 2013
A few weeks ago I introduced the “MoM” indicator in the context of my weekly key reversal levels. In this post I will give more info on the MoM and how to use it.
The main idea behind the key reversal levels is “market orientation”, where is the market right now, and where it appears to be going… While charts are very nice and can give us an intuitive “feel” about a given market, they generally contain way too much information. All the years prior tell us where the market has been, but all that “history” is not necessarily very helpful information. We can keep an eye on the past, and it deserves perhaps 20% of our attention, but if we are to trade succesfully then 80% of our focus has to be on the *now*. And that’s the problem with charts, they typically show us only 1% now and 99% past. So, they tend to keep a trader stuck with the past.
The key reversal tables try to summarize where we are right now. Is it a bull or bear market, and is the market rallying or declining? At what key price levels can we consider a change from rally to decline (or from bull to bear)?
That’s all a trader or investor really needs to know.
The MoM indicator is an even more condensed format as it simply tells us where we are on a numeric scale between 10 and -10. You could compare it to the Richter scale for earthquakes, or a market thermometer if you want.
Various levels in the MoM indicator correspond to market mood as follows:
* +8 to +10: very optimistic – euphoric (red)
* +5 to +8: optimistic (pink)
* +3 to +5 : positive (orange)
* -3 to +3: neutral (yellow)
* -3 to -5: negative (green)
* -8 to -5: pessimistic (blue)
* -10 to -8: very pessimistic – depressed (dark blue)
To see how this works in practice, here is a chart showing you the recent history of the MoM indicator on the weekly Dow Jones chart (click for larger image):
Good buying opportunities typically occur when MoM bottoms below -5 in the blue pessimistic zone, as was the case in September 2011. Bull markets will usually see the MoM rise into the optimistic pink or red zone, where they can stay for a while. So, a rise above +5 is not a reason to sell immediately, but one should watch out when the MoM starts going down from optimistic levels. Ordinary counter trend pullbacks or rebounds will typically bottom or peak in the yellow zone (+3 to -3) before resuming move in direction of the longer term trend.
Notice how most of the time the market moves in the same direction as the MoM, and that’s why we watch carefully whether MoM is going up or down.
On weekly charts it is rare to see MoM go below -8, but when it does so it are almost always great long term buying opportunities.
On daily charts we will see the MoM go to extreme values more often. Here is a recent daily chart for Dow Jones (click for larger image):
Over the past year we had three drops into the blue pessimistic zone, which presented good buying opportunities.
You can also see why MoM rising into the red optimistic zone is not a reason for instant panic. In ongoing bull markets we will regularly get a sideways pause or mild pullback with the MoM falling back into the yellow neutral zone before starting the next swing to the upside. We then get a series of MoM peaks in the red optimistic zone. So, we can just move our protective stop closer to the market whenever the MoM turns down in the red zone. That will get us out when a deeper correction comes along, as was the case in May-June and in August.
There are more possible uses for the MoM, but that will be for another post. And in case you wonder: yes, it is possible to trade based on this MoM indicator only. In fact, a patient long term investor can do very well based on the weekly MoM only.
Stay tuned,
Danny
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Posted in Market Commentary | Tagged: Market trend, MoM, MoM indicator | 2 Comments »