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Notes From the Rabbit Hole

The End of the Recovery?

By Clif Droke

March 11, 2010

I received an interesting e-mail the other day that sheds some light on the current state of investor psychology. He writes, “I hear from a hedge fund and analyst friend that most major cycle work tops out from this coming week thru April and [he says] it’s THE top. One he sites is the Bradley model which shows a devastating drop beginning after next week into October of this year to roughly Dow 6,500. Looking back all the way to 1900 chart of market I've never seen a major top without breadth deteriorating for many months or even a year or more before a major bear.”

The last statement made in the above hits the nail right on the head: market breadth is extremely positive right now. The differential of stocks making new 52-week highs versus lows is particularly strong and on Monday, March 8, the hi-lo plurality was +487 with only two stocks making new lows. The persistently strong hi-lo differential of recent weeks has translated into a rising internal market trend. Question: If this is “THE” top, where is the distribution in all this? If this does indeed turn out to be a major top it will surely rank as the greatest example of a “devastating drop” coming from absolutely nowhere.

The e-mail quoted earlier in this commentary also referenced the Bradley Model, which is apparently a stock market cycle series. I’m admittedly unacquainted with this particular timing model and am unable comment on it. What I’ve noticed, though, is the increasing number of e-mails received in just the last few days that made reference to what is apparently a growing belief among market commentators that a major top is imminent. I’m sure the analysts who see a resumption of the crash around the corner have their various reasons for believing as they do. Most, however, seem to be basing their beliefs on various cycle theories which purportedly project a major at this time.

The observation that can be made here is one I’ve made many times in the last, namely that there is a danger in a too heavy reliance on any cycle theory for stock market timing. It has always been my contention that cycles are at best rough guidelines for market trends but shouldn’t be used to initiate major trading positions. In other words, cycles shouldn’t be used as standalone indicators but should always be combined with market analysis, e.g. tape reading, the charts, etc. When an investor puts his neck on the line by risking everything on a cycle, there’s always a chance the cycle (assuming it really exists) will be “whipsawed”, which can always happen in the short-term by shifts in investor sentiment and trading volume patterns. There’s a reason why there’s no clear consensus as to which cycles are the final arbiters of stock price movements. It’s because the stock market is much more complex than cycle purists would have us believe and is governed by myriad factors, including central bank monetary policy, investor psychology, valuation metrics, insider buying and a host of technical factors. A total reliance on cycles conveniently overlooks these other variables and elevates cycles to a position of near omnipotence. One gets the impression that cycle purists believe that investors are mere automatons whose every action is governed by the cycles.

Speaking off the cuff, I’ve found that a disciplined technical approach works best when approaching the financial markets. If an investor buys when his indicators tell him to and takes profits along the way in a disciplined, almost mechanical fashion and raises his stop loss along the way he stands a far better chance of profiting from market trends. He enjoys the additional bonus of not having to worry constantly about the “next big drop” at every turn since he isn’t trying to outguess the market. Instead, he’s trading in line with the market and managing risk along the way. When the inevitable top finally comes, he’s already taken his fair share of money off the table and is protected again drastic declines and so he doesn’t “sweat” the bear market when it comes, even if he didn’t see it coming.

By contrast, when you’re trading exclusively on the basis of a cycle theory, you’re in the agonizingly painful position of always having to try and outwit Mr. Market. You’re constantly having to guess whether or not this time will be the final top or bottom culminating a major market trend. When you’re right – and statistically the odds are against you most of the time – it’s “pure heaven,” as Joe Granville was wont to say. But when you’re wrong, he adds, “it’s pure hell.” Thus our cycle purist is on a perpetual rollercoaster of emotion as he seeks to balance out his hits with his misses. He’s always having to justify his mistiming of the market, and mistiming the market is inevitable when you rely too heavily on cycles. Better to use the disciplined technical approach.

Meanwhile, the AAII investor sentiment poll released last week was quite revealing of the current state of investor psychology. The percentage of bulls was 36% compared with only 26% bears. The bears are definitely shrinking, yet the bulls aren’t nearly as numerous as one would expect given the percentage retracement of the market since last month’s cycle bottom.

Yet the most impressive statistic in the latest sentiment poll is the percentage of investors who are currently neutral. The neutral percentage is 38%, which is more than either the bulls or the bears. Most investors polled by AAII, in other words, are on the sidelines and presumably don’t have a stake in the stock market right now. This speaks volumes about the lack of commitment among investors in a market characterized by accelerating internal momentum, a strong tape and broadening participation across the board among representative stocks in the leading industry groups. It’s also a telling insight into the mind of the small retail investor, many of whom are outright bearish on the stock market’s prospects going forward.

While we’re still on the subject of investor psychology, the March 5 edition of USA Today featured a commentary on the gold market in the Money section of the newspaper. The headline, “Owning gold isn’t a bad idea,” was accompanied by a colorful photo of gold coins and ingots on the top of the front page.

We’ve talked about the significance of gold pictures showing up in major newspapers in the past and it often tends to occur after an interim rally in the gold price. In this case, however, the most significant aspect of the article wasn’t as much the implication for gold as it was for the equities market. The article drew attention to a statement made by Rachel Benepe, co-manager of the First Eagle Gold fund. Ms. Benepe’s stated that gold is “the ultimate downside protection,” a quote that was highlighted by USA Today.

The latest news story on gold in USA Today is thus an extension of the widespread fear that lingers on after the credit crash of 2008. Gold ownership isn’t being touted so much as a hedge against currency fluctuations or for its long-term investment value, but as the “ultimate” safe haven in the event of a financial apocalypse. It is this aspect of the gold promotional stories that should be viewed from a contrarian perspective by stock market investors.

Also quoted in the article was Frank Holmes, CEO of U.S. Global Investors, who said, “We think we still have deflation.” The article made the point that while many investors tend to think of gold as a hedge against inflation, the gold price can underperform in a period of inflation and can outperform during periods of deflation. There’s definitely some truth to this observation and it’s worth pointing out. Yet the USA Today piece played on the growing fear that the next big deflationary down leg is imminent. This is yet another example of the article’s psychological significance to stock investors.

So it seems that the average investor is either lethargic on the stock market if not outright bearish. Contrarian investors take note!

Tape Reading

There’s no substitute for good, solid market analysis when it comes to stock trading. Fundamental analysis is important, too, but for traders with a short- to intermediate-term outlook, being able to “read the tape” is a skill worth its weight in gold. Watching the flow of trading volume in a stock in relation to its price level can provide a major edge in buying and selling at the right time. The great advantage the tape reader enjoys over other traders who don’t use a scientific approach is that the tape reader can decide which side of the market affords the best opportunity for profit. By process of elimination, the tape reader either gets in at the commencement of a price movement or else waits for the first reaction after the move has started. As the famous market technician Richard Wyckoff observed, “Tape reading gets you in at the beginning, keeps you posted throughout the move, and gets you out when it has culminated. It has made fortunes for the comparatively few who have followed it.”

It was for the purpose of distilling tape reading to its essence that I wrote “Tape Reading for the 21st Century” in 1999. Now in its third edition, this book explains the basics of tape reading in layman’s terms. The book uncovers the mechanics of tape reading and provides the most essential rules and guidelines for understanding volumes and how they can be used to predict stock price movements. This book is unique in that it also explains how “tick” charts can best be utilized for micro-term trading along with volume analysis.

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy. The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment. He is also the author of numerous books, including “How to Read Chart Patterns for Greater Profit.”

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