The tyranny of trading ranges

Sideways trading range markets have their own unique characteristics – both technically and psychologically.  More than any other emotion trading ranges tend to elicit frustration from investors.  Nothing, after all, is more irritating to an investor than having to sit through long periods where stocks are making little or no progress.  The longer the trading range persists, the more frustrated and impatient investors tend to become. 

If the trading range is established in the midst of a longer-term uptrend it’s not uncommon for investor sentiment to remain stubbornly bullish for an extended period.  Investors have become so conditioned to rising stock prices that it often takes several months of a grinding lateral trend before they finally lose their enthusiasm.  It’s when investors finally become more pessimistic on equities that the market commonly breaks out from the trading range.  In other words, investors normally have to be “head faked” before the market can proceed to a higher level.

That pattern appears to be playing out in the U.S. broad market.  After spending the better part of the last six months in a sideways trend, the NYSE Composite Index (NYA) appears to finally be on the brink of a breakout to a new high this spring.  What makes this even more intriguing is the current backdrop of investor sentiment….

Market psychology isn’t as important as the market’s internal momentum and overall technical backdrop, yet it can still yield clues as the market’s next directional move.  And the current readings of both the “smart money” and “dumb money” sentiment indicators reflect an improving psychological backdrop.  Once the short-term internal momentum indicators improve this should prove quite handy in providing the market with enough fuel for an extended rally later this spring.  [Excerpted from the Mar. 23 Momentum Strategies Report]

Are biotechs in a bubble?

Q: Do you think biotechs are in bubble? 

A: Biotechs may be undergoing a "melt-up" but I don't think they're in a bubble yet.  We'll know they're in a bubble when everyone -- including friends, relatives and neighbors -- is talking about them and buying them with reckless abandon.  I definitely don't get that vibe right now.  A lot of the biotech ownership is among professional investors, not small retail traders.

The double-edged sword of a strong dollar

Until the latest pullback on Wednesday, the U.S. dollar index had been on a rip-and-tear for most of this year.  Earlier this week the dollar hit a new multi-year high as concerns over Europe and China have fueled foreign interest in U.S. assets.  

The greenback’s relentless strength is also a cause for concern among investors who fear that a stronger dollar will erode corporate profits this year.  Since much of the bull market of the last few years was based on the bull market in corporate profits, this point is being taken seriously by Wall Street pros.  It’s also worth examining in this our latest installment.

Also of concern to investors is the weak oil sector.  The WTI crude oil price (basis May futures) fell to a nominal 5-year low of $44.84/barrel earlier this week after testing the January bottom.  A decisive break below this level would likely catalyze another selling event in crude oil as protective stops are taken out, but if the crude price can stabilize above this pivotal low the market will get a needed reprieve. 

Weakness in the oil market has also put significant pressure on oil and gas stocks for much of this year to date.  Most of the new 52-week lows on the NYSE recently have been in the oil/gas sector.  This in turn put some short-term downward pressure on the overall stock market; remember that a persistently high number of new 52-week lows (i.e. above 40) is often a sign of internal weakness.  That may soon change, however, now that the Fed has once again given its assurance that it won’t be hiking interest rates anytime soon. 

The strengthening dollar is actually a double-edged sword.  While it hurts the profitability of corporations in the export market, it also helps consumers by lower prices for goods on the domestic level.  It also encourages inflows of foreign capital, i.e. “hot money,” which often has the effect of lifting U.S. financial markets.  U.S. equities have been prime recipients of the weakness in foreign currency markets in the last year or so, but certain municipal real estate markets in the U.S. have been huge recipients of foreign investment.  A substantial part of the demand in U.S. commercial real estate in several major cities, for instance, is coming from Chinese nationals. 

Veteran market analyst Bert Dohmen points out that flight capital can result in major economic booms/bubbles, but since it represents far less than the amount of total wealth of foreign investors, when the flight capital is exhausted demand dries up.  Concerning the flood of foreign hot money into U.S. markets, Dohmen writes:  “Those foreigners who have most of their assets in their own countries are growing poorer.  They will eventually start conserving capital and defer all new purchases.”

The dollar bull market is reminiscent of the strong dollar environment of the late 1990s.  Back in 1998-99, relentless strength in the dollar index – and a corresponding crash in several foreign currencies – led to a flood tide of capital into U.S. financial markets.  U.S. stocks and bonds were highly sought after and the Internet stock bubble of those days was at least partly fueled by foreign flight capital.  The late ‘90s dollar bull market also led to a veritable bull market for U.S. consumers as retail prices plunged to levels not seen in many years.  Gasoline pump prices fell to just under $1/gallon as crude oil dropped to $10/barrel. 

At that time the strong dollar was also part of President Clinton’s fiscal policy as then Treasury Secretary Robert Rubin, a former Goldman Sachs partner, masterminded the currency policy in the wake of the East Asian financial crisis.  The strong dollar, however, eventually led to its own set of financial problems as the economies of several countries imploded in 1998 and nearly kicked off a global commodities price collapse.  It also ignited a mini bear market in the U.S. stock market in the summer of ’98, which lasted all of 10 weeks.

So, we can see from history that while a strong dollar can definitely fuel a strong domestic economy and an equities bull market for a while, it eventually evokes its own reversal.  As Dohmen points out, since the dollar’s strength comes at the expense of foreign currency weakness.  And persistent weakness in foreign countries means that “hot money” capital flows from those countries into the U.S. will eventually cease.  When the flight capital coming into U.S. markets ceases so does the upside momentum in financial prices. 

I believe we’re still probably at least a year or two away from the proverbial “danger zone” when persistent dollar strength creates major problems for the U.S.  If anything, we’re probably closer to the “sweet spot” of the currency cycle where a strengthening dollar provides economic leverage for consumers as well as investors.  But as with any persistent trend, the pendulum will swing too far in one direction and will eventually swing back in the other direction.  Let’s keep that in mind as we look for opportunities in the coming months.

Financial Sense News Hour with Clif Droke

Financial Sense News Hour Interview with Clif Droke

The psychology of a sideways trend

A fascinating study is the psychology that accompanies a prolonged sideways market trend.  It also holds insights into what the future likely holds for stock prices.

When equities get stuck in a sideways trend for several months, investor psychology goes through four basic stages of change: 1.) initially they feel expectant that stock prices will quickly breakout of the newly formed range; 2.) when this fails to materialize sentiment turns sour as stocks drop to the lower boundary of the range; 3.) as stocks continue bouncing from the top to the bottom of the range investors begin to lose interest and eventually quit participating altogether with many selling their stock holdings.  This is what forms the basis of a bullish accumulation pattern since “smart money” professional investors eagerly snap up the disgorged supply from disgruntled retail investors.  4.) Finally, as the range is nearing its final resolution, small investors who may, or may not, be invested are thoroughly frustrated at the lack of directional movement. 

The frustration that has built up during the period of the lateral trend is released in various ways.  Not uncommonly, trading range breakouts are preceded or accompanied by various expressions of mass frustration, including protests, civil unrest or conspicuous acts of violence.  If the trading range continues long enough the subsequent release of pent-up tensions can even result in the initiation of military conflict.  Witness the collective angst of Americans of all walks of life during the 1970s, a decade which was entirely encompassed by a lateral trading range in the stock market. 

In my 20 years in the financial industry I’ve concluded that nothing exerts as profound an impact on mass psychology (to say nothing of investor psychology) than a prolonged sideways trend in equity prices.  Why this should be is open for debate, but I have what I believe are valid insights.  In highly developed capitalist nations such as the U.S. the stock market is the single biggest barometer for measuring the collective expectations for the business and economic outlook among all participants.  The majority component of the U.S. economy is finance, directly or indirectly.  Therefore everything concerning the material prosperity of the nation ultimately depends on the stock market. 

It can also be observed that humans by nature are so conditioned to the concept of progress that anything which seems to undermine the longing for growth is viewed with contempt.  A sideways trend in stock prices over a long period of months or years is rightfully seen as the antithesis of progress, hence the deep seated psychological frustration which underlies a trading range environment. 

The recent breakout from the trading range in the U.S. stock market has witnessed a corresponding increase in militant threats in several regions of the globe.  From last week’s failed cease-fire between Ukraine and Russia, to the fighting between Egypt and ISIS, to President Obama’s request for new war powers, the confluence in militarism has coincided with last week’s trading range breakout.  The timing is no coincidence; indeed, it can be viewed as a natural reaction to a long and grueling period of no progress in the financial market.

Another aspect of trading range psychology is what I call “trading range trepidation.”  I coined this term back in 2005 and have long observed its repeated influence of investors’ collective psyche.  Trading range trepidation is a mental state which investors collectively feel when the major indices have spent many weeks or months in the lower portion of a range, then rally up to test the trading range ceiling.  As the upper range is reached, investors become apprehensive.  They’ve long been conditioned to seeing stocks rally to the former price highs, only to fall back and fail to pierce through the upper trading range boundary.  Skepticism has been thoroughly established at this point and scarcely anyone believes that the market will break free from the confines of its upper limit. 

When prices reach the upper band of the range, participation even among active traders tends to wane except among short sellers.  Few traders are interested in buying along a trading range ceiling.  Only when a decisive breakout is made above the ceiling do investors begin to show any interest.

“Breakout shock” is a term that describes the psychological state experienced by investors once the major indices finally push out from a long established trading range.  Investors have become so numbed to the lack of action in the market that they’re simply unable to feel optimistic about a breakout from a trading range.  It usually takes several weeks after the breakout before enthusiasm returns for equities.  

In the final analysis, the trading range environment of the last several months has resulted in a depressed mood among small retail traders.  While the more well-heeled individual investors which comprise much of the weekly AAII investor sentiment poll are more sanguine on the market outlook, the types of traders who collectively form what is known as the “trading public” are more sullen.    

The following graph shows the Ameritrade Investor Movement Index, which tracks the amount of money retail traders are actually putting into the stock market.  As the graph illustrates, interest in the market among Ameritrade’s clients has dwindled in recent months even as the SPX was making new highs. 

As the current year progresses, I expect to see a gradual increase in participation among retail investors.  The Year Five Phenomenon should provide a favorable tail-wind for equities and when small investors become convinced that stocks are emerging from the sideways trend, they’ll almost certainly be lured by the temptation to put more of their money to work where it gets the best treatment.  And for the last few years that has been the U.S. stock market.