Market bottom in review

[The following is excerpted from the Aug. 26 issue of Momentum Strategies Report.]

U.S. stocks rallied on Wednesday after an interest rate cut from China’s central bank helped eased fears that a global economic crisis is developing.  Although the intervention didn’t help China’s stock market, it apparently was enough to calm nerves on Wall Street.  The U.S. dollar index rose nearly 2% in the last two days in response to the move by the People’s Bank of China….

And after spiking to its highest level in years, the CBOE Volatility Index (VIX) pulled back nearly 16% on Wednesday in a sign that investor fear is dissipating, at least in the immediate-term.

Also helping lift investors’ spirits was a statement from Federal Reserve member William Dudley, who said that a case for an interest rate increase “seems less compelling than it was a few weeks ago.”  That would certainly qualify as a candidate for the understatement of the year.  It was also a major improvement from the tone-deaf statement of another FOMC member who said on Monday that the recent sell-off wouldn’t alter the Fed’s intent to raise rates.

In Monday’s report we examined several technical indicators which suggested that a selling climax was imminent.  First there was the apparent volume climax on Monday in which the ratio of NYSE upside-to-downside volume was an extraordinary 1:33 in favor of declining volume.  The last time such an extreme in trading volume was witnessed was in August 2011, at the end of the primary correction low that year.  The Arms Index also spiked to 3.09 on Tuesday, a reading consistent with previous market reversals.

Then there was the testimony of the S&P 500 overbought/oversold oscillators, which had hit oversold readings not seen in several years.  The 5-day oscillator, for instance, hit its lowest reading since the depths of the credit crash in October 2008.  The more important 20-day oscillator for the SPX on Monday hit its most oversold reading since August 2011. 

The nearest weekly Kress cycle of interim significance was also scheduled to bottom by no later than Tuesday, Aug. 25.  I had stated that if the stock market didn’t rally by Wednesday and continued declining, the longer-term bull market which began in 2009 would be seriously called into question.  Thankfully that wasn’t the case as stocks were finally able to muster a short-covering rally in response to the lack of troublesome news (if not “good” news in regard to China’s policy response). 

However, equities still aren’t out of the water by any stretch.  There remains much work to be done in the way of confirming a solid short-term bottom, and there are still a lot of negative internal momentum currents that need to be reversed before we get an “all clear” signal….

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Economy: Is there really a skill mismatch?

Economists often talk about “skill mismatch” in their attempts at explaining the fact that many job seekers are unable to find employment in an otherwise strengthening labor market.  The excuse offered by economists is that recent college graduates, as well as older workers, lack the skills necessary to get jobs in today’s technically sophisticated labor market.  These job seekers are said to have either majored in low-skilled fields in college or else their skills have become obsolete. 

In truth, the phrase “skill mismatch” is heard only during economic recessions or sluggish economies.  The fact that the current recovery is one of the weakest on record explains why “skill mismatch” is such a popular term among the pundits today.  “Skill mismatch” is merely a euphemism for a soft labor market, one in which the supply of job seekers is far greater than the number of available jobs. 

The real reason for the complaints of low-skilled applicants is that demand is currently too low, which allows employers to be highly selective when seeking new hires.  In a situation like this employers can afford to be picky, and they focus on finding only the highest skilled and most experienced prospects they can.  Since such applicants are normally hard to come by it gives the impression that hardly anyone is qualified for the job in question, hence the ubiquitous complaint of a “skill mismatch.” 

When the economy is running at full steam, as it was in the late 1990s, skill mismatch simply doesn’t exist.  Demand is so high in such cases that employers don’t have the luxury of being picky; they’ll hire even marginally skilled workers and train them on the job.  Truly strong economies give prospective employees the upper hand and allow many with lower skills to obtain jobs that normally wouldn’t be available in a slow economy. 

An article appearing in the April 2011 issue of Wired magazine provides an excellent example of this.  According to Wired, members of the illicit narcotics industry have discovered a novel way of avoiding detection.  In their never ceasing attempts at evading authorities the crafty members of Columbian drug cartels have taken to shipping cocaine in submarines.  The problem is that the dense jungles of Columbia aren’t exactly ideal for building or launching subs.  That hasn’t stopped the cartels from trying, though. 

The Wired article highlighted a most remarkable find deep in the Columbian rain forest: a homemade 70-foot submarine.  The sub was never launched but was deemed to be seaworthy by the experts who examined it.  Its outer shell was made of Kevlar so as to avoid detection by Coast Guard ships possessing radar and sonar.  The sub even had the fuel capacity to make a 10-hour journey underwater before refueling.  Most remarkably, this modern feat of engineering was constructed without the benefit of electricity or access to a shipyard. 

And just how was this technological marvel built?  Why with unskilled laborers (supervised by submarine experts), of course.  To be exact, the builders were mostly poor, uneducated locals desperate for employment.  More importantly, the cartels were even more desperate for workers in such a sparsely populated locale.  This meant they didn’t have the luxury of complaining about “skill mismatch” when seeking laborers for their enterprise.  The point is that when the demand for skilled labor is great enough, skill and experience aren’t always prerequisites to meeting the needs of employers.  All that’s necessary in most cases is sufficiently high market demand.  When that basic requirement is filled, the rest will take care of itself.

So the next time you hear the term “skill mismatch” it should serve as a reminder that the labor market isn’t as tight as it could, or should, be.  

A look at some leading indicators

We’ve already discussed the negative condition of the NYSE internal momentum indicator series known as HILMO (Hi-Lo Momentum).  Also joining the list of weak indicators are the leading indices which are necessary for a healthy stock market: the NYSE Broker/Dealer Index (XBD) and the PHLX Semiconductor Index (SOX).

Let’s start by looking at the XBD.  Here we can clearly see the negative non-confirmation of the broker/dealer stocks.  The XBD chart has failed to confirm the higher low in the S&P 500, which suggests that the market isn’t quite as healthy as Wednesday’s turnaround would seem to suggest.  The strongest market environments are always accompanied by strength in the broker/dealers.  When this group of stocks fails to confirm the S&P it usually means there is latent weakness that must still be dealt with before the broad market can launch an extended rally phase.

The semiconductors have been perpetual laggards this summer.  While the chip makers aren’t as important as the broker/dealers, it’s still preferable to see strength in the semis when the major indices are rallying.  The persistent relative weakness in the SOX (below) is another reason why the market has had difficulty in launching a sustainable rally in recent months.

Notice also that the CBOE Volatility Index (VIX) is looking lively.  The 15-day moving average for the VIX is curling up in reflection of the rising short-term volatility.  Reading chart patterns for VIX can be much more deceptive than the patterns for individual stocks, but the short-term pattern suggests that the sellers may attempt another run on the market in the near term.

[Excerpted from the August 19 issue of Momentum Strategies Report.]

Will the stock market return to earth this summer?

What accounts for the equity bull market’s stubborn refusal to bend to the bears’ will despite a clear lack of internal strength?  That’s the question investors are asking right now in what has been a grinding, directionless stock market this summer.

The answer to that question is simple to answer, yet complex when you look below its surface.  Corporate funds are driving this bull market much more so than direct participation by small retail investors.  The pattern that has been established since the start of this year has been a case of wash, rinse, repeat: the S&P 500 Index (SPX) rallies to either a new high or a previous high, then the sellers enter to force stock prices lower.  The sellers rarely succeed in pushing the SPX much below its 200-day moving average before the buyers step back in to regain control.  The net result of this continual process has been a lateral trading range for much of this year.

What’s remarkable about the market’s resilience for the year to date is that internal momentum for the NYSE broad market has been negative in recent months, as the following graph shows.  This indicator is based on the new 52-week highs and lows and underlines the stock market’s internal path of least resistance based on the rate of change (momentum) of the new highs-new lows.  As my late mentor Bud Kress always believed, the new highs and lows are the single best statistic for discerning what he called the “incremental demand for equities.”  The following chart shows the complete series of Hi-Lo Momentum (HILMO) indicators as originally conceived by Kress.  They show a stock market that is beset by numerous cross-currents and a rather large degree of internal weakness.

Normally when NYSE internal momentum is as weak as this chart illustrates, the market would have nowhere to go but down.  After all, the HILMO indicators show the market’s internal path of least resistance and when they’re all declining in unison it means that there are way more new 52-week lows than there are new 52-week highs.  So why has the stock market refused to decline in a sustained fashion all year?  Probably because the public aren’t major participants in equities, unlike in previous bull markets.  Institutional funds are the primary demand drivers for stocks, and institutional participants are far less likely to sell heavily unless they have someone else to sell to, namely the public. 

A shrinking supply of stocks is another reason for the market’s resilience against bear raids in recent years is another factor worth mentioning.  The number of U.S. exchange-listed stocks has declined almost every year since the late 1990s.  According to the Strategas Group, the total number of exchange-listed companies sank to 4,900 by the end of 2012 after peaking at 8,800 in 1997.  “De-listings of failed uncompetitive technology stocks, another M&A surge in the mid-2000s and a relative shortage of initial stock offerings all contributed,” Michael Santoli observed in December 2013.  Sarbanes-Oexley and the growth of buyout funds devoted to acquiring smaller companies and turning them private also contributed to the shrinkage of publicly traded stocks.

The trend of shrinking equity supply may be in the process of ending, however.  The number of U.S. listed stocks rose to 5,008 as of last year, according to The Wall Street Journal.  This marked the first time since the Internet stock boom of the late ‘90s that the number of public companies actually grew.

Dr. Ed Yardeni has another explanation for the stock market’s resilience since 2013.  “Investors have been impervious to the sorts of anxiety attacks that caused significant corrections during the first four years of the bull market,” he recently observed.  Yardeni noted that falling commodity prices have been a concern for investors, as have the meltdown in Chinese stock prices and the ongoing bailout trauma in Greece.  Yet the U.S. equity market has refused to panic.  He attributes this to the rising trend of the 52-week average of the Investors Intelligence Bull/Bear Ratio. 

This series, which begins in 1988, is near record-high territory.  Yardeni explained: “That’s because the sentiment survey’s percentage in the correction camp is also at a record high.  In other words, when trouble mounts, sentiment doesn’t turn bearish.  Rather, it turns mildly defensive, betting that any selloff will be just a correction in a bull market.  Ironically, that helps to explain why corrections have been missing in action since the start of 2013.”

What it would it take to panic the big institutional investors into selling stocks heavily?  More than perhaps any other factor, the bull market in equities is being driven by institutional investors’ belief that the U.S. economy is gradually improving.  Indeed, virtually every positive economic news headline has been greeted with enthusiasm on Wall Street.  Even negative news is often used as an excuse by big investors to buy stocks based on the assumption that it bolsters the case for the Fed not raising interest rates. 

The belief that the domestic economy is improving is supported by the New Economy Index (NEI), a measure of U.S. retail economic strength, is near an all-time high.  Note the progression of the NEI trend since breaking out of a sideways range earlier this year.  NEI has continued higher since then, a sign that U.S. consumers are still spending despite the bad news about the global economy. 

As long as consumers believe their jobs to be secure and the U.S. economy to be inviolable, the retail spending trend isn’t likely to abate anytime soon.  Neither, for that matter, is institutional investors’ refusal to cash out their stock market holdings as the bull market nears its seventh year of existence.  

The myth of gold price manipulation

How eager are gold bugs to believe their ill fortune over the last four years is the result of sinister forces rather than a lack of prudence on their own part?  The answer is easily seen in the writings of gold commentators over the last few months. References to organized manipulation and an official conspiracy to suppress the gold price abound among many analysts and their followers. 

The collective passion behind this belief has reached a fever pitch and has created something akin to mass hysteria within the gold investing community.  To even question this ingrained belief is to elicit the scorn of the conspiracy crowd.  So ingrained is their belief that gold’s losses in the last four years are the result of manipulation that they refuse to pay heed to the underlying fundamental and technical reasons for the metal’s 4-year bear market. 

This should come as no surprise, however.  As Niccolo Machiavelli wrote, “Men in general live as much by appearances as by realities: indeed, they are often moved more by things as they appear than by things as they really are.”  This explains the eagerness of many gold investors to believe that the metal’s value has diminished due to the acts of organized manipulators instead of owing to the natural market forces of supply and demand.

Indeed, the main reason why so many gold bugs incessantly chant the mantra that “gold is manipulated” is because most of them stubbornly refused to sell at the 2011 top.  That the bull market for gold ended in September that year was made abundantly clear by the actions of the CME Group, which raised margin requirements for precious metals several times that year.  This, in no uncertain terms, established that the regulatory and liquidity framework were no longer friendly for metals, thus speculators no longer had an incentive to load up on it. 

Upon realizing that the 10-year upward trend in gold prices had broken in 2011, long-term investors still had plenty of time to sell at least some of their gold holdings in order to book healthy profits.  The worst ravages of the 4-year bear market in gold which began in September 2011 occurred in 2013.  That gave investors more than a year in which to distribute their holdings so as to minimize the impact of the decline that followed.  Yet true to form, the years since 2011 have proven to be a “slope of hope” for the many investors who refused to sell. 

In its original conception, the term “manipulation” was simply a term used to describe high pressure salesmanship in the marketing of securities.  The process by which investment assets are either accumulated or distributed fell under the rubric of manipulation, since without wide public participation a bull market cannot occur.  The professionals who undertake to either purchase or sell assets must, at times, play against the public, hence the impact of professional “manipulation” in the broadest sense.  This is not the same thing, though, as the willful engineering of a sustained market decline for the express purpose of keeping an asset’s price permanently depressed (as many gold bugs allege). 

In 1933, John Durand and A.T. Miller wrote the following on the subject of manipulation: “In the broadest sense of the word, manipulation, in the form of purposeful effort to control prices, is seldom absent from the market.  Practically every [market] has at least one professional guardian who watches to see that it does not fluctuate too erratically, and protects it against violent onslaughts.”  The authors concluded that manipulation “need have no terrors for the intelligent speculator who will take the trouble to learn its ways: he should in fact profit by its leadership.”

As far back as the early 1900s, traders who knew how to “read the tape” could easily spot the operations of would-be manipulators.  Consider the words of Richard Wyckoff in his 1910 book, “Studies in Tape Reading.”  He wrote:  “The element of manipulation need not discourage any one.  Manipulators are giant traders, wearing seven-leagued boots.  The trained ear can detect the steady ‘clump, clump’ as they progress, and the footprints are recognized in the [tape].” 

If Wyckoff’s words be true, why then do so many complain of manipulation when they should be able to counteract its negative influence with prudent market analysis?  Perhaps because of a lack of technical trading skill, the influence of manipulators is grossly exaggerated.

Gold’s 4-year slide can be explained in terms that even novice investors instinctively understand: whenever an asset is the subject of a speculative bubble and its price is driven to unsustainably high levels, the bubble must inevitably burst.  Or as they say in commodity parlance, “High prices cure high prices.”  That is, when a commodity’s price is driven to extremes, the demand for the commodity diminishes.  A decline then sets in which returns prices to more reasonable levels.  When the bear market pushes prices to unreasonably low levels, investors who recognize the undervaluation step in and begin accumulating it until eventually a new bull market commences and the cycle repeats.  This is the fundamental law which governs all tradable assets; gold is no exception.

The question I posed in my original commentary on gold manipulation remains unanswered: why invest in gold at all if one truly believes the market for it is manipulated?  If one truly believes that gold is controlled by manipulators who want to depress its price, then owning it must surely rank as the ultimate fool’s errand.  Or could it be that there’s another reason for gold bugs’ stubborn refusal to sell? 

The drawing below by the political cartoonist Darkow is worth a thousand words.  This was during the investing public’s hue and cry over High Frequency Trading (HFT) on Wall Street and the supposedly “rigged” nature of the stock market in consequence of it.  Of course the real reason for the outcry over HFTs is because the public needed a scapegoat to blame their lack of participation in the stock market rally of 2009-2012.  But like every other specter, HFTs gradually disappeared from the public’s consciousness and was replaced by another fear, namely manipulation. 

As an 18-year veteran of the gold market, I fully understand the mindset of most gold bugs.  They believe that gold prices should proceed higher in a non-stop linear fashion until it reaches what they consider to be “fair value,” that is, somewhere between $10,000 and $20,000 an ounce (if not higher).  A gold price anywhere south of $10,000 is considered by this crowd to be an outrage and the obvious work of evil conspirators.  Any decline in gold prices is most emphatically the result of dark and sinister forces bent on establishing a New World Order.

                                 

This leads us to our next question, viz. what is the driving force behind the conspiratorial mindset?  What exactly motivates the conspiracy theorist into believing that his world is shaped by powerful manipulative forces?  The answer is that there is a certain measure of emotional comfort in the belief that big market declines are completely outside one’s control.  Hence there is no need for actively evaluating one’s investment decisions.  That the 4-year bear market in precious metals can be explained by a far-reaching conspiracy to depress gold prices provides a cathartic effect to many investors.  It soothes the sting of the losses these investors have suffered since 2011 as they’ve watched the value of their gold holdings continuously plummet. 

The belief in a conspiracy to suppress gold prices originates from the accrued losses that many buy-and-hold investors suffer whenever gold enters an extended bear market.  In just the last couple of years we’ve seen the gold market conspiracy theory belief grow into a rather profitable cottage industry for some.  Indeed, certain commentators have made a lucrative living from books, newsletter and websites devoted to explaining gold manipulation.  There’s even an organization dedicated to uncovering and stopping the participants alleged to be involved in it.

The words of Robert Edwards & John Magee are worth quoting: “The market is big, too big for any person, corporation or combine to control as a speculative unit.  Its operation is extremely free, and extremely democratic in the sense that it represents the integration of the hopes and fears of many kinds of buyers and sellers.  Not all are short-term traders.  There are investors, industrialists, employees of corporations, those who buy to keep, those who buy to sell years later – all grades and types of buyers and sellers.”

Yet, as previously mentioned, there’s also no denying that some degree of manipulation exists in the everyday operations of gold and other asset markets.  With the stakes as high as they are, this is to be expected.  An experienced investor recognizes this truth and can generally avoid the ill effects of manipulation.  Certainly any investor worth his salt would not be so foolish as to risk his hard-earned capital on an extended period where markets are showing signs of undergoing distribution (i.e. organized selling) or other periods of extreme volatility.  If an experienced investor suspects that any of his investments are the subject of organized manipulation he certainly would have enough sense to unload them rather than suffer the vagaries of such a campaign.  “Holding and hoping” is the last refuge of the naïve and inexperienced. 

None of this is to say that gold is a poor long-term investment.  It’s worth pointing out that gold has outperformed many other commodities and asset categories in the last decade.  Even today, after a 4-year bear market, its price per ounce is still well above its previous bear market low of 2001.  Moreover, as one of my readers has pointed out, “Gold price has kept pace with inflation and then some since 1970s.”  Claims of manipulation notwithstanding, gold has done an admirable job of maintaining value over the last 40 years.  When viewed from the perspective of the long-term chart (below), its performance since 2001 is even more impressive.  In fact, it’s hard to understand the gold bugs’ cries of “manipulation!” when looking at the following graph.

This is cold comfort for the conspiracy-obsessed gold bugs, though.  They won’t be satisfied until gold rockets to $10,000/oz. and the gold standard is reinstated.  Until that day arrives they will continue to vilify the invisible hordes of manipulators and conspirators who seek to bring about an Orwellian slavery by eliminating gold ownership and replacing it with “monopoly money.”

There is consolation, however, in the knowledge that this, too, shall pass.  In due time the prevailing fears over organized gold market manipulation will be replaced by yet another fear.  This is how public opinion proceeds -- from fear to fear and from outrage to outrage.  Eventually all discussion of manipulation will be forgotten as this phantasm disappears into the fog of the collective consciousness.