Oil - Double Bottom ... again

Last week I presented the concept of forecasting future price targets based upon patterns which develop within price movement.  To illustrate, I used a long term chart of the Nasdaq which had created a pattern in 2011 that projected a future price that came within 2% of the forecast.  While the accuracy was most excellent what I find very compelling is the chart identified this price 3 years before it happened.

This week I want to show not only a different pattern but also that price projections work across all investment types (since many don’t just invest in stocks and bonds).  The chart below is a 3 year look at the daily price of crude oil. You can see in the highlighted area on the left hand side of the chart a double, divergent bottom formed in 2011. I have included the pattern’s projected price target in a callout box, which forecasted a high of 103.82. Price topped out 5 months later in March at 109.45, exceeding the target by 5%.  While that is pretty good, it fell short of last week’s 2% miss on the Nasdaq

If you let your eyes drift to the right side of the chart you can see another highlighted area where the exact same divergent, double bottom has formed. This one started at the end of last year and has yet to complete.  The upside target of this pattern is just under $109/bbl. Experience tells me that I should expect this target to fall short of the actual high we eventually see. Why? Because oil is a highly geopolitical “tool”, sensitive to Middle East disorder. In addition, it is a relatively thinly traded market making it subject to price swings. So, while I stated above that patterns work across all investment types, I find price projection accuracy can be quite variable when using vehicles outside of those which are highly liquid such as stocks and bonds. This does not mean they should be ignored. Au contraire, like any technical analysis it should be used in conjunction with other tools to create the most profitable investment plan. 

In the meantime, keep oil on your radar and let’s circle back around and see how this pattern actually plays out. If I were a betting man, based upon the latest geopolitical cross-currents, I would put my money on a big miss to the upside as I expect price will exceed the target and maybe even by double digits.  Remember, news ALWAYS trumps the charts.

The Nasdaq - 3 years later

Many wonder why market technicians spend so much time analyzing charts. The main reason is a skilled analyst can find opportunities, warnings and most importantly expectations of the future buried in price movement. Over the next couple of weeks blog posts I am going to not only go dust off some old charts I created a few years back (when I first started work on my CMT designation) and see how they are playing out but also introduce a few new ones.

This week let’s start off with an old chart I created at the start of 2012 and have presented every year since then of the U.S Nasdaq market. At the start of 2012, based on the prevalent bullish pattern that developed after the 2011 (-20%) pullback, the price objective of that pattern pointed at 4413.  At the time the Nasdaq was about 2900 as you can see. I didn’t want to believe it. After analyzing and reanalyzing because of my disbelief, I thought to myself there had to be something wrong with the chart. If not the chart, it had to be me. I had to be either drawing or interpreting it incorrectly. There was no way it was going to go up an additional 50% from there. Jump forward almost 3 years and we can see the high created earlier in March of this year topped out at 4336. That is less than 2% away from the pattern target. If you are like me, you are wondering if now that it hit its target is that the end of the run or do we need more time to see if it can push higher?

With 3 years of additional data (and experience) to complement the original chart let’s see what, if anything, it may be telling us. In February the oscillators warned (negative divergence in red) correctly of a pullback … which eventually occurred. Subsequently, the oscillators (reverse divergence in green) are advising of the probability at least one more new high will be made. The price objective of that new high is 4460 (not much above the original target of 4413) but could extend as high as 4740.  The reason why I have a range for the next target and I had one specific price on the original is that I am using a different pattern this time to develop the new target price. With this pattern there are two different, acceptable methodologies to calculate the target and as such, I have provided both.

In case anyone is wondering … No, technical analysis does not always give answers that work out as well as this one. What it does do though, is provide a toolset that should, if used correctly, give the user an advantage over the majority of market participants.  It is merely a windsock.

Next week I will pull out the old chart of the SP500 I created back in 2012 at the same time as the Nasdaq chart and see what the old windsock is telling us.

Presidential Seasonality Market Patterns

My ongoing expectation for 2014 is that stocks are going to struggle and better returns will likely be found elsewhere.  I have a list as long as my arm as to why, many I have written about here on the blog but the rest in personal conversation with clients. There are two major seasonality patterns on that list that keep me awake at night. The first most everyone is aware of as it has been beaten to death in the media (including by me) which is the “Sell in May” scenario. While it did not work out last year the statistics are unbelievably compelling and the fact that last year did not play out just increases the odds it works this year.  The second and less well known of the two major seasonality patterns is the presidential cycle.  What this shows is that the second year of the presidential term is the worst especially during the May to October time frame.  And to add even more bearish overtones, the second year of a president in his second term is almost 2x worse than one in his first.

Below is a chart illustrating historical performance of the presidential seasonality scenarios described above.  The green line is the average historical performance of the SP500 by month of the second year of all presidential terms. The red line show historical performance of the SP 500 by month of the 2nd year of a president only in his second term.  The black line is 2014 year-to-date.  What should jump out at the reader is under both historical seasonality scenarios is the markets top out in April and decline through October.  The other major take away is that when the summer-fall weakness subsides, the 4th quarter has been a great time to insure you are invested in stocks as returns have averaged between 7-10%.

If the presidential cycle is going to work out this year it will require a slight modification. Instead of topping in April, it will have to change to May since last week market highs inched above those made in April on the broadest of market indexes. Based upon the presidential cycles the higher probability trade is in the bear camp so investors who are long the market should consider being not too long.

US Stock Market Bifurcation

Bifurcate - divide into two branches or forks.

I have spoken to dozens of investors of late and have tried to verbally explain what has been happening in the market. I describe that since the beginning of the year investors are reducing stock risk and they inevitably ask “how can that be when the major indexes are at all-time highs?” It is explained by a rotation out of the riskier, more volatile stocks and into the big cap stocks. This rotation has created a bifurcated market.  The chart below is performance of the US stock market since the start of the year by stock size. As you can see, the biggest stocks are up ~1% while the rest of the market is down ~4-5%.

Below is a 3-year look-back at the US stock market by (market-cap) size.  You can clearly see 1) the bifurcation that has developed (big cap = up, small and mid-cap = down) and just as importantly, this is a rare occurrence.   

I looked back at this relationship as far back as my charting tool will let me and it occurred only one other time in the last 20 years.  Interestingly, that time was in 2007, just before the SP500 began its second largest major historical decline. The timeline for that one occurrence was about 5 months as it started in June and ended in October when the SP500 peaked.

Remarkably, this relationship appears on the inverse and it’s just as rare, too.  Only once in the last 20 years did I find a time where the small cap and mid-caps moved higher while the bigger caps were falling. This occurred in 2002, at the bottom of the dot-com collapse, just before the market began its historic 100%+ run. The timeline for this occurrence was more than a year before it resolved itself.

What this all means or how it will resolve itself, no one knows for sure and only time will tell.  I have my theories but I have given up predicting the future (at least in writing :-> ).  But we do know that when rare events happen we need to stand up and pay attention.  The difficulty is these events unfold over many months and living the markets day-to-day you can be distracted by the noise as it will do everything it can to give you a multitude of false signals. Without going out on a limb and making a prediction here I will say that while this bifurcation can exist for a while, at some point all segments of the market will have to get back in synch.  That is the norm. The $64,000 question is will the small and mid-caps begin to out-perform the big guys in an attempt to catch up or will the big guys fall to match the levels of their smaller brethren? Considering market seasonality and past timelines, I think we will find out the answer to this question between now and the end of fall.  

Margin debt and how I was wrong

A man must be big enough to admit his mistakes, smart enough to profit from them, and strong enough to correct them. - John C. Maxwell

I was wrong. There, I said it.

Over the past few years many market technicians (including myself) were looking at the continuously increasing new highs in margin debt as a warning sign stocks were topping.  In retrospect and having a different perspective I have concluded we were wrong.

There is no arguing, margin is fuel to the bull market fire. For those not aware, when investors/speculators run out of their own money to invest, they can borrow from their brokerage institutions against a portion of their brokerage account. As long as they can make more money than the costs to borrow it can make sense to use margin.  The times it becomes a problem is when those same investors/speculators have 1) reached their borrowing limit or 2) if stocks decline. If investors have no more money to invest (whether from their own sources of funds or borrowed on margin), the market runs out of buyers and can go no higher. If stocks decline margin investors are forced to sell positions to pay off the outstanding margin debt which is being demanded from their broker. Since they have no remaining liquid funds (all funds are fully invested) this forced liquidation adds more sellers which of course, drives the market down even further.  And on it goes, potentially snowballing. Where the level of margin debt really matters is that the greater the margin debt, the greater the possible decline.  

Back to being wrong … My view had always been because margin debt reached a new high it could not go higher and so stocks had to decline. As it turns out that thinking was completely wrong and where I should have focused my concern was not at whether it was making new highs (because that is actually very bullish) but rather if margin debt CHANGES DIRECTION and starts to decline.  Going higher has the effect of pushing prices higher, falling margin has just the opposite effect.  It seems so simple now, what the heck was I thinking?

This leads me to this week’s chart which is that of a historical look back at margin debt updated through the first quarter of this year.  The red line is the US Stock market (SP500) and the blue line is margin debt.  What I would hope you take away from this chart is at least the following

1)    Rising margin debt = rising stock prices

2)    Falling margin debt = falling stock prices

3)    Peaks in margin debt have coincided with peaks in the stock market

4)    Margin debt peaks first

Now you have that firmly ensconced in your brain, ask yourself this, “is the decline in margin debt from the start of this year a temporary blip or the start of a new trend?”  Don’t know the answer? Me either but I do know this, it is not the time to be attempting to be a hero and taking on excessive risk.