Aug 9, 2008: A possible structural shift in the markets

  • Intro
  • Intermediate bottom confirmed for now
  • Possible new leadership
  • What's next for the markets

  • Intro

    The data-driven investing learning journey continues with a 360-degree look at the markets.

    With the intermediate-term bottom on July 15 pretty much established (just like our timing model said just 2 trading days earlier) and with the breadth of the US markets showing pretty healthy signs for the short term, we go on looking for opportunities far and wide: regions, countries, sectors, even currencies.

    No, the big bad bear market isn't likely to be over just yet. How far further will it go? There's an attempt below to quantify when the long-term bottom will finally be established. It looks like we were about 2/3rds of the way there on July 31st, which is encouraging.

    Read on.

    Intermediate bottom confirmed

    On the weekend of July 12, I wrote about my experimental intermediate timing model and my belief that an intermediate market bottom is in the process of being established in US markets.

    My model's resolution is 1 week, since I train it on weekly data and since I don't believe I can get much more accurate than that anyway.

    The broad U.S. markets have bottomed on July 15th, just two trading days after the model signalled a bottom, and have by now printed a series of higher lows, and higher highs (chart below).

    The breadth picture

    Looking at the breadth picture, the advance decline lines are nicely up-trending, while the new high/low lines are still trending down (see chart below) but at a slower rate. This is due to the fact that the previous leaders (oil, materials, agribusiness) which were the ones making most of the new highs, are no longer making them while the rest of the stocks are so far away from 52-week highs that they are not likely to hit them anytime soon. This is ok, and actually healthy. I would focus on the Advance/Decline charts for now.

    I think this up-leg has some more room (a few more weeks, and possibly even more) to continue before the next bear-market leg down hits. I'll wait for a breadth deterioration before increasing broad-short exposure. To those who want to hedge earlier with a market neutral pair, I would be shorting Europe but only as a hedge to some equivalent or greater long US such as SPY.

    Possible new leadership

    There's a clear shift in leadership going on right now. Only time will tell if it persists, but it is worth noting the following:
    Short term regression analysis

    How can one distinguish between "dead-cat" bounces and genuine strength that may be indicative of a new leadership? Essentially, in two ways:

    Top 15 ETFs sorted by Alpha in (daily) 2-week linear-regression (Alpha, Beta, Correlation, Sigma) vs. SPY
    ETF	Alpha	Beta	Corr	Sigma	Full Name
    ---	-----	-----	------	-----	---------------------------------------
    EUM     0.64    -1.09   -0.88   1.01    ProShares Short Emerging Markets
    SDP     0.64    -1.16   -0.72   2.00    ProShares UltraShort Utilities
    IHF     0.66    0.39    0.46    1.31    iShares Dow Jones US Healthcare Provider
    SMH     0.74    0.42    0.63    0.92    Semiconductor HOLDRs
    TUR     0.88    1.12    0.49    3.57    iShares MSCI Turkey
    KRE     0.95    1.77    0.88    1.71    streetTRACKS KBW Regional Banking
    TLL     0.95    -0.95   -0.79   1.31    ProShares UltraShort Telecommunications
    EFU     1.00    -1.67   -0.95   0.98    ProShares UltraShort MSCI EAFE
    EEV     1.17    -2.08   -0.86   2.22    ProShares UltraShort Emerging Markets
    DUG     1.28    -1.63   -0.48   5.21    ProShares UltraShort Oil & Gas
    USD     1.36     0.67    0.43   2.44    ProShares Ultra Semiconductors
    SMN     1.37    -2.10   -0.64   4.38    ProShares UltraShort Basic Materials
    EWV     1.48    -1.71   -0.92   1.32    ProShares UltraShort MSCI Japan
    FXP     1.74    -3.22   -0.86   3.34    ProShares UltraShort FTSE/Xinhua China 25
    AGA     1.82    -0.42   -0.16   4.61    DB Agriculture Double Short ETN

    What's next for the markets

    I don't think that the bear market is over yet. Being an intermediate term timer, I try my best to ride the smaller waves, but comparative analysis tells me that after this leg up, we should have 1-2 more legs down before I can call a long term bottom.

    How much more we have to fall? The best method I have is comparative analysis. Since no two bear markets are exactly the same, we can try and find parallels we can use to map one to the other. One such parallel is investor psychology: despair vs. hope. In bear markets, as we have seen over and over, there are very strong rallies and some extreme up days reflecting investor hope that the bear may be over.

    If we take the ten biggest up-days since 1990 in both the tech-sector and the financial sector, we'd see that almost all of them occur during their respective bear periods. Images courtesy of Bespoke Investment Group:

    During the 2000-2002 bear market the tech sector crashed 82%. So far -- up to Jul 31 -- the financial sector was down about 42%. But we have to keep in mind, that the tech bubble was a bigger bubble at least as far as valuations are concerned, so how can we compare?

    Let's look at these 10 up-days:

    What we can now do is see whether there's any correlation between these biggest up days, and what are the linear-regression coefficients between the two series. I did this and the comparison tells me that the ratio between the two vectors over the top 10 points is surprisingly strong (Pearson coefficient is 0.98): with a mean ratio of about 0.77 and a very small standard-deviation (0.0466).

    IOW: tech crash top 10 up-days were about 1.0/0.77 ~ 30% bigger on average than financials top 10 up-days so far.

    Applying the "Harry Seldon psychohistory device"

    Following the wisdom of Harry Seldon, the daddy of psychohistory, in order to match the investor psychology during the two bear periods, financials should be down overall:

    -82% * 0.77 = -63.14 % from their peak when they hit the long-term bottom.

    This means the bottom should be reached when (drum roll please...) XLF hits 14.04.

    As of July 31, 2008 financials (XLF) were only -42% from their peak about 2/3 (0.66) of the way to 14.04 (and since then, they've rebounded pretty sharply). So even if we want to be optimistic, I believe we still have a way to go down till the final bottom in financials, in this bear market.

    Looking deeper: in the July 15 bottom XLF closed at 17.17. A bit above my target. July 15 also had record volume (469M ETF units) which typically marks bottoms (both intermediate and long-term ones).

    However, we dont have to bet on financials exact bottom point. It is too risky to bet on one proposition. In bear markets, not all stocks bottom together. The new leaders of the next bull market should bottom well before financials do, and may even have already started their journey up. Note the extreme resilience of the Dow Transports and now, for the first time in many months, Small-Cap US stocks as well.

    I will keep updating readers in this space.

    Disclaimer: this should not be considered as investment advice. It is merely describing my own thoughts and actions.

    Disclosure: Long Dow Transports, US Small Cap, Technology, Biotechnology, Health-care. Planning to reduce beta and short Europe when breadth deteriorates and my intermediate market timing model flashes a top.

    As always, any feedback is welcome.

    -- ariel