May 24, 2008: Markets are, again, too narrow for comfort

Highlights:
  • Market breadth update
  • Is Oil in a bubble?
  • What is driving Oil prices?
  • SZDM marketocracy status

    • Introduction

    We've had a great 2 months in the markets since the March bottom. Unfortunately, some signals appear to tell me that the good days may be coming to an end. The narrowing breadth now calls for caution.

    Market breadth update

    While market have gone up significantly since their March lows, they are now taking a breather. The most important point to take home is that market breadth is narrowing and new clouds are gathering on the horizon.

    On the main US exchanges, fewer and fewer issues are making new highs, vs a larger number of issues making new lows. Also, A/D (advancers vs decliners) lines have started to make lower highs or started pointing down.

    Here are 6 key charts courtesy of stockcharts.com:

    The code names for the charts are:

    I recommend you keep the URL for this image handy: Stockcharts.com URL for the key breadth metrics snapshot

    Moreover, the group that is making the new highs has been narrowing as well. In particular, the biggest darling: Energy, now looks way too overbought. Some energy stocks have been showing signs of consolidation in the past 2-3 days of trading. This pullback can be temporary, or it may be a beginning of a more significant correction in Oil.

    As an investor, I've learned that the worst time to chase returns are when darling charts turn parabolic, while the rest of the market gets narrow. I think it is time to take a break and wait on the sidelines until this brewing storm clears. I won't be surprised to see the both the darling Oil stocks correct in the coming weeks, while the broader, and weaker in comparison, indexes, lose some more altitude.

    While I was hoping for the markets to continue to broaden, the past two weeks have been disappointing on both extremes of the spectrum. On the weak side, US financials have now broken their 2-month uptrend, and it is reasonable to assume they may go back and revisit their March lows and possibly even hit new 52-week lows.

    On the 'strong' side, the picture isn't pretty either. While some select investments like Energy, or Materials, or even Mid Cap Growth have been making new highs as late as the beginning of last week, the charts of Energy stocks, in particular, have been spiking up in what looks like unsustainable trajectories.

    Riding leaders can be a long fun ride as long as the markets are broad enough. But when few leaders spike alone, leaving all the rest of the markets behind, I find the best course of action is to sell these leaders and get defensive.

    Oil bubble?

    A recent Wall Street Journal article, looked at some recent bubbles in the markets: the tech boom in 1995-2000, the housing boom 2001-2006, and the recent Oil boom. The article makes the observation that bubbles take typically 5 years to develop till they peak, and that during these 5-years, the bubbly asset-classes typically go up about 6x - 8x in price.

    Here's the key image from the article: is Oil finally ready to pop? And a similar, easier to compare, chart by Bespoke, detailing the periods, the percentages of the increases and, for the NASDAQ and home builders, the drop to the bottom as well:

    Even if Oil hasn't peaked yet, and we may have some way to go, I believe we're getting very close. I no longer believe the "it's different this time" proclamations.

    What's driving Oil prices

    Crude oil has hit a record price of $135/barrel last week.

    If you think this is bad for you as a consumer, thank heavens you're not a gas station owner these days. These poor guys on the corner are being squeezed from both sides: from the Oil companies and refineries charging more on one side, and the consumer driving less and less on the other.

    Here's a really good investigative article from AP: "Who is to blame for gas prices?" It explains how the pie is being divided whenever you pay $4 for a gallon of gasoline, and what are the dynamics driving the prices. The bottom line is that prices are mostly driven by market speculation (spot/futures prices) and not by actual scarcity of crude oil. Essentially what happened in the past 6 years is a "commoditization" of the commodities markets. While in the past only a few would directly invest in those financial instruments, today, indexes of commodities are available to everyone through ETFs and other popular vehicles. Many institutions have been allocating a part of their regular asset allocation pie to commodities, and this trend keeps inflating this bubble.

    In terms of actual crude-oil consumption, right now, China is building its reserves preparing for the 2008 summer Olympics, while the US is already seeing a decline in consumption due to the economic slowdown.

    The point is, that investor psychology can turn on a dime. To paraphrase the immortal words of Kosh Naranek (Babylon 5), when the avalanche starts, it may be be too late for the pebbles to vote.

    While buying oil related stocks may look tempting, remember what happened to those who bought tech in early 2000. Better be safe than sorry. If you feel you must buy Oil, be reasonable in your allocations, and make sure you don't put all your eggs in one speculative basket.

    May 28 update:
    Here's another excellent article covering the subject: Quantifying Commodities Speculation from Mike "Mish" Shedlock Global Economic Analysis blog.

    Two charts illustrating the magnitude of speculation in commodities including oil from that article are reproduced below.

    Marketocracy status

    My Marketocracy portfolio (SZDM) managed to hit an all time high last week. It was almost 5% above its October 2007 high, but the last 3 day dip pushed it down -2.93% for the week (vs -3.44% for the S&P500).

    So the good news is that even with this drop, SZDM has been beating the major indexes pretty consistently. And it has done so, on all Marketocracy measured time frames: a week, a month, 3 months, 6-months and a year, all with lower volatility than the market.


    Here's the more detailed summary vs. the S&P500


    The bad news, is that in order to achieve this out-performance, I've been forced to be more active than I would have liked.

    I have found that holding for a year or more is almost never advantageous overall. My typical holding times these days are down to 2-6 months on average. The most important skill I've been trying to improve is lightening-up when charts get overbought and re-deploying cash on oversold conditions. I still have a lot to improve in this area.

    Since my turnover is high, a relevant question is: have the new assets I have bought, been doing better than those assets I have sold?

    For that Marketocracy has been tracking SZDM's timing record. Marketocracy's numbers show that the buy/sell choices have been pretty consistently good on all time-frames (screenshot):


    At this time, I'm leaning towards preserving capital over beating the indexes on a down-leg, I'm a bit late (should have done it a week ago), but I think this new trend has more to go, so I'm planning to raise cash next week and keep a defensive posture at least until the markets become oversold again.

    As always, any feedback, question, request, criticism, is welcome.

    -- ariel