In August, I had warned about a stock market decline in the September-October period, possibly a very sharp one. Until September 18, when the Fed decided not to reduce the QE, that view was “inoperative.” However, it was a matter of “delay,” not a cancellation of the forecast.
Several positive factors had kept moving the markets upward, such as a positive election outcome in Australia, Larry Summers withdrawing his name for Fed chairman, and finally the Fed announcement. Obviously, that was enough to allow the high frequency trading outfits to squeeze the shorts.
The surprise Fed announcement on Sept. 18 propelled the major indices to new highs on that day. But there was no follow-through. It was an “exhaustion move.” The next day the market started its decline and hasn’t stopped. A rule in technical analysis: never trust a move that occurs on a news item.
The fact is that the Fed’s decision has not rescinded any of the other negatives. There is a sharp slowdown in earnings gains. Earnings are rising, but the gains are shrinking. For the markets only the rate of change is important. And that’s negative now.
Here is a chart, courtesy of
The brown bars are the percentage gains in earnings. They are now getting closer to the zero line. The blue line is the price of S&P 500 index (x-financials). Note how that mirrors the percentage change in the earnings. All of the earnings gains of the S&P 500 index came from financial stocks. Take them out of the equation, and the S&P earnings gain would be zero! What multiple would you put on that?
On a technical basis, the bulls now have more to worry about. The DJI, the S&P 500, and several other indices made new record highs on Sept. 18. Those were quickly reversed, starting a decline that is more than a normal pullback. That suggests the high was a “false upside breakout.”
The DJI is now below the level of May 3. Incredibly, we haven’t heard analysts mention that. That means that my warnings this summer of a sharp decline in the fall were correct. The early September upmove was on low volume, just like the early October 2007 rally to a slightly higher high, when we identified the top within two trading days. The similarity is almost scary.
The Sept. 18 high was a “false upside breakout,” which is notorious for being followed by strong moves in the opposite direction, namely downward.
Sentiment on Sept. 18 was as excessively bullish as is normally seen near very important long-term tops. Contrarian opinion has to be understood. The majority is usually wrong. That doesn’t mean that these people are stupid. It just means that if they are bullish, their money is already in the market. And when there is universal bullish sentiment as in late 2007, all the money is already committed. That leaves no money to push stocks higher.
The “three-peak top” in the DJI is a typical “distribution” pattern seen at important tops.
"Distribution" is when the smart money sells to the more naïve money managers who believe in the “buy and hold forever” mode of investing. The first peak was in May. That means that the distribution has been going on since that time. The longer the distribution period, the longer the ensuing decline.
The big, smart trading outfits recognize the lack of progress in the big caps and the severe headwinds coming at the economy. They start taking profits. And then they start selling even more, in order not to incur losses. By the time the major indices are down 20%, even the bulls start getting worried. In other words, the phase where investment buying stopped was this summer. We have now entered the phase in which the selling starts.
In the U.S., short positions in September touched record lows. According to the market data firm Markit, just 2.4% of S&P 500 shares were on loan to short sellers. That’s a sign of truly excessive bullish sentiment. According to CNBC in September, short selling in the stock market by hedge funds was at the lowest level in years.
U.S. retail investors were just as bullish in September. Money inflow into mutual funds hit a new monthly high this summer. Individual investors usually get most optimistic near market tops (i.e. 2007) and very bearish at the bottoms (i.e. March 2009).
These are all indications that investors had thrown caution to the wind ahead of last month’s top, just as in 2007.
The so-called “frontier markets” were strong this year while the more respectable “emerging markets” declined. Lots of money flowed into them, just as it was in 2007. Many people would consider some of these countries too unsafe to visit as a tourist. But people are sending their investment money there. Amazing!
Markit reports that the overall value of short positions on European shares has dropped to $144 billion, the lowest level since the data provider began monitoring in 2006. Have you noticed that the bullish sentiment on Europe is almost unanimous? This while youth unemployment is above 50% in some European countries, and only one country that is not in recession. Where will the recovery come from? The huge obstacles to employment growth have not been removed. The labor unions are as powerful as ever. The optimistic side is much too crowded.
Does anyone remember the Internet/technology bubble that ended in March 2000? Many of these popular stocks had no earnings, others had P/E ratios of 400. Well, it’s much worse now. High flying and promoted stocks like
Those stocks are great to trade as momentum stocks when they rise, but you have to get out when the momentum changes from up to down. You must be able to turn on a dime and can’t procrastinate. A sudden U-turn is by design so that the latecomers can’t sell, and will hold the stocks all the way down, hoping for a rally so they can “get out even.” But these stocks never have that rally again. Investors will now find out that earnings do matter.
Here is the good news: As traders, we love market plunges because stocks decline much faster than they rise. We made great profits during the 2008 global crisis and will work hard to do it again. These are great times to make money. And when the recovery comes, I will reverse positions just as we did at the exact low on March 6, 2009. Successful investors always have an open mind and are flexible. The biggest profits are made in times of adversity, not when everything is overpriced.
The mess in Washington is far from being resolved. The consensus opinion is that just in the nick of time before a default, there will be an agreement. Taking a contrarian view, what if there isn’t, even if there is enough money to service the debt? The repercussions would bring tremendous turmoil. For example, money market funds, holding T-bills, would have to write them down to zero for the period of the default, and the funds would “break the buck.” Legally, that’s a huge problem.
Don’t be complacent. Be careful about accepting popular opinion. My work suggests that the economy is deteriorating, not improving. If there is a recession next year, all the optimistic earnings gains will have to be revised. However, don’t get bearish to the point of inaction. Life goes on. Every market decline is eventually followed by a rise.
For the next several months, hope for the best, but prepare for the worst. And remember, “the worst” will offer some great opportunities.
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Bert Dohmen is founder of Dohmen Capital Holdings, Inc.
