October’s Stock Market Surprise

Was the mid-September to mid-October move the entirety of the 10% correction called by some analysts or is the bear lurking?  A couple of months ago, I penned an article discussing the position of the stock market in early August.   The tools of my analysis are the market’s geometry and sentiment indicators.  Underlying both of these is human action from the small investor all the way to the Wizards.

Market Geometry

The market’s geometry is what I see in charts.  The feature of charts I most enjoy is that it is a mathematical representation of market movement.  Given my formal education in engineering, this joy is understandable.  Charts embody the hopes and feelings of the market in a picture.  It is then up to the analyst to interpret what he or she sees.  As a student of the famous commodity trader W.D. Gann, chart analysis formed the basis of my futures trading.  The highly leveraged world of futures trading punishes those lacking proper trading discipline.  As a futures trader it is possible to have success even if the majority of your trades are not profitable - cut losses and ride profits.  Gann suggested losing no more than 10% of your capital in a single trade.  In this fashion, it would take 10 consecutive losing trades to wipe you out.  Provided the trader employed a sound algorithm, the probability of ruin was minimized.  In order to operate in this manner, you have to understand trends. 

Stock market charts differ from futures charts since trading does not “end” after a defined period like it does in commodities.  Futures also tend to express greater volatility as those in the agricultural markets can attest.  Thus, it is important to identify trends since that is an important part of cutting your losses (“the trend is your friend”).  My guess is the individual stock investor is not a trend follower since they are often counseled to invest “for the long run”. 

My trend identification acquires three forms: Short-Term (ST), Medium-Term (MT), and Long-Term (LT).  The ST indicator encompasses daily price movement, the MT indicator looks at weekly patterns, while the LT indicator focuses on monthly price action. Other horizons could certainly be employed. For example, I have seen many charts that track price movement in as small as 5 minute increments, certainly appealing for day traders. I simply chose those three for the sake of simplicity and convenience. 

Stock market charts also exhibit fractal patterns.  Fractals are patterns that repeat, or are self-similar, at different degrees of scale.  Daily, weekly, and monthly charts reveal similar patterns even though the time periods are different.  This self-similarity allows me to apply the same trend following algorithm for the ST, MT, and LT indicators.  

Throughout the course of a trading year there will be more changes in the ST trend versus the MT trend versus the LT trend.  For those familiar with moving averages think of it as going from a smaller moving average to a larger moving average.  One would expect the stock market to cross a 30-day moving average more frequently than a 100-day moving average and so on.  When the U.S. stock market experiences a change in my ST trend, I notice but don’t get terribly excited.  If I was an index trader, not investor, I would pay attention.  When the MT trend changes, I take notice.  Since the last major low in stocks (2009) there have been very few MT trend changes to a bear.  There have been no LT trend changes since 2009. 

Stock Market September-October

Market action from mid-September to mid-October provided a body blow to the market bulls and for a few days the market appeared staggered.  Then something very interesting happened. 

Friday, October 17th was an important day for my algorithm and in particular the MT indicator.  Had the market closed the week near the levels of 10/15 and 10/16, the MT indicator would have changed to bearish.  Moreover, hovering near those levels to close October likely would have triggered a bearish change in the LT indicator.  I have had no bearish LT indicator changes since 2009. 

Trading action on 10/17/2014 was akin to the start of the Indy 500.  After the gentlemen started their engines, they roared ahead with aggressive buying.  S&P500 futures (open outcry) begin trading at 8:30am Central concurrent with the 9:30am Eastern opening of the stock market.  Additional electronic trading in the S&P500 occurs overnight.  Figure 1 shows what happened on 10/17.  This illustration is a chart of the S&P500 December 2014 futures contract.  On this day, the market gapped at the open (10 pts) meaning the opening price of 10/17 was higher than the high of 10/16.  This gap signified an intense build-up of buying pressure.

Figure 2 shows what happened in the Dow Jones Industrials that same day.  There was no gap in the chart but the opening price in the Dow was the same as the low.  I refer once again to the Indy 500 metaphor – there was a race to buy.

Before you take a great deal of comfort about the race to buy, I offer Figure 3.  This figure illustrates the trading volume of the Dow 30 for the last couple of months.  The green lines depict a steady increase in volume during the market’s fall towards the October 15th low.  The red line shows how volume decreased during the bounce up to and including 10/28.  Throughout much of the market’s move since 2009 higher volume accompanied falling prices.  Conversely, lower volume accompanied increasing prices.  This is not a healthy condition. 

The concerted buying activity of October 17th buoyed the market the degree to which remains unclear.  We know the Fed just concluded their Quantitative Easing program but don’t think central banks and sovereign funds are absent from the equity market.  The Official Monetary and Financial Institutions Forum published a report this past summer suggesting $29.1 trillion in market investments by hundreds of public sector entities in 162 countries.  This investment is more than just equities but it speaks to contribution of the Wizards in creating frothy markets.   

Sentiment Indicators

Dividend Yield – The yield in the S&P is little changed from August and is now actually lower at 1.99%.  For Nasdaq it is the same at 1.13%.  For the Dow it is slightly lower at 2.75%.  These yields are low for historical standards.  For those who surmise that yields are low simply due to lower prevailing interest rates consider that the dividend yield of the S&P 500 is roughly the same as it was 4 years ago when interest rates were higher. 

VIX – This indicator peaked around 25 at the market’s low on 10/15 and has fallen since to the 14 range.  Fourteen (14) is not high by any means though there is a slight uptrend since this summer.  The VIX hovered near historic lows much of the summer and continues to reflect complacency. 

AAII Survey – Recording a 6 month low in stocks in October did nothing to dampen individual investor enthusiasm. 

Investor’s Intelligence Survey – Last month the survey recorded the lowest percentage of bears since 1987.  The current bullish percentage is 44% which is high but not at levels seen since 2009. 

Headlines – Widely circulated publications made headlines with the following:

• “Bears Capitulate” (Wall Street Journal, 9/9/14)
• “Wall Street Bear Caves” (USA Today, 9/8/14)
• “Former Pessimists Throw in the Towel (Wall Street Journal, 9/15/14)

These sentiments are contrary indicators and reveal complacency, bullishness, and capitulation.  The near 10% drop in the equity markets did little to dampen bullish enthusiasm.  Mathematically, I can confirm this since my MT indicator did not change. 

Summary

The market was quite resilient to the spooking received into mid-October.  On the basis of trend, the market maintains its bullish posture.  On the basis of sentiment, the market remains much closer to a top than it is to a bottom.  There is no time limit, however, for contrary sentiment indicators.  Excessive bullishness and complacency have no expiration.  Ultimately, the market consists of human beings making emotional decisions.  As each day passes though, market participants become increasingly susceptible to being scared by the bull.