It Was a Lovely Dream

Recently minted day traders, newbie speculators, and seasoned investing veterans alike are being reintroduced to the idea that stock prices move in two directions.  Long fed by the Federal Reserve’s repeated “quantitative easing” (QE) policy, Wall Street mopped up each infusion of cash and credit and poured it into stocks, bonds and real estate in an “everything” bull market.  So much cash was created that we had to invent things to invest it in.  Cryptocurrencies and their offshoots such as NFTs (non-fungible tokens) are a direct outgrowth of global centrals banks’ QE policy, and a growing distrust of their willingness to print money without regard to side effects.

But crypto issuers have had their QE moment, as they’ve hatched cryptocurrencies at a rate that would make Fed chair Powell look like an amateur.  Currently, there are just over 10,000 active cryptocurrencies available for investment today, and the time it takes to set one up ranges from a few weeks to a few months.  With crypto prices making legendary up moves, it’s no wonder so many got into the game.

There is this sense of a dream in this idea that all these cryptos are really worth something.  With low barriers to entry and a questionable “asset” base, it is hard to see cryptos as little more than speculative vehicles.  The most popular crypto, Bitcoin, isn’t popular because it’s valued as currency, it’s popular because it goes up and down by thousands of dollars a day, and the speculative element loves it.  Early adopters became millionaires, on paper anyway.

Unluckily for the buyers at the latest peak, the purported virtues of cryptocurrencies have bent and sometimes broken.  Bitcoin, by far the most popular crypto, has fallen 70% from its high of November 2021, underscoring a volatility that hardly deserves association with traditional currencies.

More troubling are the cryptos that were touted as money market alternatives, called “stablecoins.”  Backed by cash, short-term paper, or other cryptos, these funds were managed to maintain a $1/unit value.

The stablecoin TerraUST “broke the buck” in May and fell to 30 cents a unit from $1.00, and caused a selling panic in the underlying crypto, called Luna.  Luna promptly lost 99% of its value in a matter of weeks.

Celsius, a crypto alternative to traditional banks that touted deposit yields of up to 18%, suddenly froze customer withdrawals in an apparent sign of financial stress, stoking fears it may soon be insolvent.

Despite its high-tech underpinnings, Celsius is suffering an old-fashioned bank run as depositors head for the hills.  Unlike banks, there is no FDIC insurance, so it remains to be seen if customers will lose their money.

This series of crypto calamities has laid waste to many of the supposed virtues of cryptocurrencies and revealed them to be just another speculative invention of mankind.  Moreover, they underscore the willingness of naïve investors to believe in the implausible, as long as making profits from it is easy.  The crypto dream was lovely while it lasted.

Why bring up the travails of cryptocurrencies now?  Aside from being the poster children of QE bubble financial excesses, their implosion may be a sign of better times to come.

Major blowups have regularly occurred in the late stages of bear markets, marking a sort of “emperor has no clothes” moment.  The Orange County, CA bankruptcy in 1994, MCI WorldCom’s accounting fraud in 2002, and Bernie Madoff’s Ponzi scheme collapse in 2008 all befell the markets within months of their bear market lows.  Is today’s crypto carnage similarly a bullish canary in the coal mine?  While we can only answer that question in retrospect, evidence is piling up that a low risk buy point may be approaching.

We have been telling clients for years that psychology will provide an early clue when that time arrives.  When investors are depressed, headlines and news stories are consistently negative, and the dour state of Wall Street has percolated down into Main Street’s psyche, you begin to get the conditions that lay the groundwork for the next bull market.  Awareness of the bear can be seen in mass market publications such as The Economist, Fortune, or even the local newspaper.  When Wall Street’s problems become front page news, you know fear is widespread.  One of our favorite contrarian indicators, The Denver Post, carried this front page headline on June 14th: STOCKS IN A “BEAR” MARKET.  Hard to get more obviously fearful than that.

A more scientific approach to measuring market psychology comes from Investors Intelligence (“II”).  This firm is our primary source of point-and-figure charting research, but they have also tallied investment newsletter opinion since the mid-1960s.  Originally assuming that high levels of bullish opinion would lead to higher stock prices, they found just the opposite: high bullishness occurred at market peaks, and high levels of bearishness (i.e. fear) coincided with major low points.

Market declines in the 13 years of the QE era have been sharp but very brief affairs as the Fed rushed to turn on the liquidity spigot in response to Wall Street’s temper tantrums.  This left little time for negative sentiment to get entrenched, and emboldened the “buy the dip” crowd, conditioned to the belief the Fed would always bail out the stock market.  Not so today, as stocks have been grinding lower since their November peak, wreaking havoc on portfolios large and small.  At this point there is no one left to get the news that we’re in a bear market.

II’s most recent sentiment survey reflects this unambiguously.  Bullish advisors comprise only 29% of the total, while those advising their clients to be bearish clock in at a whopping 43% of the total.  A third category, “correction” (i.e. short-term bearish) makes up the 28% difference.  Moreover, the percentage of bears has outnumbered the bulls for 11 out of the last 15 weeks, an unusually long stretch of fear that has now permeated the thinking of investors large and small.  Readers can get more information here: www.InvestorsIntelligence.com

It is important to remember that market trends lead the psychological response.  Market sentiment only reflects the “condition” of investor mood, and is not by itself a “signal” to buy or sell.  For those signals we must turn to our old friends the NYSE advance/decline line and the NYSE Bullish %.

The NYSE advance/decline (a/d) line measures the broad trend of whether most stocks are going up or down in price and is an egalitarian indicator in that each stock gets “one vote,” unbiased by market-capitalization weighting schemes (e.g the S&P 500).  The message from the a/d line is one of caution.  Both the daily (shown) and weekly calculations show clear downtrends.  Despite some upside index bursts that got everyone excited for a bottom, the a/d line shows that the majority of stocks are grinding lower.  We advise stock investors to become more aggressive buyers only when the a/d lines give buy signals (which we will highlight when it happens).

The second indicator, the NYSE Bullish %, confirms the cautious message of the a/d line.  The NYSE Bullish % measures the percentage of stocks on point-and-figure buy signals, and like the a/d line, is a measure of the “breadth” of price trends.  A late March market rally pushed the Bullish % to a buy signal, but it quickly reversed to a column of Os and then a sell signal, reflecting the broad and consistent selling pressure stocks are now suffering.  The Bullish %s for the S&P 500, Nasdaq, and small- and mid-cap stocks all show a similar bearish pattern of lower lows as the market decline drags on, with one hopeful caveat.

In major declines, the Bullish %s will bottom at levels of 30% or less.  The exact level has varied, of course, but below 30% one can say that much of the damage has occurred.  This is the time when investors are most likely to project the current bad news far into the future, something they should have done when the Bullish %s were up in the 70% range.  While the Bullish % for the NYSE sits at 26%, other indexes are far more “oversold,” with the Russell 2000 (small cap) at 19%, S&P 500 at 14.5% and the Nasdaq 100 Bullish % at 10%.  This is not a recommendation to buy simply because these measures are “down,” but a reflection that these key indicators are much closer to bottom levels than investors may realize.

For today’s investors the last two years had a dream-like quality as making money in stocks seemed effortless and magical.  Even fantasy investments such as cryptocurrencies levitated to epic peaks, though they were backed by nothing more than the promise of selling to even greater fools greedy for gains, without the pain.  Today, the fools have disappeared, leaving a vacuum into which prices are sliding.

Though the dreams of investors are running up against the rocks of reality, numerous indicators are quietly moving to more positive modes.  Sentiment is very bearish, a positive from a contrarian view, and the Bullish %s are entering oversold territory.  While it will take some time for these measures to confirm a new uptrend, we believe now is the time for investors to look for reasons to be bullish.

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