The Pips Are Squeaking

Far from enjoying the traditional winter Santa Claus rally, Wall Street has been delivered a wagonload of coal. Stock markets around the globe have careened lower in the month of December, pushing many down 20% or more from their summer highs. This has triggered proclamations by many renowned Wall Street strategists that the bear market has finally arrived, coupled with varying degrees of dire projections of worse to come. The media has followed suit, producing feverish headlines about whether the markets are above or below the magical (though arbitrary) 20% level that has somehow come to define a bear market.

For their part, Wall Street traders have done little to calm the markets, as multi-hundred-point swings in the Dow Industrial Average have become the norm this winter, with any rally attempts being slapped down in subsequent days by sellers anxious to get out. The days surrounding Christmas are a case in point: Christmas Eve, a perennially bullish period, saw an unprecedented 3% decline in the major indices, then December 26th saw a 5% gain (an also unprecedented 1000-point gain in the Dow). While the post-Christmas gain was widely cheered, to us it is a sign, not of strength, but of the immense indecision among investors.

It is no wonder the public is running for cover. Investors have reacted by pulling funds out of the market, with some $56 billion of net outflows from mutual funds for the week ending December 16th. The gravity of the market decline has finally penetrated the psyche of Main Street, and they are moving to protect their savings. With Wall Street and Main Street selling with gay abandon, it is clear that panic has set in. In other words, the “pips are squeaking.”

When we say the pips are squeaking, we really mean to convey that logic and rationality are being thrown out the window, and raw emotion has taken over as the primary decision criteria. Sober analysis means little right now. The pain of the decline has become too much to endure for many investors, and they have reached the point where they need some relief, which can only come from selling. When we reach this point in a market decline, it is time to summon up as much courage as possible and look as objectively as possible at the situation in which we find ourselves.

Causes for the decline are not hard to find. Continuing trade war rhetoric is now translating into a very real softening of global trade. FedEx and UPS, both considered barometers of economic activity, have reported slowdowns in transportation activity. The widely watched Richmond (VA) Federal Reserve Manufacturing Composite has fallen significantly in the past three months, while the pace of home sales has flattened. Unsurprisingly, consumer confidence, which reached a post-recession high in September, has taken a meaningful step backwards. Talk of recession in 2019, which seemed far fetched this summer, is now dominating discussions among economists.

One can’t discuss causes for the current malaise without mentioning the actions of the Federal Reserve. The Fed has continued with its policy of gradually raising interest rates to get monetary policy back to normal after the aggressive policy of money creation and interest rate suppression during 2008-2014. While it is interest rate hikes that have come under attack by Donald Trump in recent weeks, they are small potatoes compared to what is going on behind the scenes.

From 2008 to 2014, the Fed increased its balance sheet from $1 trillion to $4.5 trillion, through the purchase of high quality bonds and mortgage backed securities. This, in effect, created cash within the banking system which, it was hoped, would find its way into lending for homes, factories and equipment, and refinancing existing debt. And while it was successful in that regard, lots of that money also found its way into Wall Street, helping artificially fuel the bull market since 2008. However, in early 2017, the Fed actually began to reduce the size of its balance sheet, in small increments at first, but increasing the rate of reduction to its current level of $50 billion a month.

It is this withdrawal of liquidity that is the single most important cause of today’s market declines. While Wall Street clings to the outmoded belief that it is solely corporate earnings that drive stock prices, it is clear that in recent decades markets have been driven by the Fed’s creation of liquidity cycles. This has been true since Alan Greenspan took over as Fed Chairman in 1987 and began using monetary policy to stave off investors’ pain during market declines.

In that respect, we are witnessing a sea change in the Fed’s relationship with the financial markets. The current Fed Chair, Jerome Powell, has signaled that he is trying to break the market’s “co-dependence” on the central bank. At the December Fed meeting, the central bank raised rates 0.25%, as expected. But stock markets dropped soon afterward as Powell said the Fed would not stop its pace of hikes in 2019, as some had hoped.

Mohamed El-Erian, chief economic advisor at insurer Allianz, speculated that the Fed would react to the market sell-off by saying “It’s about time the markets stand on their own feet.” He went on to say that Powell, under criticism from investors and Trump, is ending “this notion that the Federal Reserve is our best friend forever.”

While paradigm shifts don’t occur very often on Wall Street, this would certainly qualify as one, and one that we welcome as long-term investors. Going forward, it first means investors should no longer count on the Fed to “save” the market during every little hiccup. Today’s environment is a good example of the pain investors will need to get accustomed to, but which will create genuine value and true buying opportunities in the markets. Second, it implies that fundamental factors such as earnings, dividends, and the level of interest rates will, in fact, become more reliable indicators of a stock’s likely up or down trend. The artificial “sugar high” of encouraging ever increasing leverage through interest rate suppression is coming to an end. Last, a value oriented approach to security analysis (the Graham and Dodd kind) will probably be more fruitful in generating gains than in the past two decades, where ever declining interest rates and (over the last 10 years) massive amounts of monetary stimulus have pushed price/earnings ratios up to unsustainable levels.

Where does that leave us today? One counter-intuitive aspect of investing is that when the “merchandise” goes on sale (as during a bear market) investors want less of it. As we come to the end of 2018, the damage done to stock prices is widespread and profound, and many of our indicators are down to levels last seen at the major lows of 2008, 2011, and 2016. This does not mean that stocks are preordained to rise, but it does imply that risk in the markets has fallen significantly. For example, our weekly tally of stocks above their “major trend line,” based on the point-and-figure charting technique, is down to 29.6%, matching the lows of 2011 and 2016.

Confirming this indicator is the NYSE Weekly High/Low Index, compiled by our friends at Investors Intelligence (www.InvestorsIntelligence.com). This measures the weekly ratio of 52-week highs to 52-week lows, and is plotted on a 0 to 100 scale. In bull markets, the ratio will be at the upper end of the scale, while in bearish periods as now, it will be at the lower end. It has the advantage of putting into perspective how low “low” can be in bearish markets, and at this time we are reaching the levels seen at the major bottoms labelled on the chart.

Sentiment measures, however, best exemplify the pain that investors are feeling right now. Measures of investor psychology are uniformly bearish; that is, respondents are saying they feel negative about the market. It is important to remember that sentiment indicators are trailing measures. In other words, shifts in investor psychology will only occur after a market move has occurred. Remember the near parabolic up move in stocks in early 2018, when the tax cut was passed? Investors Intelligence bullish sentiment rocketed up to a 40-year high of 66.7%, after the market had risen. Now, of course, psychology is plumbing the depths of despair, after the market has fallen. CNN’s Fear and Greed Index has reached a very pessimistic reading of 3 in recent days, underscoring just how negative psychology has become. This is a positive, from a contrarian point of view. Very negative investor psychology suggests lots of fear, and by implication that investors have sold out their positions. At some point, the selling pressure dissipates, marking the first hurdle that must be met to begin a rebound, which is that stocks must stop going down.

Many market pundits are advocating investors take advantage of this sell off to “buy at the bottom.” But they are confusing an “oversold” condition with an actual uptrend. “Oversold” means that recent price action has been overwhelmingly downward, and has reached an extreme. That is certainly the case today, as nearly every breadth or momentum chart shows deeply oversold conditions. But that is not enough to justify making aggressive purchases in the stock market.

The majority of stock prices are in down trends, so we must look to our workhorse indicators to identify when that is going to change. The first of these is the NYSE Bullish %, which measures the percentage of stocks on point-and-figure buy signals. It has the advantage of revealing what IS happening, not what SHOULD happen. As more and more stocks give buy signals, this percentage will rise, and that is the key characteristic of a bullish market. The NYSE Bullish % has dropped from a bullish 72% (January 2018) to mid-50% levels earlier in the year, and has now taken another leg down to a current bear market low of 17.8%. This means that over 82% of the issues on the NYSE are on sell signals, hardly a bullish profile. Moreover, the Bullish %s for other indices are similarly depressed, with the Dow (10%), S&P 500 (12.5%) and NASDAQ 100 (14.7%) all at multi-year lows. Thus , the first criteria needed to declare an uptrend has begun is that the Bullish %s need to turn up, and ideally, give point-and-figure buy signals.

Our second workhorse is the NYSE advance/decline (a/d) line, which has given a sell signal on both the daily and weekly calculation. This is also a slow-moving indicator, but captures what investors are DOING with their money, not what they are SAYING. If the majority of investors are buying, stocks will start to rise in price, and this will be reflected in the a/d line starting to rise (i.e. reverse to a column of Xs). If only a few of the biggest and most popular stocks get all the attention, the a/d line will not respond much. The recent volatility is a case in point, as even the 1,000 point Dow rally of December 26th did not reverse the chart up into a column of Xs (although it is about 500 net advances away from doing so as of this writing). A rising a/d would indicate a meaningful rally is probably occurring , and a buy signal in this measure would be a very bullish signal indeed.

It will take some time for these measures to turn positive, so again, we would urge investors to assume that bear market rules still apply until more positive signals confirm that an uptrend is in place. Any reader wishing to get updates on the a/d line or NYSE Bullish % should feel free to contact our office at the email below.

Sentiment measures and deeply oversold price momentum indicators imply that the worst of the selling is over for the moment. This is counterbalanced by the fact that neither the Bullish %s nor the advance/decline line have turned upward, let alone given the buy signals that would signal that a new uptrend is at hand. Investors should embrace a hopeful, but watchful, approach to the markets as the notion that the “pips are squeaking” implies that panic selling, among individuals and professionals, is taking place right now. But we should also recognize that turnarounds take time, and will test our fortitude. We should therefore let market signals, not emotions, guide our actions through this uncertainty.