Submitted by Mark Hanna
Courtesy of MarketMontage. View original post here.
At one level, the stock market is much about probability and statistics. Of course there are many other levels as humans are involved, hence emotions, sentiment and the like are also keys. If it were just about statistics and probabilities, the best stock pickers in the world would simply be computers who could analyze reams of data and discern patterns.
We've seen an impressive rally since mid December, and indeed all of 2012. There has been no volatility and the market has either gone sideways or up nearly every session. The S&P 500 has not even come down to test its 10 day moving average more than once during the entire move. The big question on everyone's mind has been is the European LTRO (info here and here) the new quantitative easing ("QE")? Why? A lot of of probabilities and statistics go out the window during periods of massive central bank intervention as both psychology and arguably (temporarily) a different form of reality take over. As the central bank's balance sheet takes in huge amounts of inventory of product (whether Treasuries, mortgage backed securities, or whatever the ECB is currently willing to take as collateral in its LTRO program), funds are freed up to (temporarily) bid up other assets. Aside from European LTRO the prospects of a new American QE are also on the table, and the market has learned to front run the official announcement.
Why does it matter? Because going back to sentence one – at one level macro moves in the general market are about probabilities. It's the rubber band theory – once we get to extremes, the market eventually gets snapped back to a trend line. However, the central bank interventions of the past few years have created even more extreme extremes (if you will), so one has to be cognizant of this.
I mention these things because right now the market is at a short term extreme on many (!) measures. But what environment are we in? The kind where extremes can stay so for a long period of time (i.e. during QE2?) or a more normal environment where a "rubber band" effect should be coming soon. Obviously I don't know the answer but if you go with probability you have to assume the rubber band snaps back to some degree – even if the longer term technicals of the market have improved. That said, those assumptions of the rubber band working as normal proved painful to those on the bear side during periods of massive central bank intervention the past few years.
Let's take a closer look both from a fundamental point of view and chart wise. In this week's Barron's Mike Santoli's weekly letter is titled "The Dangers of Complacency" and has a few interesting snippets:
- More worrisome is the fact that real-money indicators are hinting that equity investors are leaning out over their skis a bit too far for the immediate term. Short interest has shrunk severely in both exchange-traded funds and stocks. Volume in leveraged-upside ETFs versus bearish ones has reached the kind of extreme that recently has preceded market pullbacks, even as overall volume and technical momentum have been unimpressive.
- McMillan Analysis pointed out Friday that the Standard & Poor's 500 was three standard deviations above its 20-day average, which tends to portend at least a short, sharp reversal.
- …the ratio of the 15-day volume of bearish puts on the S&P 100 Index to bullish call volume hit 2-to-1 last week. Traders of these instruments, known as OEX options, are proven smart-money actors, so their caution should be heeded. In the past decade, this ratio hit this level only in February 2007, February 2011 and April 2011; it also nearly reached 2-to-1 in late October of last year. Each instance foretold an imminent correction of some significance.
Let's focus a bit on that last piece of data. OEX is an index for the S&P 100 … if you believe option players are 'smart money' we are seeing a 2:1 ratio of puts to calls on a 15 day ratio. That has only happened 4 times in the past decade. Each instance preceded a meaningful correction. Interestingly 3 of those 4 instances of the decade happened in the past year which I think reflects the ETF, HFT dominated "risk on, risk off" world we live in, where moves go in one direction without rest. (prior to 2007 upside moves were generally slower in nature, whereas downside moves were fast – now upside moves are often as quick as downside moves) I've posted a chart of the past year highlighting what happens after these OEX option extremes are hit: February 2011, April 2011 and October 2011.
Now beyond this Barron's article, let's look at another measure that shows a lot more secondary indicators at major extremes. And what happened in the past… it will also highlight that "normally" X happens but during a central bank intervention "Y" happens. So the question of if we are dealing with X v Y has important implications.
One of the other financial writers in the blogosphere uses a technical measure I was not that familiar with but have been studying for a few weeks – they are called Keltner Channels. For those of you technically inclined they are similar to the much more familiar Bollinger Bands but with some key differences:
Keltner Channels are volatility-based envelopes set above and below an exponential moving average. This indicator is similar to Bollinger Bands, which use the standard deviation to set the bands. Instead of using the standard deviation, Keltner Channels use the Average True Range (ATR) to set channel distance. The channels are typically set two Average True Range values above and below the 20-day EMA.
There are two differences between Keltner Channels and Bollinger Bands. First, Keltner Channels are smoother than Bollinger Bands because the width of the Bollinger Bands is based on the standard deviation, which is more volatile than the Average True Range (ATR). Many consider this a plus because it creates a more constant width. Second, Keltner Channels also use an exponential moving average, which is more sensitive than the simple moving average used in Bollinger Bands.
Looking back on the S&P 500 the past few years, we have some very interesting data using Keltner Channels. In almost every instance, when the S&P 500 breaks out over the top of the Keltner Channel (i.e. an extreme level) we've had a material correction – minimum 20 S&P points, and often much more. Of course, the exceptions were…. wait for it… during QE2. But even during QE2 we had two instance of this sort of indication that worked. Let's look at the multi year chart which I've started from the time QE2 was hinted at by Bernanke at Jackson Hole Wyoming in late August 2010, which I've also overlaid with Relative Strength and Full Stochastics.
Arrows with purple show this specific combination:
- The index broke above the Keltner Channel
- Relative Strength was near or at 70
- Full Stoch was at or above 90
Arrows and lines in green are where we have the latter 2 conditions true, but the index continued to swim along at or slightly above the top of the Keltner Channel – all these instances were during QE2.
So what's the takeaway here? We have just broken over the top of the Keltner Channel again the past 2 sessions. Relative Strength is at 69, and that is combined with a Stochastic reading of 99+. In every non QE2 instance that this happened in the past few years, this led to at least a modest correction (sometimes much more than modest). The few exceptions (green arrows) were during QE2 when obviously normal extremes are affected by 'psychological' (animal spirits) differences as speculators believe the Fed has their back no matter what.
Hence this leads us back to the title of this piece… and the question of what environment are we in? With the ECB's balance sheet exploding ala the Fed's during previous quantitative easing, are we in an X or Y environment? If X (non intervention environment) probabilities are extremely high for a pullback. If Y (intervention environment) the probability is still there, but upside moves can continue for even longer as the rubber band gets pulled even farther back.
Disclosure Notice
Any securities mentioned on this page are not held by the author in his personal portfolio. Securities mentioned may or may not be held by the author in the mutual fund he manages, the Paladin Long Short Fund (PALFX). For a list of the aforementioned fund's holdings at the end of the prior quarter, visit the Paladin Funds website at http://www.paladinfunds.com/holdings/blog
