A Post Mortem – the Influence of Black Box Systems

Here is a brief update on the recent market action and what we think one should watch out for now. First of all, we already noted in our last market update that something about the recent “mini crash” was quite unusual. For one thing, it started to get serious in an options expiration week, which happens only rarely. One rather scary precedent is actually the 1987 crash: on that occasion the market declined sharply during expiration week and crashed the following Monday.

Phoro credit: Oocoskun

However, something else is quite strange about this decline. We did of course get ample warning from deteriorating market internals, which we have extensively written about in the time period shortly before the mini crash (see e.g. “The US Stock Market and a Major Recession Warning” posted at the end of July), so in that sense it wasn’t a surprise that the market went down. What is surprising is how it happened. We have never before seen the stock market plunge at similar speed from a trading range just a few percent below an all time high so shortly after the ATH was put in.

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S&P 500 over the past four years. The recent decline is highly unusual

Normally, crash patterns involve an initial decline that undercuts a support level, followed by a rebound that then fails, in most cases at a lower high. Usually this initial part of the crash sequence looks perfectly harmless. Nothing of this sort happened here – instead, the market just crashed “out of the blue” and the decline looks anything but harmless, given how much technical and psychological damage it has inflicted.

There are several possibilities here. Perhaps this actually was the “initial decline” and things will really get dicey after a rebound that fails at a lower high. Another possible explanation is that the increased computerization of trading – with about 70% of all trading volume executed by HFTs and systematic “black box” trading programs – has fundamentally changed market action.

Readers may recall our frequent remarks over the years about extremes in sentiment and positioning data which the market seemed to completely ignore on the way up. Computers obviously don’t have emotions. A black box system that trades primarily on price information and charts ultimately follows a set of fairly simple rules. Thus a break of an important moving average or a predefined support or resistance level may be all it takes for a great number of such programs to execute buy or sell orders in unison. In fact, we believe that this has indeed happened and has exacerbated both the rally from the 2009 low as well as the recent decline.

What Happens Next?

So what to expect now? It is of course extremely difficult to call short term moves in such an extremely volatile market environment. The market’s bounce attempt on Tuesday seemed a natural development, but surprisingly, it actually failed to hold. As we are writing this, the market is trying for another bounce, and it seems likely to us that it will actually succeed this time around. Sentimentrader’s short term optimism index (or Optix) on the stock market recently went to zero – it cannot go any lower. This makes a rebound highly likely (but notmandatory – in 2008, similar readings did not keep the market from plunging further in the short term).

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The short term Optix on stocks recently hit zero

Luckily the decline has established easily identifiable resistance areas which will help us to determine failure or success of the any upcoming rebound attempts. A reversal at or below these resistance areas will be a major warning sign that the worst is yet to come. Conversely, if the market were to overcome these resistance areas, one would have to reassess the situation. In that case it could be that the decline merely represented a brief “growth scare” that was necessary to make market participants less complacent.

We believe the latter scenario has a very low probability though. The ferocity of the decline actually makes us think that it represents the “kick-off move” to a bear market – quite possibly a major one. Here are daily charts of the DJIA and SPX with their respective resistance areas penciled in:

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The DJIA has strong resistance in a region between approx. 16,900 and 17,200. A rebound that fails at or below this resistance area would signal that an even worse decline is yet to come.

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S&P 500 daily, close-up – major resistance awaits between 1,970 and 1,980

We could post more such charts, but this should suffice to get the drift – all the major indexes are in roughly similar positions now relative to resistance. In terms of support levels, it is the low of October 2014 that is decisive.

The DJIA and the NYA have already broken below it, but the RUT (Russell 2000), SPX and Nasdaq Composite haven’t. In the short term, this actually represents a slight positive divergence, but the important point is this: if the SPX breaks below this level in the next downturn as well, it will represent confirmation from a technical perspective that a significant bear market has begun.

In fact, it is actually worth to take a look at the NYA and the SPX relative to the October 2014 support level. One thing this is telling us is that the broader market continues to be far weaker than the handful of big cap stocks that has held the market up until very recently. So even though the divergence could be interpreted as short term bullish (i.e., indicative of short term rebound potential), its longer term message remains actually bearish.

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The NYA vs. the SPX – the former has undercut the October 2014 low both on an intraday and closing basis, the latter hasn’t – at least not yet

Finally we would like to add that there are very good reasons for us to doubt that the market will just go back up and things will return to “business as usual”. We have recently posted three charts of long term significance, which you can see by clicking on the following links: margin debt, mutual fund cash ratio and the retail money market funds/SPX ratio.

In combination with the fact that valuations are extremely high (in terms of both the Q ratio and the CAPE), these data are telling us that the potential for a major unwinding of the bubble is enormous. This is in spite of the fact that the market continues to receive a lot of support from fairly strong money supply growth.

With the Fed’s “QE” operations out of the picture, money supply growth currently depends on commercial banks increasing their inflationary lending further. However, private banks don’t act in a vacuum. In view of deteriorating economic data, and several extant sub-credit bubbles, which are either already bursting or in danger of doing so in the not-too-distant future, banks will likely become increasingly reluctant to extend additional credit. The credit sub-bubbles we are referring to here are corporate junk bonds (especially those of energy and commodity producers), the student loan bubble (which will be bailed out by tax payers) and the sub-prime lending bubble in car financing.

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Junk bond ETF JNK, weekly, over the past 5 years

Conclusion

Crash waves are notoriously volatile – several of the biggest one day rallies in history have occurred before and during crash waves (record one day advances happened in the DJIA either shortly before or during crashes in 1987, 2000, 2008 to name a few examples; enormous volatility was also a hallmark of the 1929 to 1932 bear market, which was host to several of what were then the largest one day and weekly rallies ever seen). This makes short term forecasting even more of a coin flip than it normally is.

However, we believe it is important not to lose sight of the forest for the trees; stock markets around the world have been in bubbles driven by extremely loose monetary policy, which ipso facto allows us to identify them as an example of artificial price distortion. Such bubbles always collapse sooner or later – unless the monetary authority decides to simply destroy the currency it issues, as has happened in Zimbabwe and is currently happening in countries like Venezuela and to a slightly lesser extent Argentina.

We don’t expect the central banks of the developed nations to follow suit, at least not yet. It seems more likely that central banks like the Fed, ECB, BoJ and BoE could end up destroying their currencies by mistake rather than by design – simply by dint of eventually underestimating the long term effects of their money printing. However, we are still far from that point.

At the moment, central bank bureaucracies are still very much focused on self-preservation, as the example of the SNB recently showed. After pumping up the Swiss money supply in unprecedented fashion to defend the peg to the euro, the SNB relented and discontinued the exchange rate floor overnight – and we believe it did so because it wanted to ensure its own survival.

As long as this self-preservation instinct drives the actions of the central planners, we should expect them not to go totally overboard with the printing press. However, there is still plenty of room for more intervention on their part, and we will definitely see this if the market downturn should worsen significantly. Our main point is though that one cannot rely on their willingness to attempt to prevent a stock market downturn at all costs priorto a major decline. Moreover, we believe that when this attempt is eventually made, it could very easily fail.

Charts by: StockCharts, SentimenTrader