Market Anthropology: Binary Outcome

Friday, August 12, 2011

Binary Outcome

I could very well be under the illusion of my own bias (that this is more indicative of a panicked tape and not a grizzly bear), but I consider the market’s wide and structured range over the past week as understandable. It comes as no surprise to me considering the angle and velocity that the market came in at – it was for all intents and purposes a crash. While unnerving to experience a days gains evaporate the very next morning, the market’s considerable energy from the move is simply maintaining its inertia within the tape without extending itself – or rolling over. Unlike a true dead cat bounce where the market strings several days of gains together in a sharp reflective trajectory, the market is working off the energy in place, which will likely lead to decreasing volatility, a diminishing intraday range and a bottoming process towards scaling the wall it just fell off of. I’m not saying we won’t revisit these lows one month out (very likely), but, it supports the idea of moving forward in a constructive fashion – instead of grinding on a glide-path lower, or worse. 

Like I have mentioned in my past notes, I like to search for what I perceive as extremes on the data continuum, because it washes out a bit of the noise and can yield greater perspective of where we may be in the cycle. The chart below is a weekly correlation study of the 10 year yield and the BKX banking index. The weekly correlation coefficient for these two components is at 0.97. As I have written about recently (see Here), I anticipated that the financial sector was approaching a price region of where I perceive them to be a longer term buy. 

I believe they are at this region today for investors. Traders looking for a lower low, may get an opportunity in early fall.

This is based on the charts, as well as my understanding that although these sovereign debt issues are very much a material concern to the relative stability of the global financial system, they do not present the same inherent and powerless predicaments that precipitated the magnitude of the 2008 and 2009 crash in the financial sector.

The key difference here is in 2008 the banks had very little control in raising collateral to the mortgage-backed securities that were imploding the system from within. Today, with the sovereign debt concerns, the stronger EU members such as Germany and France will eventually play the remaining, yet powerful, existential card by bellying up to the plate and restructuring the debt in a manner that will preserve the system – or at least until the next inevitable crisis arises. I believe we will start getting more details of these emergency measures after Merkel and Sarkozy meet on Tuesday of next week. 
Interestingly, the monthly BKX:SPX ratio chart is roughly at the same point from where the market bottomed in 2009.
The following series of charts are of the market environments corresponding to the hash marks on the correlation chart. I added the VIX for some contrast. 
I believe these charts illustrate the binary outcome for the market going forward from here. The financial sector either begins to participate with strength after digesting the sovereign debt concerns – or we follow them once again down the rabbit hole. My money will be on the former.