Market Anthropology: Long Term Motives

Tuesday, December 6, 2011

Long Term Motives

After reading Jeremy Grantham’s erudite quarterly missive I felt better for not having more to say this morning. There is such a tendency for traders and investors to overcomplicate the obvious. I know I certainly at times get lost in the nuances of the day to day machinations. Too much time watching the grass grow will inevitably cause you to miss the larger forces at work. Anyone that travels for business for an extended period of time will tell you they are keenly more observant of their family’s physical and emotional condition upon their return. The same is true with the markets. 

So with that said, to date the SPX closed roughly where it opened on January 3, 2011. One way of looking at things is the glass is half full. We know of the considerable headwinds that have developed across the Atlantic, yet the markets have absorbed each respective blow. Or you could simply make the observation that the market has frustrated the majority of participants and has yet to reveal its longer term motives. 

That is where a little perspective goes a long way and where Mr. Grantham typically shines. 

Lately I have been wearing a more dogmatic coat to work. Whether it was the early winter storm, the below freezing temperatures or the market’s longevity under inclement conditions, I have maintained the belief that the markets were not out of the woods. 

Mr. Grantham, I believe – would agree. 

In his latest letter, he speaks of the typical arc of a post bubble equity market contraction that breaks “way below trend line values.”

“No Market for Young Men.” Historians would notice that all major equity bubbles (like those in the U.S. in 1929 and 1965 and in Japan in 1989) broke way below trend line values and stayed there for years. Greenspan, neurotic about slight economic declines while at the same time coasting on Volcker’s good work, introduced an era of effective overstimulation of markets that resulted in 20 years of overpriced markets and abnormally high profit margins. In this, Greenspan has been aided by Bernanke, his acolyte, who has continued his dangerous policy. The first of the two great bubbles that broke on their watch did not reach trend at all in 2002, and the second, in 2009 – known by us as the first truly global bubble – took only three months to recover to trend. This pattern is unique. Now, with wounded balance sheets, perhaps the arsenal is empty and the next bust may well be like the old days. GMO has looked at the 10 biggest bubbles of the pre-2000 era and has calculated that it typically takes 14 years to recover to the old trend. An important point here is that almost no current investors have experienced this more typical 1970’s-type market setback. When one of these old fashioned but typical declines occurs, professional investors, conditioned by our more recent ephemeral bear markets, will have a permanent built-in expectation of an imminent recovery that will not come. For the record, Exhibit 1 shows what
the S&P 500 might look like from today if it followed the average flight path of the 10 burst bubbles described

Interestingly, my chart work over the past month has strongly agreed with this opinion. Namely, when you look at the longer term picture of various global equity markets – as expressed in my note from a few weeks back, Trapped

For the last 10 years the respective global equity bourses have traded in an ascending triangle/wedge formation. In essence, trading between the major market inflection points of October 2002, October 2007, March 2009, and just recently – April 2011. 

And while the last pivot is equally important as a major market inflection point, it is certainly more discrete – predominantly because it was not a new all-time high and still appears in the rear view mirror. 

At the end of April I had a brief chart (Bull-Trap) that described the yet to be fulfilled bull-trap as it was first breaching resistance. In light of the previous note on Spain, I thought it would be compelling to show the same time period with several different markets. The trap is rather evident on all of the respective charts. 

This view is also reinforced through one of my favorite ratio charts – the silver:gold ratio. As I have mentioned in the past, the silver:gold or gold:silver ratio is utilized by traders for a variety of reasons. I predominantly utilize it to depict the underlying risk appetites for traders in the market. The below chart has the actual values hidden and merely expresses the 35 week moving averages for the respective underlying assets. As evident in the chart, the weekly moving average for the SPX has rolled over for a third time since the 2000 top. When you contrast this observation with the near vertical move higher in the silver:gold ratio and see that it too has rolled over – it reinforces the notion that a major market pivot is underway. 

So what are the precious metals, specifically gold – telling us today? 

Over the past two sessions, gold and silver have moved sharply lower as the equity markets have continued their ascent higher. This is precisely the opposite dynamic that transpired in 2007 when the Fed reactively provided liquidity to the gathering credit crisis. This market is different in the sense that asset movements are much strongly correlated to one another than in 2007. This makes the past two days actions in gold and equities that much more suspect and noteworthy. 

I believe at the very least gold is flashing a warning signal to the equity markets that something is afoot and headed their way. In light of the exuberant sentiment picture in equities and the anticipated positive developments on the European front – I would not be surprised to see a sell the news reaction develop over the next several sessions. 

As always, stay frosty.