This page has been archived and commenting is disabled.

"From Self-Reinforcing Speculation To Fragile Instability"

Tyler Durden's picture




 

While the only fun-durr-mentals that matter appear to be global central bank liquidity injections (and thus the level of leverage entrusted to the JPY carry trade), the crowd is swayed by truthisms and "common knowledge" memes that recovery is here, that things are improving, that earnings are 'solid', that markets are still cheap, and that historical analogs are different this time. However, with monetary policy at a turning point, we also appear (fundamentally and technically) to be at "the inflection point from self-reinforcing speculation to fragile instability."

Earnings expectations are crumbling...

Just as they have done year after year from the totally unbiased and independent folks at your friendly local sell-side strategy shop

As companies continues to guide down en masse...

But hope remains that margins will save the day...

And the herd has hardly ever been more tightly packed (dispersion of forward-earnings estimates is near record lows)

As Forward P/Es remain on the high-side...

And worryingly, given the current level of Forward P/Es, any shift in rates is a negative for multiple-expansion...

Which suggests the only thing that can help multiples is moar confidence...

s a gentle reminder, as we have noted previously - this move in confidence is key...

But, it's all about confidence... investors will not be willing to pay increasing multiples unless they are confident that the future streams of earnings are sustainable and forecastable... And simply put, the current levels of Consumer Sentiment need to almost double for the US equity market tp approach historical multiple valuation levels...

 

Good luck with that... and while this week's "reflexive" bounce has many proclaiming the worst behind us, John Hussman has some historical analogs worth sharing that shed an uncomfortable light on how far we have come and where we go next...

...the potential for short-term gains is overwhelmed by the risk of deep cyclical and secular losses.

in the context of log-periodic bubbles – as we’ve observed in U.S. equities since 2010 (see The Diva is Already Singing) – the “critical point” or “finite time singularity” is not a crash date, but the inflection point from self-reinforcing speculation to fragile instability. Didier Sornette observed this more than a decade ago in Why Stock Markets Crash. Our best estimate of that inflection point remains about January 13. It’s also worth remembering that the “catalysts” associated with sharp market losses have often been fully recognized only after the fact, if at all. As Sornette emphasized, “The collapse is fundamentally due to the unstable position; the instantaneous cause of the crash is secondary.”

The following chart is reprinted from our November 11, 2013 weekly comment A Textbook Pre-Crash Bubble.  What is important, in my view, is not simply the log-periodic structure, but the broad array of additional classic speculative features that emerged as the market approached its recent highs.

A few months ago, Bill Hester examined a century of price data, and observed that the non-overlapping periods most closely correlated with the past 5-year trajectory of the S&P 500 were the advances preceding the 2007, 2000, 1987, 1937 and 1929 market peaks. This shouldn’t be a surprise – the past 5-years have largely resembled a diagonal line, as did the advances to those extraordinary market peaks. Diagonal lines always have a nearly perfect correlation even if there is some amount of variation along the way.

Again, we would dismiss historical analogs like this if the recent market peak did not feature the “full catastrophe” of textbook speculative features – particularly the same syndrome of extreme overvalued, overbought, overbullish, rising-yield conditions observed (prior to the past year) only at major market peaks in 2007, 2000, 1987, 1972, and 1929. The main temptation to ignore this concern is that similarly extreme conditions emerged in both February and May 2013 without consequence. Less extreme variants of this syndrome have also emerged periodically in the past few years (these variants also capture 1937 and a few other bull market peaks, as well as the April 2011 peak after which the market briefly retreated by nearly 20%). Overall, my view continues to be that the consequences of the more recent instances have not been avoided, but merely deferred – and those consequences will be worse for it.

To offer some perspective of how major peaks have typically evolved, the following charts present the Dow Jones Industrial Average in the final advances toward, and the few weeks after, what turned out in hindsight to be major stock market peaks. For reference, let’s examine the recent market peak. Notice several features:

  1. A series of moderately spaced peaks forming a broad sideways “consolidation” over several months;
  2. A breakout from that consolidation, leading to a steep and only briefly corrected speculative blowoff into the market’s peak;
  3. A steep initial selloff from the market peak, and finally;
  4. A “reflex” rally (classically on low volume – indicative of a short-squeeze with sellers backing off) that retraces much of the initial selloff.

One can observe that same general dynamic in the chart below – a series of moderately-spaced peaks forming a largely sideways consolidation, a breakout to a steep and only briefly corrected speculative “blowoff”, an initial retreat, and finally a reflex rally. This chart depicts the final advance to the 1929 market peak.

Largely the same dynamic was evident in the advance to the 1973 peak (after which the market lost half its value into late-1974): a series of moderately-spaced peaks comprising a broad consolidation, a breakout to a steep and only briefly corrected speculative blowoff and market peak, a steep initial decline, and a short-lived reflex rally after the peak.

As it happens, the sequence described here is not at all new. Instead, it follows a pattern that technical analyst George Lindsay described in 1970 (and notably before even the 1973 instance above), which he called “Three Peaks and a Domed House.” Lindsay observed this pattern repeatedly across historical market cycles, describing about half of the bull market tops in the DJIA.

My sense is that it is enormously ambitious to label 28 separate points in a technical pattern, but the central observations do appear to nicely characterize many historical instances. Lindsay called points 8-10 a “separating decline” that distinguishes the series of consolidating peaks from first vertical portion of the speculative blowoff (the “wall of the first story”). Following a choppy correction, the pattern completes with the “domed house” – which is roughly the analog of a narrow head-and-shoulders pattern: "after peaking at 25, price tumbles to 26, retraces to 27, before heading lower to 28, completing the pattern."

(chart and background h/t Claasen Research, James Goode, Thomas Bulkowski)

Though the “separating decline” after the mid-1999 consolidation was quite deep, as was the initial decline from the January 2000 peak in the Dow Industrials, the same essential features were evident then as well. The correspondence isn’t nearly as pretty as in the present instance, or those of 1973 or 1929. It’s worth keeping in mind that despite a hard initial decline, many (though not all) historical bull market peaks include an “exhaustion rally” anywhere between 2-9 months after the market peak, which can carry prices within a few percent of the high. The problem is that there is too much variability to count on either their timing or extent.

From the standpoint of investor psychology, it seems understandable that the speculative enthusiasm and short-covering that contributes to bull market tops is fueled when the market “breaks out” after a period of consolidation (and what Lindsay called a “separating decline”). The blowoffs that followed – both recently and in the examples above – were accompanied by clear overvaluation on reliable measures, and also featured clearly defined overbought conditions and lopsided bullish sentiment.

I’ll say this yet again, because it’s a crucial point – we would have zero interest in historical analogs like this if the recent market peak was not also accompanied by an extreme overvalued, overbought, overbullish, rising-yield syndrome that – prior to the past year - has emerged only at major market peaks. As with the recent log-periodic bubble, the pattern itself should be simply be treated like an interesting experiment. Lindsay’s and Sornette’s observations are largely consistent in that Lindsay’s pattern is basically a slightly irregular refinement of the very end of a Sornette bubble. The “three peaks” of Lindsay’s pattern correspond to log-periodic oscillations, and the left side of the “domed house” is essentially a final blowoff and short squeeze featuring much shallower fluctuations approaching the high.  

Without tracing through over a century of price data for every instance (including "setups" that did not follow through), we can't say categorically that this pattern is always followed by market losses. What one can say is that when Lindsay’s pattern has been accompanied by rich valuations (say, a cyclically adjusted P/E over 18), the market has typically been at the cusp of a significant retreat. Those periods of rich valuations are easily identified, and the corresponding blowoff patterns emerge in 1901-02, 1906, 1929, 1937, 1961, 1966, 1969, 1972-73, 1987, 1998, 2000, and today. The 2007 peak had less fidelity to Lindsay’s pattern because the reflex rally in October slightly exceeded the July peak of that year. Of course, lopsided bullish sentiment – as we observed in December and January – further narrows the set and worsens the average outcome, as do razor-thin risk premiums on corporate debt, soaring margin debt, and severely overbought conditions following a largely-uncorrected multi-year market advance.  It’s not any single pattern that concerns us here, but rather the entire syndrome of classic speculative features that accompanied the recent peak – in the words of Zorba the Greek, “the full catastrophe.”

In any event, our present investment outlook certainly doesn’t derive from or rely on such patterns, and are much more related to a broad ensemble of evidence that we can validate over a century of market data. As I’ve noted in numerous prior weekly comments, 1929, 1972-73, 1987, 2000, 2007, and recent market highs belong to a rather exclusive group of instances featuring a similarly extreme syndrome of overvaluation (based on normalized measures that are well-correlated with subsequent 7-10 year market returns, such as 10-year inflation-adjusted earnings, price/revenue, and market capitalization / GDP); overbought conditions (based on the extent and duration of price advances); strikingly overbullish sentiment (based on the proportion of advisory bulls versus bears over a period of weeks); and typically rising interest rates (for example, 10-year Treasury yields above their level of 6 months prior).

 

 

Market cycles often display regularities, but investors should never conclude that they follow precise rules... but QE provides a potetial catalyst to prove it's not different this time...

The primary beneficiary of QE has been equity prices, where valuations are strenuously elevated. QE essentially robs the elderly and risk-averse of income, and encourages a speculative reach for yield. Importantly, one should not equate elevated stock prices with aggregate “wealth” (as higher current prices are associated with lower future returns, but little change in long-term cash flows or final purchasing power). Rather, the effect of QE is to give investors the illusion that they are wealthier than they really are. It is certainly possible for any individual investor to realize wealth from an overvalued security by selling it, but this requires another investor to buy that overvalued security. The wealth of the seller is obtained by redistributing that wealth from the buyer. The constant hope is to encourage a trickle-down effect on spending that, in any event, is unsupported by a century of economic evidence.

 

The risks of continuing the recent policy course have accelerated far beyond the potential for benefit. The Fed is right to wind it down, and as it does so, the FOMC should focus on addressing the potential fallout from speculative losses that to a large degree are now unavoidable. Ultimately, the U.S. economy will be best served by a return to capital markets that allocate scarce savings toward productive investment rather than speculative activity. The transition to that environment will pose its own cyclical challenges, but is well worth achieving if the U.S. economy is to escape the grip of what is now more than 15 years of Fed-enabled capital misallocation.

 

- advertisements -

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Sun, 02/16/2014 - 19:51 | 4443266 lasvegaspersona
lasvegaspersona's picture

If only I didn't know that the Fed (and friends)  can control so much of the market with derivatives...I might be able to believe...

Sun, 02/16/2014 - 20:10 | 4443310 Fish Gone Bad
Fish Gone Bad's picture

The economy is like a blind man driving a car down the road.  The road falls out from under his car and he thinks it is a pothole which the FED will fix and he will continue driving down a smooth road ( http://research.stlouisfed.org/fred2/series/WSECOUT ), but the longer his wheels are off the ground the sooner he realizes he is experiencing a Wile E Coyote moment just before he plunges off the table top of life and into/onto something quite different, and far far below.

Mon, 02/17/2014 - 04:45 | 4444448 The Vineyard
The Vineyard's picture

I'm too stupid to understand the numbers.  Bitches.

Sun, 02/16/2014 - 19:51 | 4443267 Yen Cross
Yen Cross's picture

  Who draws these charts> Goon'ness gracious<

Sun, 02/16/2014 - 20:28 | 4443363 Yen Cross
Yen Cross's picture

 greenie from me.

Sun, 02/16/2014 - 19:54 | 4443273 Blame Crash
Blame Crash's picture

Don't believe everything you read or see. (ie: the above)

Mon, 02/17/2014 - 09:20 | 4444645 Element
Element's picture

And we have your werd on that?

Sun, 02/16/2014 - 19:56 | 4443279 Theta_Burn
Theta_Burn's picture

With all that sidelined money via MYra's soon to be invested directly into the stockmarket, will make today look like 1979

On and on this shit will go until the nations of the world say fuck off with your ribbon bound scrolls,

Party on Garth...

Sun, 02/16/2014 - 19:57 | 4443283 philosophers bone
philosophers bone's picture

When it inevitably blows up client money, Wall Street will point to "consensus", "don't fight the Fed", "independent analysis", "long term outlook", "patient capital" , the "smart money", and, of course "unprecedented times" and "most did not see this coming", etc. etc. to justify their collective negligence / fraud.

And amazingly they get to keep their bailed-out businesses and their individual freedom.

And the process will start all over again. Or will it?

Sun, 02/16/2014 - 20:16 | 4443327 Fish Gone Bad
Fish Gone Bad's picture

MF Global stopped being newsworthy.  I am certain no one went to jail, and no one got any money back.  That must inspire confidence in the criminal elite to do it bigger and better this time.

Sun, 02/16/2014 - 20:41 | 4443413 Amish Hacker
Sun, 02/16/2014 - 20:49 | 4443421 James
James's picture

Fish Gone Bad, creditors/investors of MF Global have got most of their money back.

The balance of 230B will be paid out in '14 per court order.

http://www.zerohedge.com/news/2013-11-18/mf-global-admits-liability-will...

edit, Amish Hacker wins by a nose

Sun, 02/16/2014 - 23:08 | 4443920 StychoKiller
StychoKiller's picture

Munny (FRNs) != MONEY, which is what was stolen from some MFGlobal customers.

Sun, 02/16/2014 - 20:51 | 4443433 philosophers bone
philosophers bone's picture

Yes: Fraud, breach of trust, breach of fiduciary duty, theft, gross negligence and willful misconduct magically become.......

A "failure to supervise".

In a potentially criminal non-securities situation like George Zimmerman or this Dunn dude in Florida, they bring it to trial. Sometimes the prosecution wins and sometimes they lose.... That is the system. But in these securities cases it is always either a "settlement agreement" involving a way lesser charge or non-criminal civil charge (often involving only the "firm" not the criminal individual) or they charge the 30 year old minion who followed the direct orders of superiors in order to keep his job.

Sun, 02/16/2014 - 19:57 | 4443285 OwnSilverPlayMusic
OwnSilverPlayMusic's picture

Nothing is okay, so it's okay.  But that statement does nothing for this feeling of impending doom deep inside of me.

“In a closed society where everybody's guilty, the only crime is getting caught. In a world of thieves, the only final sin is stupidity.” Hunter S. Thompson
Sun, 02/16/2014 - 20:04 | 4443291 ebworthen
ebworthen's picture

Lot's of retirement accounts and pension funds being led to the slaughterhouse.

Bonus chart: http://data.bls.gov/timeseries/LNS11300000

Mon, 02/17/2014 - 01:17 | 4444235 bdub2
bdub2's picture

OD'ing on chart meth resulted in speculating on Labor Force Part. Rate.

Back to 40's. Head and Shoulders pattern w/o any discernable support until 58% area. http://data.bls.gov/timeseries/LNS11300000

Granted, it's general witch craft, but it seems interesting, especially if chasing the Chart White Horse.

Sun, 02/16/2014 - 20:27 | 4443358 Yen Cross
Yen Cross's picture

  Tu much do.do.

Sun, 02/16/2014 - 20:53 | 4443435 Droel
Droel's picture

It's amazing how history tells us that we are in for a major crash, yet we still question it.

 

If the FED did not intervene, these graphs that mimick 1929 exactly would not be and we would not be approaching a crash.  Was there anyting in the past leading up to crashes that had similar effects on the markets as what the FED is doing today?

 

If there is a crash as history predicts, the FED is only to blame.

 

Alternatively, if we make it out of the recession, then the FED is genius.

Sun, 02/16/2014 - 21:32 | 4443551 Droel
Droel's picture

I must not understand what I wrote.  Why the thumbs down?  This is what ZH preaches (except for the last comment which is sarc/on, maybe that's the problem)

Sun, 02/16/2014 - 21:17 | 4443507 mt paul
mt paul's picture

hard core

chart porn ..

Sun, 02/16/2014 - 21:19 | 4443511 Australian Economist
Australian Economist's picture

On the bright side gold and silver vertical since the Asia open

Sun, 02/16/2014 - 22:25 | 4443739 Croesus
Croesus's picture

That'll be "fixed" soon enough...with all the gold authors lining-up to predict an up year, the price for paper will be taken down again (over the course of the year), which will happen immediately following the next round of bail-ins...

You heard it here first. 

Disclosure: I'm long ABP (anything but paper). Believe me, I'd love nothing more than to see some of these more outlandish Gold price predictions come true...$55K equivalent, (in 1999 purchasing power), would do me nicely, but I don't see how anything has changed, yet. 

Same people are still calling the shots, same criminal banksters are still walking around, and I don't see TPTB as being out of options, just yet. 

Mon, 02/17/2014 - 00:04 | 4444093 thtmnbhndthecrtn
thtmnbhndthecrtn's picture

jesus, I gotta remember to keep a barf-bag on hand for these chart-frenzies.

Mon, 02/17/2014 - 03:15 | 4444352 Spungo
Spungo's picture

Don't fight the fed. Let them destroy America bit by bit.

Do NOT follow this link or you will be banned from the site!