Before I publish my market outlook for 2018 in the days ahead I thought it might be useful to recap some lessons learned from 2017. While I want to focus on technical considerations some larger market context first is equally important.
The biggest mistake bears always make, myself included, is underestimate the sheer recklessness of bulls. They keep raising the bar higher and higher, get everyone positioned long and when the construct ultimately fails they beg for bailouts and artificial liquidity comes in to save an industry that is 100% reliant on convincing retail to put money into the system. This may seem a harsh assessment, but this has been the script for the last 30 years as we’ve transitioned from one market bubble to the next.
Bubbles are notorious for getting people sucked into believing things that are absolutely unrealistic. Multiples get expanded to high heaven on projections that never pan out. Every. single. time.
In this context it’s actually quite easy to be a bull. Keep raising targets, always be optimistic, and when something breaks shrug your shoulders and say: Hey what are you gonna do? Stuff happens, but the Fed will bail us out. And the cycle begins anew.
It’s a dangerous game for investors as Wall Street will look right for years and complacency breeds more complacency as bearish voices are ignored as they look wrong precisely at the time when they are the most right.
Take 1999. Bears were completely wrong, but also entirely correct. The bubble run-up was pure fantasy, but it kept going and going until the rug got pulled:
Similarly in 2007 nobody gave you warnings, and Wall Street kept pushing price targets higher for 2008:
And people got hurt big time every time.
The then predictable response: We need bailouts, must get rid of mark to market and the Fed obliged with QE 1, 2, 3 and global central banks joined the foray. And this has been the running game for over 8 years now:
The result: The combination of unprecedented global central bank intervention, record passive ETF inflows, the promise and delivery of tax cuts combined with the loosest financial conditions in decades has created a one way price stairway to heaven and propelled this bubble higher while killing off all volatility as sellers completely disappeared from markets:
Let me be clear: This is not normal. Nor is it desirable. Corrections are a healthy & normal functioning part of markets. No corrections at all is not on either count and eventually invites systemic risk.
What would charts like these look like without $20 trillion in central bank intervention, negative/low rates and a global debt construct that has expanded beyond $217 trillion? Nobody knows, but I’ll be so bold and say organically derived prices would be much, much lower.
Artificial liquidity, short for active market management by central banks, has towered over the price discovery process and US tax cuts offering free money to already cash rich corporations has dominated market mechanics the entire year.
Ultimately this will cause massive pain as the underlying economy is not keeping pace with the multiple expansion. After all 2017 represented a continued expansion in wealth inequality, debt, leverage, government spending and further allocation of capital to the few. Nothing, and I mean nothing, has been done to address structural challenges facing the global economy. But this is left for another discussion. Suffice to say there are massive concerns evident in key macro charts and readers are welcome to view them here:
While price expansion looks wonderful for passive investors it is nevertheless a short term illusion brought about by a lack of selling and fully long allocations:
Bulls will aim to justify higher prices with positive growth & earnings data.
I call bullshit. Here is US total market capitalization relative to GDP:
I trust you see the issue: The base economy is not keeping up with the multiple expansion. Indeed household financial asset values are now 4x+ the underlying GDP level. 12% above the 2000 and 2007 peaks, and this was at the end of Q2:
People no longer even care about valuations or risk. It’s just an abstract to them. And that’s the illusion.
And this is the equation bears always miss and get astonished by: The amount of people succumbing to complacency, gullibility and sheer greed. FOMO (fear of missing out).
2017 has been a particular difficult year to keep an intellectual honest thread going while engaging with these markets looking for reasonable setups in an unreasonable market environment. It’s been frankly a challenging exercise to partake in. We see hedge funds closing left and right as anyone trying to use active judgement in these markets gets ground up as passive participation has completely taken over:
Some of the comments from these fund managers throwing in the towel: “Hall, 67, blamed the “frustrating” dominance of algorithmic traders. Mindich, 50, blamed industry headwinds, a difficult market environment and disappointing results from the previous year. “There’s a long list of why some managers just prefer not to operate in the current environment,” said Brett Turenchalk, an associate in client analytics at Novus Partners. “It goes on and on with low volatility, crowding and too much competition.”
Note these comments are coming as US market capitalization is exceeding 143% of GDP. What happened the last time we reached similar capitalization levels? Here from March 2000:
“Julian Robertson, once regarded as one of Wall Street’s highest rollers, announced plans to liquidate all six of his Tiger Management funds Thursday. “As you have heard me say on many occasions, the key to Tiger’s success over the years has been a steady commitment to buying the best stocks and shorting the worst,” he wrote. “In a rational environment, this strategy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much.“
History does not repeat, but it rhymes.
However in this case markets have been subject to unprecedented volatility compression. Never has a year or quarter closed lower:
My original expectation for 2017 was for volatility expansion following a climactic upside risk event. Early in 2017 our upside risk for the year had been technically capped to 2450-2500 on $SPX followed by a correction. While we did get a technical reaction off of the 2490 zone for a move toward the 100MA any expectations for a larger corrective action did not pan out as the expectation and delivery of tax cuts proved too much of an incentive to not sell stocks. Indeed if anyone had been so bold as to expect even a 3% pullback they would’ve looked the fool as any corrective activity has been removed from markets. Markets literally fell asleep with a continuous bias to drift higher.
As it stands it’s been around 80 days now there hasn’t been an either 1% up or down move on the $SPX. 5% pullbacks don’t exist any longer either:
What was critical for active participants was to recognize that market conditions were changing and to identify what was relevant and what was not.
I’ve discussed some of this previously here:
But I want to walk you through some public charts I posted that highlight our own evolution in recognizing and dealing with a changing market environment in 2017 as it also lays the groundwork for what we want to do and share in 2018 (I’ll discuss in a future post).
The first key was to recognize that markets were well confined in a downward sloping volatility trend. I pointed this $VIX chart out back in March:
This $VIX chart proved to be consequential for the entire year. While the $VIX itself is the output of a mathematical formula the chart proved an incredible timing device in context of a market that was not correcting.
Consider this sequence in $VIX charts I posted:
And again the trend line tag proved to be the end of the line for volatility:
Time and time again the interplay between daily RSI overbought reading and trend line tag proved to be a viable tradable signal. And while the $VIX also gave us signals when a volatility spike was coming:
….it also told us when to pack up the short bags & play long:
Here’s what that day looked like at the end of the day:
Here’s why this is important:
The total move from October 23 to October 25 was a pitiful 1.4% pullback. 1.4%. And yet it produced intra-day $VIX RSI readings in excess of 71%. 1.4% is not a correction, it’s not even a real pullback. But the $VIX told you the move was over. The volatility compression program that ran all year prevented any further selling.
Now you can either argue with that chart or you can react to it.
Yes I can argue that in any historical setting such a $VIX RSI reading would be in context of a 3-5% pullback or even more, but 2017 was different and one had to adjust.
Indeed if anyone was waiting for a standard buy signal or oversold reading you were waiting in vain.
Here’s a 2 year $SPX daily chart with RSI readings and note the complete cessation of any daily oversold readings (i.e. 30 level) in 2017. Not a one. The last one occurred during the US election in November 2016:
As you can see on both charts the lack of any oversold readings only became exacerbated following the August 100MA tag I mentioned previously. The typically most volatile months of the year became the least volatile months.
What we noted early on was that the daily oversold readings were no longer relevant, but rather 2 hour charts gave us the oversold readings:
RSI readings below 30 on the 2 hour chart were your signal to cover shorts and/or to go long, no matter how little the corrective move. That is up until August. Then markets transitioned from a 2 hour chart to a 15 minute chart.
Here’s the December view as an example:
Yes, 5-8 handle pullbacks turned into oversold readings as sellers were completely absent with anticipated tax cuts eliminating natural sellers from the market equation.
I repeat: None of this is normal. Indeed for many days in 2017 participants could only watch paint dry as a lot of the “price discovery” occurred only via overnight gap ups with virtual no movement in between. Example:
The biggest danger I see is that these new realities invite traders/particpants to develop really bad habits that they will end up paying dearly for when the environment changes. But still all this action has actually been proven to be technical over and over again.
Examples of other technical tools continuing to prove useful are fib levels and trend lines.
Here’s the $RUT using fib levels in context of overbought $VIX RSI levels and oversold $NYMO levels:
But fibs work on the short side as well:
Trend lines have continued to show superb relevance on key index charts. Here’s the $NDX as a prime example again in context of ever further volatility compression :
While volatility compression has taken control of US indices traders have sought to find volatility elsewhere in crypto in particular.
For our members Mella has introduced her technical SetUp Stream a few months ago covering a range of different asset classes and the impressive track record she has demonstrated there yields an important lesson to me, to her, and all of us: Despite this volatility compression technicals continue to work in broader asset classes and our job is to identify these set-ups where we see them. I’ll share much more on these in the days ahead as I see it as a critical opportunity for active participants.
Mella especially is doing a fantastic job finding these set-ups. I recently posted one of her SetUps pertaining to bitcoin as it was technically just too gorgeous not to share:
To not only put a technical target of 10,700 out at with price above 17,000, but to see it then reach this target precisely within hours and then bounce over $3,600 off of that target shows some serious technical charting voodoo.
Mella has come back to twitter. She hasn’t tweeted yet, but you can follow her here: