The Bigger Picture?
by Brian Pretti CFA, Contrary Investor. November 7, 2008
Quite unfortunately, we need to quickly revisit and update a monthly discussion topic from August of this year. That discussion, entitled Doscientos Mes, primarily focused on the history and importance of the 200 month moving average in looking at and trying to assess the health of the major equity indices. We will not spend a lot of time rehashing our comments, as you are free to read or reread that discussion in our Monthly Archives. To the point, recent history of the last three to four decades tells us that very often major equity bear market lows can be found at or around 200 month moving average levels. Specifically, this is exactly where the NASDAQ bottomed at the 2002 lows. The Nikkei flirted with and danced around its own 200 month MA for almost half a decade prior to plunging below its own 200 month MA, which has not acted as upside resistance for a good decade. As we stated in the August discussion, failure to find support at the 200 month MA may indeed be quite the fundamental and technical warning sign. Events of the last few months, especially October, force us to revisit this topic and perhaps expand our time horizon viewpoint just a bit in terms of watching the forward character of the major equity indices. This is one of those discussions where the charts do the bulk of the talking.
Before getting to the issues at hand, we all know October was one of the meanest months for equities really globally any of us have seen in quite some time. The purpose of this discussion is not to take one month of financial market experience and draw hard and fast conclusions. That would be a useless exercise. Rather, we simply hope to provoke thought and perspective about what lies ahead, regardless of market direction. Secondly, as it has been described by a number of market commentators, and we completely agree, we are also watching the largest macro “margin call” over a compressed period of time in the global financial markets we’re probably ever going to see in our lifetimes.
As we have been saying for close to a year now, deleveraging is the key fundamental macro construct of the moment. Deleveraging in the hedge and broader levered speculating community globally has been nothing short of stunning since late September. The magnitude of leveraged positions that still need to be liquidated ahead, the rate at which this liquidation will occur, and the time required until the conclusion of this credit cycle reconciliation process plays out are all unknowns. In periods such as the present, fundamentals take a decided back seat to the very process of asset liquidation itself. But what clearly compounds any type of accurate forward fundamental assessment of companies, economies and financial markets themselves is that this very process of liquidation indeed impacts the forward character of fundamentals themselves. So not only is the “margin call” driving current equity and other financial asset prices daily, this margin call process will clearly impact real economies globally in the months, quarters and years ahead. Just as credit cycle acceleration helped shape and determine real economic outcomes for close to three decades now, the reconciliation process that has begun will equally impact real economic outcomes ahead. The fundamentals we think we know will not be static, but rather reinforced to the downside by the deleveraging process. Although this may sound wildly simplistic, we need to remain incredibly flexible in outlook ahead.
When we wrote the article in August, it was a warning about potentially reaching the 200-month moving averages for the major equity indices. The time for warning is now behind us as you are fully aware. Every major US equity index reached and exceeded their respective 200-month moving averages to the downside in October. The following charts very simply review where we stand at October month end. But what we’ve also done this go around, and what we believe is now important in light of recent months financial market activity, is to try to broaden our thinking into a much bigger picture time frame than we have so far into this current down cycle. Why do this now? The market is forcing us to do so. Have a look and we’ll have comments below.
Certainly the 200-month MA levels relative to current prices are clear in the graphs above. For a while now on our subscriber site, we have been charting the equity markets and watching the prior equity bull market Fibonacci retracement levels quite closely. All in the spirit of risk control. In light of recent equity market events, it's sure starting to appear to us that we may indeed have the time period frame of reference incorrect. Potential generational events in the real economy should have more of a generational perspective as we look at the very financial markets that should mirror that economy, no? What prompts us to have a bit longer term view of life are actual equity market levels seen in mid-October, especially as this applies to the relatively broad S&P 500. The charts above of the S&P, Dow, NASDAQ and Wilshire date from 1980 to the present. What we are chronicling in these charts are the 50% and 61.8% Fibonacci retracement levels over that entire period. As you'll see in the first chart, the low hit by the S&P on Friday October 10 shortly after the open, which touched down at a level of 839.8, was all of three tenth's of one percent away from the 50% retracement level of the entire 1980 to present period. Yes, as of the open on October 10, the S&P had essentially given up half of its entire 28 and three quarter year gain. Relatively dramatic when characterized as such. Now you know why we need to change time horizon vantage points. We’re simply trying to listen to the market’s message.
Quickly, as a bit of an adjunct to the very long cycle Fibbonacci retracement sequences we’ve drawn into the charts above, we also want to highlight the well known Dow Theory 50% principle. We’ve been ranting and raving over the 50% principle of Dow Theory in many a discussion over the summer. But the 50% retracement levels for the major equity indices observed over the 2003-2007 bull market were cut through like a hot knife through butter over the last month. We suggested to subscribers that should 50% bull market retracement levels of the 2003-2007 bull be violated, there would be trouble. The 2003-2007 Fib retracement levels provided almost zero technical support. Although we may sound reactionary based on recent month events, we believe we need to incorporate longer cycle thinking and analysis into the equation as we move ahead. So as we review the charts above, those 50% Fib retracement levels from 1980 lows to present now become critical, in addition to watching the 200 month moving averages.
One last point to notice in the charts above are the 14 period monthly RSI levels detailed for each index. And guess what, we've never seen such low levels anywhere since 1980. Academically, big time oversold on all of the major equity indices? You bet. In a relatively rational world (whatever that means) this would tell us at least some type of bottom is nearby. But there is one other long-standing market dictum that also needs to be respected right now. And that is very oversold markets that fail to rally can indeed be large warning signs in and of themselves. A warning not only for the forward trajectory of the financial markets themselves, but for the real economies whose trajectories these financial markets anticipate. Again, "market driven" answers to our observations lie dead ahead. Lastly, please note that when market prices were last seen near these incredibly low monthly RSI levels for the S&P, Dow and NASDAQ, the indices again retested their price lows after subsequent rally periods. These retests were characterized by price landings slightly above the prior lows accompanied by higher highs in the monthly RSI readings. Classic technical divergences. This tells us that perhaps the cautious money waits for retests and broader technical indicator divergences on those retests before committing to market exposure. As always, risk acceptance and commitment is in the eye of the individual market participant.
So, as we stand here today and try to make sense of what we are seeing, a few issues come to mind. First, and quite simplistically, the NASDAQ is certainly in the worst technical shape of any of the major equity indices from a long cycle perspective. We believe the 200-month MA of the NASDAQ is the key for now. Yes or no, has the 200 month MA for the NASDAQ now become important upside resistance? It’s the first “step” we are watching as we review the ongoing motion of the NASDAQ ahead. For the Dow, S&P and the Wilshire, the 50% and 61.8% 1980 to present Fib retracement levels now take on meaningful importance in terms of watching for support necessarily in conjunction with the respective 200-month MA levels. For now it's a bit of a mixed bag. The SPX closed the month slightly below its 200-month MA while the Wilshire closed slightly above. The Dow is really the only major equity index to close well above both its 200-month MA and long cycle Fib support levels.
Two last charts of interest and we’ll call it a day. We need to simply remember that downside violations of 200 month moving averages are quite the rare beasts. As we suggested when we last covered this topic, the only times we’ve seen occurrences where this has happened have been accompanied by periods of very meaningful fundamental economic challenge. As you can see below, we’re there again. So, either the forced liquidation and deleveraging of the moment is anomalistic enough that it is not allowing the financial markets to more properly discount forward economic reality to come in current prices, or this very deleveraging process itself will further contribute to negative real world economic outcomes ahead and the markets are suggesting as much. This is one big reason why we are a bit obsessed about trying to get the proper technical time horizon correct when looking at levels of potential support and resistance.
Finally, and this is not a happy thought at all, the experience of the Nikkei from 1990 to present tells us that in equity bear markets of secular importance, 200 month moving averages act as very important upside resistance barriers. This is probably the biggest reason we felt it important to revisit this topic again.
Although we’re really talking to ourselves more than not, it’s a time to remain calm, unemotional, flexible and focused on bigger picture messages of the financial markets. Daily volatility has been quite extreme as of late. Markets are reacting violently to sound bites and make it up as we go along monetary and fiscal policy really globally. The credit markets are a massive key as to ultimate financial market reconciliation and real world economic outcomes. We necessarily need to monitor credit market character closely. Uncertainty and fear abound. We simply hope that staying focused on the proper longer-term time frames can help not only necessary ongoing risk management activities, but also help keep emotionalism at bay in decision making to the greatest extent possible. All part of trying to keep our heads together in the bigger picture.
© 2008 Brian Pretti