Friday, September 05, 2008

Making Sense of the Current Market Weakness

I'm going to postpone my first "Introduction to Trading" post to offer a bit of perspective on the current market weakness. The indicator reviews of late have indicated a stalling out of the market bounce since mid-July, with negative dollar flows into stocks and more evidence of sector rotation than actual sector trending. With Monday's reversal, we've seen a steady selling sentiment hit the stock market, taking us to multi-week price lows. Here are a few thoughts on the market action:

* Fear Goes Up - I mentioned a little while ago that the VIX had broken to the upside and that readership of this blog, which seems to swell during periods of market weakness, was more consistent with levels we see at market tops than bottoms. Well, on Thursday, the number of visits to the blog swelled by 40%. An hourly view of readership indicated that visits to the blog expanded precisely at the time the major indexes were breaking below their multi-day support levels. This doesn't necessarily mean we're at a bottom, but the jump in the VIX to 24 and the expansion of interest in psychology themes suggest that one element associated with bottoming processes has now entered the picture. Institutional fear has been on the rise as well, with credit-default swaps on the rise. That means that it costs more to protect corporate bonds from default: a useful indicator of fears regarding economic weakness. We've yet to see equity put option volume exceed equity call option volume on a multi-day basis; that's been one sentiment indication that has been present at recent intermediate-term bottoms. Nor is the percentage of stocks trading above their 20-day moving averages at levels normally seen at bottoms. Fear is up, but several indicators suggest we could have more to go.

* This is a Global Affair - The striking feature of the recent weakness is that it is associated with a strong U.S. dollar (the dollar index is up about 10% from its July low) and weak commodities (the CRB Index has fallen roughly 20% from its highs. Emerging market stocks are leading the downside, with EEM down by roughly a third since May and now hitting new lows. Global weakness is the theme: that is weighing on commodity prices, and it is making the U.S. dollar a relative safe haven. If I had to opine, I'd say that the market is voting that the countries that have been fighting inflation by maintaining high interest rates have gotten it wrong. As a result, they will be looking at recessions more severe than they would have been otherwise. According to Bloomberg, global markets have lost $17 trillion since the market top in 2007, with global financial companies down 29%. Incredibly, China's Shanghai A index has fallen from over 6000 late last year to about 2300 at present. Russia's RTS Index is down about 40% just since May. This is not just about the U.S.; in relative terms, the U.S. is outperforming many global equity markets.

* Keep An Eye on Participation to the Downside - We're seeing new lows among energy, utility, and materials shares. The broad NYSE Index has moved to new price lows for the year, as has the NASDAQ 100 Index, but the advance-decline lines specific to common stocks in those indexes has not yet made new lows. We had 417 new 20-day highs among NYSE, NASDAQ, and ASE stocks on Thursday, against 1863 lows--a clear widening of weakness. Demand, my index of the number of stocks closing above their volatility envelopes, was 17; Supply was 187: a very skewed reading. Still, among NYSE common stocks, we only had 10 52-week highs and 99 lows. Compare that with about 450 new lows in mid-July and 700 new lows in January. A number of sectors, such as Consumer Discretionary and even many of the Financial shares, remain well above their July lows. It is not at all clear to me that this will be a fresh bear market leg down. I'm open to the idea that this may be an ultimately successful test of the July lows and part of a larger--and quite significant--bottoming process. Participation to the downside will tell the story.