Unexpectedly Intriguing!
August 11, 2014
Stock Market Chaos

We didn't set out to solve a mystery, but once again, it appears that we have.

Specifically, we've solved the mystery of what accounts for the recent weakness of the stock market. Better still, we're able to dispose of a competing "theory" that really invokes the animal spirits of financial paganism and the mystic belief system of at least one financial industry sacrificial goat entrail reader/"technical analyst". CNBC explains:

Multiple theories have been put forward for the recent stock market weakness, none of them particularly satisfying.

The notion, then, that a lot of the current upset could be traced back to a so-called Death Cross a few months ago in the 10-year Treasury yield seems as plausible as any.

According to an analysis earlier in the week from Abigail Doolittle at Peak Theories Research, the benchmark note's 50-day moving average "crossed" below its 200-day trend, a move that technical analysts believe represents a substantial turn in sentiment that will lead to further market weakness.

In the case of the 10-year yield, the move actually is bullish for bonds and, as is often the case with the relationship between the two asset classes, negative for stocks and the S&P 500 index in particular.

"After the highly bearish trading action of late July, this is worth considering with the 'what's next' question front and center for most investors. There's little doubt that the slicing of the S&P's six-month uptrend was vicious, but it may be less clear what it will mean going forward," Doolittle wrote in a note clients Tuesday. "This is where the 10-year yield's Death Cross enters the equation as a handy tool—'tell'—on what may be ahead for the S&P."

When laughing hysterically, it often helps to take a short time out to catch your breath before continuing on with the thing that provoked your laughter. You'll want to pause now, because the carefully selected and limited number of spooky coincidences are discussed next....

In four previous instances since 2007, the cross has been harbinger of bad things to come. Successive instances in September 2007 and November 2009 preceded a 58 percent drop in the market; in the spring of 2010 the cross helped foretell a 17 percent drop, and a move in late spring of 2011 came ahead of a 20 percent fall, according to Doolittle's analysis.

We should probably mention Doug Short's bottom line on the value of the "Death Cross" as an indicator of the future: "I find this "ultimate" variant of the 50-200 day moving average -- nominal or real -- to be a strange curiosity and (at the risk of being tediously repetitious) completely worthless as an indicator for the market or the economy."

We point Doug's essential insight out now because it doesn't appear that 2014 has been following the Death Cross script.

So far in 2014, though, the results have been different. Since a cross in April, the market's been on an upward trajectory, with the S&P 500 gaining about 4 percent. However, stocks have been sputtering lately, with the index falling about 3.3 percent over the past month. Wall Street analysts have blamed the market ills on turbulence in Europe and the Middle East as well as concerns over a possible sooner-than-expected rise in interest rates.

Doolittle believes the S&P and Dow industrials have moved on "what charts out as 'noise' (as) some investors have been moving toward safe haven assets and probably for a reason."

Wow! Who would ever have thunk that investors do things for reasons? Unfortunately, while a good detective or analyst might evaluate the means, motives and opportunities of such investors in making their investment decisions before explaining the actions of the market, in the world of technical analysis, having that kind of information before offering any analysis is frowned upon.

"Today there are many reasons why some investors have been moving toward safe haven bonds but from the perspective of the charts, it doesn't matter what the 'what' turns out to be," she said. "It is more important to take notice of this shift on the risk continuum toward safety with the move away from risk likely to come just as it did in 2008 and in the summers of 2010 and 2011."

As is thinking before acting where the role of investors are concerned. All that matters is that certain doom lies ahead and that action must be taken now!

The end result, Doolittle estimates, is a "formal and possibly severe correction" for the S&P, indicating a drop of at least 10 percent, that will mean "the Fed bubble is likely to burst." The latter statement refers to the Federal Reserve's liquidity programs that have helped levitate stock prices about 190 percent from their March 2009 lows.

We have to admit that we've enjoyed engaging in a bit of satire that makes fun of this kind of doomsday prognostication from time to time. But then, we have the actual chops to anticipate where stock prices are likely to go next, which is why we're such detractors of these kinds of "technical omens". What's our secret?

To be sure, technical omens have many detractors who believe that it is fundamentals—profits, the economy and monetary and fiscal policy—that ultimately drive stock prices.

Reality. What a crazy concept! The trick though is to carefully work out the relationships that exist between the things that drive stock prices and stock prices, which is ultimately why technical analysis fails so badly - its practicioners are not aware of any such relationships.

But working out those fundamental relationships to make sound investment decisions is not the business that much of Wall Street is really in, otherwise so many firms wouldn't be involved in so many hyped efforts to provoke investors to make so many commission-loaded transactions.

Which is, of course, the motive for why the crackpot theories associated with technical analysis don't just refuse to die, but instead become part of Wall Street's marketing pitch.

But the Death Cross theory is getting some attention.

Jeffrey Saut at Raymond James believes there could be something to the indicator and on Wednesday specifically cited Doolittle's work as what triggered his interest. Saut, the firm's chief market strategist and a long-term bull who nevertheless predicts a near-term 10 percent to 12 percent market drop, said a friend at the Wharton School sent him a query about the Death Cross and whether it's triggering a legitimate sell signal.

"Whether that proves the case here will play out in the days ahead, but it does foot with many of my other indicators that are counseling for caution on a near-term basis," Saut said.

Now, we said at the beginning that we had solved the mystery of why stock prices were weakening. Simply put, investors today currently expect that the growth rate of dividends (the sustainable portion of profits earned by publicly traded companies) at the specific point of time in the future to which they have focused their forward-looking attention in making their investment decisions today (the end of 2015-Q2, which is when the Federal Reserve will most likely begin hiking the short-term interest rates over which it has the most control), will be weakening.

That's it. That's all the theory it takes to understand why stock prices have been following the trajectory they have been following since mid-July 2014, and pretty much anytime before in the absence of real noise events in the market. If you don't like that trajectory, well, all you need to do is to get investors to collectively shift their forward-looking attention to another point of time in the future to get a different outcome. It's not hard - just be careful which future you pick with respect to the future that comes next.

Alternative Futures for S&P 500, 30 June 2014 through 30 September 2014, Snapshot on 2014-08-08, Rebaselined from One to Two Years Earlier

What we do is complex, but not difficult. And it's all based on fundamentals with a bit of insight on how to quantify investor expectations of the future.

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