The Rally - ends here?

US equities have peaked,

… but before I pronounce the rally dead – and hail the start to a significant bearish phase, we ought to check how global equity indices have performed in the last 6 months and see if the price structures point to where the markets are headed next. 

 Santa Rally still to come?

I want to pour a little water on the torches of the “Santa-rally-comes-early” torch bearers. Here is a cockeyed comment I had in my inbox this morning: “Should we worry whether the Santa Rally is on for 2015 or not?” it asks. And then goes on to insist that “the short term considerations don’t matter for the long-term investor and his investment goals.” HELLO, this is “My-Diesel-is-Clean” talk and we know what happened to those talkers next.

The above chart tells us that Santa’s returns vary greatly depending on the actual period t (t= year end. t+1 then is 1 day to year end, t+2 means 2 days to year end, etc.), and the number of years. The fact that the period after 1990 has more instances of negative returns (with losses that surpass percentage gains) should not go unnoticed!

Strictly speaking, the Santa rally lasts 5 trading days before New Year and ends early in January. If we consider that in S&P 500 terms, the average return for this short period, according to the almanac investor, was 1.5% since the 1950s, then ignoring it would be really silly. The ratio of positive-return-delivering December months and negative Decembers is overwhelming, too.

So why would Santa not deliver this year?

Two mundane aspects could disturb the sentiment: One, escalating geopolitical tensions in the Middle East, exacerbated by the acute refugee crisis engulfing Europe and two, the FED’s idea of raising interest rates while Europe and Japan are feasting on more quantitative easing.

Considering stock market cycle and technical analysis, the picture presents more reasons to worry.

Markets Deteriorate in 2nd half of 2015

The big wakeup call this year came in August when the US markets saw the biggest one day losses since 2008, with the S&P 500, for example, losing >11% in 6 trading days. That figure is partially misleading: it does not take account that over the same corrective period the USD lost an additional 6% versus other currencies!

In my blog post from 18 October I predicted the lowpoint to the day – and 100% recovery for major indices, - though I asked you not to hold me to the 100% suggesting that some indices might not get that far. The following table confirm my turning points in August - and in October. It also shows you when the overall correction (not just the most nerve-wracking few days in August) really started, who the biggest losers are and – the likely market direction going forward.

The DOW JONES TRANSPORT AVERAGES INDEX

The correction began as early as December 2014. The first index to experience selling pressure was the DJTA, which contains all the transport companies. Considering that these are companies, which should have benefitted from a low oil price, the deterioration of values MUST have come as a surprise. But not once was it mentioned by the talking heads, despite the fact that the DJTA is considered a LEADING indicator for the global economy. Something is amiss. The DJTA correction lasted almost 9 months, yet recovered more than 90% of its losses in just 2 ½ months.

The second, more pronounced selling wave started mid-April (a new moon!), followed by more pressure half a moon phase later (full moon) at the end of April. This time, the equities in Canada, Europe, Australia and Hong Kong started correcting.

The start to the third wave coincided with the new moon in June, and affected the Shanghai Stock Exchange, and the Russell 2000 (US small caps).

Despite the change in sentiment elsewhere, the US indices kept climbing ever higher with a final peak on July 20^th. The last phase of the correction set off on July 20, and accelerated early August when the largest one-day losses occurred. This time all major US indices, the TecDAX – and Japan’s NIKKEI 225 were affected. The period to the bottom was shortest for the final phase candidates, lasting just 35/36 days. The recovery took 70 days, twice the time it took to go from peak to trough. Only the indices of this last phase retraced 100% of the losses incurred since the start of the correction.

Japan extended the correction to 69 days, just about double the time. Yet, it took only half the time to retrace 92% of the correction, generating a completely inverse time ratio to the US indices.

MORE TIME TO CORRECT AND SHORTER TIME TO BOUNCE BACK IS OFTEN INDICATIVE OF THE CORRECTION PREPARING FOR ANOTHER LEG DOWN, ONCE THE UPWARD MOVE IS COMPLETE.

I mention this now, because all other indices on the table (below the TecDAX, yellow cells) display the same inverse time ratio correlation as Japan. I guess Santa is going to have a tough time to please you this year.

Time Ratios

The table further provides insight into typical time ratios, which tend to point to a short-term ending pattern, followed by change in direction. As most markets have been trending upward since mid-October the time ratios now suggest that we are very near a top.  The only real exceptions could be Japan, China Mainland equity (NOT Hong Kong), and - maybe - a few country indices in Europe.

These are ratios that appear in most of the indices: 1 : 2, 1.86 : 1, 2.8 : 1, and 3.7 : 1. These are established Fibonacci ratios, technical analysts watch out for. The number of days in each of the moves also reveal close Fibonacci relationships.

Another relationship I find revealing is seen in the recovery percentages. At the end of this correction they look very similar for indices across the globe, - even leaving aside the distortion by currency swings. The only notable exception is the Shanghai Stock Exchange (SSE).  So, when some ignoramuses insist that financial markets are random and accidental in their movement, I marvel at the number of unused capacities in their brain cells.

A closer analysis suggests that “soon” a change of fortunes is coming: Based on the table above, at least 10 markets are almost 100% correlated and set to return to the downward trend. 6 of them showing signs that they may buckle the trend.

In the next chart, left, I simply want to show how, one by one, indices around the world succumbed to selling pressure but then rally in sync in October to reach a climax almost at the same time, during first days of November.  

So much correlation usually shows up when the market is building up to a big move. And I am not talking about a bullish rally!

There are two indices that don't quite fit in so well: 

1. the BSE SENSEX of India: Its downward trend is in full force and should take the index much lower in the coming months. 
2. The Shanghai Index experienced the largest drawdown, though the path to the peak with a return of >150% was extraordinary by any standards. In contrast, the recovery has been abysmal so far. Many blamed the Chinese stock market for the losses in August. It DID NOT START the correction as the chart clearly shows but it added momentum. The index will continue to be susceptible to US monies leaving Asia, i.e. Chinese stocks will suffer more volatility near term but the index should not move below the low points in September. 

FED Decision for Rate Hike: Parameters Turn Up

With US employment figures unexpectedly strong, the decision to raise interest rates in December looms large on investors’ minds. Already the USD has moved sharply higher against all major currencies. The chart on the left shows the USD movements since April this year, and the arrows indicate where I believe how the currency will move till the end of 2015. 

Bond yields, too, have gone up. This could be the signal for US investors to pull out of their overseas investment, especially in Asia and Europe and repatriate it to the US. That would almost certainly kill the bullish sentiment for most global equity and high yield bond markets. Quite what will happen to the bond markets is an open question. The safety aspect of treasuries and investment grade bonds is important to a large majority of investors, especially institutional investors. And if bond prices do go down they usually wait patiently for the rebound and collect the yield in the meantime.

But the selling is not just noticeable "overseas", it is also happening in the US as the DJTA and the Russell 2000 remain firmly on the downtrend. 

This coming week will probably start off the volatility, more to come later this month and December looks - well – slippery as of now. I hope you stay safe. 

The next blog post:
What exactly is safe? What's happening to Gold? How did fund managers fared in this divergent market environment? All about that in next week's blog.