The Pendulum is Starting to Swing Back
There are three things we must always remember at a time like this. The first
thing is that the pendulum usually swings too far when markets rise and when
they fall. Second, markets are usually influenced by what investors expect will
happen 6 to 12 months in the future. What is happening right now may not be
as important as we think.
Thirdly, markets don’t bottom when all the problems are solved, they bottom
when everyone who wants to sell has sold. If you do not understand this, you
cannot make sense of how markets function.
For example, one of the signs that everyone who wants to sell has sold is when
there is a key reversal day. This is when stocks drop sharply in a day and then rise
just as violently later in the day to close higher than the day before. US and
Canadian stock market averages had a key reversal day on October 13th, as stated
in the opening paragraph of the October 13, 2022 Investment Update. The title of
the October 6, 2022 Investment Update was, “A Surprise Can Happen At Any
Moment.” An event like the key reversal day on October 13th was unexpected for
many, but not for you. This is what Edward Moya, a Senior Market Strategist at
OANDA and former Chief Currency Strategist at Trading Advantage, had to say
after the wild swing to the downside followed by a big gain on October 13th.
“It was a massive rally, and one that came out of nowhere. And it’s left market
observers like yours truly wondering what the heck just happened. There wasn’t
any new data, no headline-making speeches, no event that occurred just after the
open to spur such a move. It literally came out of nowhere – and left us grasping
for possible reasons. Today’s market reversal was a head-scratcher.”
This is proof that there are smart, educated, experienced market experts that
just do not comprehend how markets actually function. This did not come out of
nowhere and there is a very simple reason why it happened. It was not a headscratcher
at all. It was a classic sign that the selling had been exhausted, which
human behaviour has created over and over again at major market bottoms.
However, if daily current events are all you rely on to determine what is
happening in the markets, it does not make sense.
From what I have observed, it often seems like everyone else is doing what
everyone else is doing without thinking about what everyone else is doing. This is
why someone like Edward Moya does not even seem to be aware of how common
and significant key reversal days are at a time like this. I would not be at all
surprised if we will all look back a year or two from now and realize that a new
long-term bull market actually started on October 13, 2022.
What I have learned, I have learned on my own. This often conflicted with
what I was taught and with what other experts were telling me. However, what I
learned made sense and explained what was happening so I continued to study
patterns of human behaviour in the markets. Now, decades later, behavioural
investing has become an accepted form of market analysis.
Some of my peers labelled me as a heretic in my early years, since the Chief
Strategist at Pemberton Securities despised technical analysis, which is the study
of human patterns of behaviour. (I started working for Pemberton Securities in
1982.) When Pemberton Securities was bought by Dominion Securities in 1989,
my colleagues and I discovered that DS had a Trend and Cycle Research
Department, which focused on technical analysis. That was when I was vindicated
and knew that I was on the right track. (RBC purchased 67% of Dominion
Securities in 1988 and 100% in 1996.) Make sure you follow your dreams too!
While key reversals are one day events that occur near market lows, a pattern
of two market bottoms in the same price range at least four weeks apart is also a
classic sign seen at the end of bear markets. Please see the illustration of the
typical double bottoming pattern.
The second low (or Eve low) usually flushes out all of the remaining sellers.
The year-to-date chart of the S&P 500 below shows what it looks like in reality
this year. The first low occurred on June 16th and it seems like the second low
was completed on October 12th, the day before the key reversal day on October
13th. (Chart from WSJ)
It takes time for a double bottom pattern to form. This simply charts the
mental process that some investors and portfolio managers go through at times of
great uncertainty. This process cannot be rushed. It seems like this emotional
process that flushes out all of the selling is complete. This means that conditions
are now ideal for prices to start a new uptrend.
As mentioned earlier, the pendulum typically swings too far, from too much
optimism to too much pessimism and visa versa. Levels of optimism and
pessimism can be a good guide if markets are near a high or a low, but the timing
is not usually exact. In my research, I discovered that oscillators can be one of the
best tools to better determine when trends are reversing, especially from the
downside to the upside. Remember, it is three times as hard to determine when
prices are peaking compared to trying to figure out when prices are bottoming.
Near the lows, prices are like a coiled spring that has been compressed so far
that it cannot go down anymore. At this point, the pressure for the spring to
rebound is very great. While not perfect, I have found that oscillators are one of
the best tools to show us when the worst-case scenario has already been factored
into current prices. When this happens, prices cannot go down anymore, no
matter how bad the news is. The oscillators for all of the important assets I look at
have reversed their trend since the key reversal day and the double bottom in mid-
October. Please see the oscillator for the S&P 500 below. The green arrow shows
the oscillator reversing from a downtrend to an uptrend.
The long-term oscillator for TLT (a US ETF that holds long-term US bonds) has
just turned up as well. While the FED could still raise rates at the next meeting,
bonds may have already factored in the worst-case scenario. Longer-term
mortgage rates are based on the bond market so this reversal could be significant.
The US Volatility Index (VIX) peaks around the time that prices bottom. The
oscillator for the VIX below has just peaked and turned down. The oscillator was
stretched higher than it was during the Covid sell-off in March 2020. See the
green arrow in the middle of the chart. This is a positive sign as well.
When there is uncertainty, domestic money moves into cash and foreign money
moves into the US dollar. The oscillator for the US Dollar Index (DXY) has also
peaked and turned down. (See the red arrow.) This indicates that all those who
wanted to move into the US dollar have already done so. This also suggests that
investors are becoming more comfortable with risk. Now the pendulum seems to
be swinging back the other way.
The ARK Innovation Fund is a US ETF that invests in almost 50 innovative
companies in various sectors. It peaked in February 2021 at $156 and had a low of
$34 on October 13th, a decline of 78%. In a similar way, shares of smaller
innovative companies like Ballard Power and Plug Power have also been hit
unusually hard in this bear market along with biotech and other innovative
companies. However, the oscillator for this ETF is also turning up from the fully
oversold level. This has definitely flushed out many of the stocks that were in weak
hands. Sometimes, this is when the best gains can follow. The desire by European
countries to wean themselves off of Russian oil and natural gas only increases the
momentum for the move to clean energy.
When investors think that the risk is increasing, they often gravitate towards
large companies and away from smaller companies. This is another reason why
BLDP and PLUG have sold off. However, as said before, this sell-off has been
much more vicious than normal for smaller innovative companies.
It will be a positive sign if all of these oscillators continue to move in these
current trends as investors in stocks and bonds think about what conditions might
be like 6 to 12 months from now. Markets may also be even stronger after the midterm
US elections are over, since that will remove an uncertainty. As of today, the
S&P 500 is up 11% from the lows only two weeks ago.
In summary, by having a key reversal day and forming the classic double
bottoming pattern, investors seem to have now completed the emotional process
that they need to go through in order to end a bear market and start a new bull
market. Investor sentiment has also completed the necessary process by falling to
levels of extreme pessimism. Optimism in increasing again, which is good. The
long-term oscillators for the S&P 500, US bonds, DXY, VIX and innovative US
companies have all reversed their trends as well. This indicates that the worst-case
scenario has already been factored into current prices. A falling US dollar and
Volatility Index are signs that investors are becoming more comfortable with risk
again. Therefore, most of the critical conditions that need to be in place for a long term
advance to begin are now in place. The next step is for the percentage of
stocks in an uptrend to rise above 20% for the S&P 500 and the TSX. That data is
available at the start of every month so I will be monitoring that next Tuesday.
I value your trust and confidence during these turbulent times my friend! In the
meantime, do not forget to focus on the long-term which shows that we are in the
midst of a 16 to 18-year uptrend that should enable US stock prices to triple from
these levels in the next ten years or so.
Please see a photo of a farm close to my office creating a wonderful place for
the kids to enjoy fall.
Happy Halloween! Have a great weekend!