CHART 30.3 Gold, 1970–1999
Chart 30.4 shows bond yields and commodity prices. When yields are rising and it appears this trend will never end, an alternative scenario is to use the knowledge that peaks in yields are often preceded by peaks in commodity prices, which in turn precedes a slow-down in economic activity. This is shown in the chart by the rightward sloping arrows. Thus, if it’s possible to spot a top in industrial commodity prices, the alternative scenario of weaker business activity may well come to pass.
CHART 30.4 Commodities and Bond Yields, 1970–1998
3. Figure Out When the Crowd Reaches an Extreme
When the crowd reaches an extreme the question is not usually whether, but when and by how much. In other words, when the crowd truly reaches an extreme, it is a forgone conclusion that the trend will continue. It is not even questioned by the crowd, only the timing and amount are in doubt. Such times are often associated with analysts making extreme forecasts that in the highly charged emotional atmosphere appear credible but that would previously have been greeted with mirth or great doubt.
Sentiment Indicators Sentiment indicators, or long-term oscillators reaching an extreme, also represent one possibility for gauging that the crowd has reached an extreme.
The Media Sentiment indicators are not available for every market, so another useful exercise comes from a study of the popular and financial media. Most of the time, they are silent on financial markets or individual stocks, but when significant coverage appears, that is the time to pay attention. Major peaks and troughs are often signaled by cover stories in the popular and financial press. Time, Newsweek, Businessweek, and The Economist magazine are my particular favorites. Since many of these publications are going out of print due to technological developments, we will probably have to refer to their digital editions for such information. The more of them that give space to a particular market, the stronger the signal. It’s not that the editors and writers of these magazines are idiots for publishing bear stories right at the low or bullish ones close to the absolute high. It lies more in the fact that they are journalists keeping the pulse of market conditions. As good journalists, it is their duty to give more space to articles when the emotions in and around the floors of the exchanges come close to reaching a crescendo. Generally speaking, cover stories are a fairly reliable indication of an impending turn, but they are not infallible, and often lead turning points by a week or so. As with any form of analysis, it’s important to use a good dose of common sense. For example, there is the famous “Birth of the Bull” cover story in Time magazine several weeks from the 1982 market bottom (Chart 30.5). Just applying “contrary opinion” blindly would have led to the conclusion that the bull market was over in the course of a few weeks. However, it is important to remember that it takes time for crowds to reach an extreme, as the long-term trend of rising prices adds more and more careless bulls to the fold. Also, bear markets are usually preceded by rising interest rates. In the fall of 1982 the Fed was following an easy money policy, not a tight one.
The exact opposite was true in 1990 (see Chart 30.5) when a Businessweek cover featured the troubled brokerage industry. In this instance, the prices of brokerage stocks had fallen sharply, but the Fed was engaged in an easy money policy, which is good for the equity market and certainly good for brokers, who get more underwriting fees and commissions in a bull market. In addition, the hard times they had just gone through would have resulted in substantially lowering their break-even points. Increased revenue from the bull market would then go straight to the bottom line.
CHART 30.5 S&P Composite, 1970–1999, and the Discount Rate
One of the problems of cover stories is that the advent of electronic media is gradually sapping the life of their print brethren. Newsweek, which I referred to earlier, no longer has a print version. One substitute is to use Google Trends, where a graph similar to that shown in Chart 30.6a is displayed for a specific search. In this case, it was “gas prices.” The various letters on the Google Search chart correspond to those on the price series in Chart 30.6b. Note that the intensity of the data does not necessarily correspond to the magnitude of the peak in gas prices and timing occasionally is early. That’s why it’s a good idea to also use an oscillator, such as the stochastic (24/15/10) featured in the lower panel of Chart 30.6b.
CHART 30.6a Google Search Gasoline Price(s)
CHART 30.6b U.S. Gasoline Prices, 2003–2012, and a Momentum Indicator
Charts 30.7a and b follow a similar path, but this time for a commodity price search. Here again, we note that extreme intensity does not translate into an extreme turning point. You can also see that points X and Y are the lowest during the search and Y certainly corresponds with a low (disinterest) in commodities. On the other hand, there seemed to be more interest in declining prices when the sharp 2008 decline was taking place. At the same time, interest was peaking momentum at B in Chart 30.7b and offered one of the lowest ROC readings in the whole 6-year period covered by the search. Combining sentiment in the form of the Google numbers with momentum paid off handsomely in this case.
CHART 30.7a Google Search Commodity Price(s)
CHART 30.7b CRB Spot Raw Industrials, 2005–2012, and a Momentum Indicator
Another way in which the media can point to major turning points is when it is possible to observe what I call a misfit story—when a heretofore “invisible” market is given the prominence it rarely, if ever, achieves.
For example, the financial media is always featuring stories on the stock or bond markets. That is normal and offering us no contrary bones. On the other hand, when we see a story in the popular press about an otherwise obscure market, then there is something to gnaw on. For example, in 1980, the sugar price peaked following a long and strong bull market. Close to the day of the high, the CBS Evening News led with a story on how traders were forecasting higher sugar prices. To my knowledge, sugar has never before or since been featured so prominently in the news. It was unusual and highly significant for the sugar market. Prominent stories in the U.S. press concerning specific “foreign” stock markets, currencies, etc., can also be valuable clues that these markets have reached an extreme. If you are long coffee, beware of media stories concerning food companies raising their price, as this unusual activity also tends to reflect major peaks.
Best-Selling Books Another area to monitor is that of best-selling nonfiction books. If a financial book appears on the list, it is usually a sign that a particular market has attracted the attention of the majority and that the good or bad news has been fully discounted. Thus, Ravi Batra’s book on the coming depression became a best-seller just after the 1987 crash, a classic sign of a bottom. The first edition of Adam Smith’s The Money Game (Vintage, 1976) reached the same list just as the mutual fund boom was ending in late 1968. Perhaps the most unlikely of all was a book on money markets by William Donahue just as short-term interest rates were making a secular peak in 1981.
Politicians A classic contrary indicator is the attitude of politicians, especially to bad news that is likely to adversely affect their election possibilities. Since politicians react to poll numbers and other trends in what we might term constituent psychology, they represent an excellent and reliable lagging indicator. They are the last to take action, and when they do, the next trend is usually underway. For instance, at the end of 1974, Gerald Ford introduced the famous W(in)I(nflation)N(ow) buttons, but consumer price inflation had, for all intents and purposes, peaked for that cycle. I remember watching the network news in the fall of 1981, right at the secular peak of interest rates. The news was full of stories of congressmen returning to Washington “determined to do something about high interest rates.” They had earfuls of complaints from their constituents and were resolute to do something about it. The problem was that the economy was already weakening and rates had peaked. When politicians promote price controls, you can be fairly certain that the specific commodity is in the process of peaking. By the sa
me token, when oil prices are spiking and politicians start to blame the “greedy speculators,” it’s time to liquidate and probably go short oil.
Unrealistic Valuations A final pointer that the crowd has reached an extreme arises when a particular market reaches an historic level of over- or undervaluation (progressively more mispriced in John Schultz’s definition). For example, it was reported that the real estate value of the emperor’s palace in Tokyo was worth as much as all the land in California at the height of the Japanese real estate boom. In Psychology and the Stock Market (American Management Association, 1977), David Dreman noted that during the 1920s real estate boom in Florida, it was reported that there were 25,000 brokers in Miami, an equivalent of one in three of the population. This was not a valuation measure, but the statistic showed that things had clearly got out of hand. At one time in the 1990s tech boom, priceline.com, an online travel service, had a capitalization greater than the combined value of several of the airlines it represented. At its peak, the stock reached $160, but a year later it had fallen to just over $1.
Applying Technical Analysis
Since the crowd can and does move to an extreme well beyond normal experience, being early can be particularly harmful to one’s financial health. This is where the integration of technical analysis and the theory of contrary opinion can be quite helpful. Let’s consider a couple of examples. The Japanese bull market of the 1980s represents a classic mania where price earnings ratios and other valuation methods reached incredible extremes. The top had been called many times in the 1980s, but it never came. The crowd had clearly reached an extreme, but records continued to fall. In the end, the bubble was burst with the alternative scenario most likely to undo stock market bubbles—rising rates. Chart 30.8 shows that just after the 1990 top, both the Nikkei and Japanese short rates crossed their 12-month moving averages (MAs) for the first time in many years.
CHART 30.8 The Nikkei and Japanese Short-Term Interest Rates, 1982–1997
Both series also violated trendlines, thereby offering substantial technical evidence that the bubble had burst. Twenty-two years later, the Nikkei was still struggling at just over one-fourth of its 1990 high.
Charts 30.9 and 30.10 show two Businessweek cover stories in 1982 and 1984 concerning the bond market. The fact that the bond market should be featured so prominently after prices had fallen significantly was a sign that the crowd was at or close to an extreme. The next step was to appraise the technical position to see if there were any signs of a reversal. In the 1982 case, the 18-month ROC in Chart 30.10 had already completed and broken out of a massive 4-year base. Later on, the price broke out as well. This secondary breakout took place several months later, but it’s important to remember that we are looking at the reversal of an extremely long trend and those sorts of things take time.
CHART 30.9 U.S. Government Bond Prices, 1977–1990, and an 18-Month ROC
CHART 30.10 U.S. Government Bond Prices, 1977–1990, and an 18-Month ROC
In 1984, the “Disaster in Bonds” cover story cumulated a 2-year decline. In this instance, the ROC was close to an extreme oversold condition and the price had reached support in the form of the extended trendline marking the previous breakout. The bear market trendline break was the triggering mechanism that indicated the crowd had now moved away from the bearish extreme and was now trending in the opposite direction. In both situations, the cover stories would have indicated that the bearish arguments were now well understood and discounted and that the trend-line breaks were the signals that it was time to play the contrary “card.”
Distinguishing Between a Short-Term or Long-Term Turning Point
Before we close our discussion on contrary opinion, it is important to understand that the crowd can move to a smaller, less intense level of extreme. This type of sentiment is associated with a price reversal of a short-term or intermediate-term nature. An example might be a 2- to 3-week run-up in the corn price, cumulating in a lead article in the commodities section in the Wall Street Journal. Such features are not uncommon—after all, some commodity is featured every day. The idea here is that when a commodity gains such attention, it usually comes after it has experienced a significant rally or reaction. The story develops because of excitement on the floor for that particular commodity and is reflective of the crowd reaching a short-term extreme. When confirmed by a technical indicator such as a 1- or 2-day price pattern, a trendline break, or a reliable moving-average crossover, this contrary position is usually well rewarded.
Another example might come from a recently released government employment report which indicates that the economy is stronger than most traders expected. Since bond prices react unfavorably to good economic news, they could sell off sharply. Speculators now reverse sentiment from positive to a state of discouragement. Not only are bond prices declining, but rumors of a pick-up in inflation causes prices to fall even further and sentiment to become even more bearish. The consensus mood among traders is now quite black. However, the chances are that this is only a small top. The alternative scenario in this case is to look through the gloom and examine the trend of employment and other economic numbers to see if the recent report was likely to be an aberration.
Summary
1. During the unfolding of a trend, the crowd is usually right. It is at the turning points that it is wrong.
2. Three prerequisites for justifying a contrary position are the original premise becomes a dogma, the premise loses its validity, and the market becomes progressively more mispriced.
3. Three steps to forming a contrary opinion are figuring out what the crowd is thinking, coming up with alternative scenarios, and determining when the crowd reaches an extreme.
4. It is difficult to go contrary in practice because of competing forces around us.
5. When the crowd reaches an extreme, the question is not whether, but when and by how much.
6. Signs that the crowd is at an extreme include cover stories, best-selling books, reaction by politicians, extremes in sentiment indicators, and gross over- or undervaluations.
7. Since mass psychology can move well beyond the norm, technical analysis should be used as a triggering device for signaling when the crowd is backing off from a bullish or bearish extreme.
8. Contrary analysis should be used as one more indicator in the weight-of-the-evidence approach.
31 WHY INTEREST RATES AFFECT THE STOCK MARKET
In this chapter we will examine why changes in the level of interest rates are an important influence on equity prices and apply technical analysis to credit market yields and prices.
Changes in interest rates affect the stock market for four basic reasons. First, fluctuations in the price charged for credit has a major influence on the level of economic activity and, therefore, indirectly on corporate profits.
Second, because interest charges affect the bottom line, changes in the level of rates have a direct influence on corporate profits and, therefore, the price investors are willing to pay for equities.
Third, movements in interest rates alter the relationships between competing financial assets, of which the bond/equity market relationship is the most important.
Fourth, a substantial number of stocks are purchased on borrowed money (known as margin debt). Changes in the cost of carrying that debt (i.e., the interest rate) influence the desire or ability of investors and speculators to maintain these margined positions. Because changes in interest rates usually lead stock prices, it is important to be able to identify primary trend reversals in the credit markets.
The Indirect Effect of Interest Rate Changes on Corporate Profits
Perhaps the most important effect of interest rate changes on equity prices comes from the fact that tight monetary policy associated with rising rates adversely affects business conditions, whereas falling rates stimulate the economy.
Given time, most businesses can adjust to higher rates, but when rates change quickly and unexpectedly, unless cash flows
are extraordinary, businesses have to curtail expansion plans, cut inventories, etc., and this has a debilitating effect on the economy and, therefore, on corporate profits. Higher rates and smaller profits mean lower price earnings multiples and, therefore, lower stock prices.
When central banks become concerned about the economy, they lower short-term rates and a reverse effect takes hold.
The Direct Effect of Interest Rate Changes on Corporate Profits
Interest rates affect profits in two ways. First, almost all companies borrow money to finance capital equipment and inventory, so the cost of money, i.e., the interest rate they pay, is of great importance. Second, a substantial number of sales are, in turn, financed by borrowing. The level of interest rates, therefore, has a great deal of influence on the ability and willingness of customers to make additional purchases. One of the most outstanding examples is the automobile industry, in which both producers and consumers are very heavily financed. The capital-intensive utility and transportation industries are also large borrowers, as are all the highly leveraged construction and housing industries.
Technical Analysis Explained Page 45
