I am a little bit of a fence sitter when it comes to technical analysis. Although I acknowledge there are aspects of technical analysis that work, my main complaint is that technical analysts try to explain every squiggle when more often than not, it is completely random. In my previous life as an index trader we used to get big orders that pushed around the entire stock market. Sometimes as we moved up or down the market, we would reach a point where another big client would fill our order. All of a sudden, the market might go from being better bid to offered, as our new seller would continue leaning on it. Later that evening when I would go home and turn on the business news, I would sometimes see a technical analyst talking about how the market reached an important Fibonacci level and couldn’t break through resistance. Well, I was part of the discussion persuading the seller to plug our buyer, and I knew full well that Fibonacci levels and every other technical indicator under the sun has absolutely zero influence. I don’t think technical analysis never works, I just don’t think it can be used to explain all the random price movements.
Yet sometimes you see a pattern that happens so often, it is difficult to believe it is random. For example, take the recent 100 day moving average of the US stock market.
The ovals represent all the times the S&P 500 dipped below the 100 day moving average. Of course that could be a random pattern, but it also could represent a level where a big buyer (or multiple buyers) has decided to put money to work.
Let me tell you another story from my days as an index trader. Just as I had taken over the liability responsibility for our index derivative desk, I learned one of the Canadian provinces had been mandated with switching their pension portfolio (which was stuffed to the gills with only bonds) into a more balanced portfolio that included equities. Of course every institutional Canadian broker knew the same information, and everyone was vying for the mountain of business. Although we had salesmen on our desk, I decided to tackle this client on my own. Those who know me are aware that I am no natural salesman. I was not born with the gift of smoozing. I figured there was no way I would win the business if the client wanted to be wined, dined, pampered and told how great he was (which is too often what works).
So instead I went with the straight forward gee-shucks-all-cards-on-the-table approach. I told the client that given the enormous amount of stock he had to buy, if he demanded liquidity from the marketplace, he would pay an enormous price. He would cause a feeding frenzy, and everyone and his dog would front run his order. The friction cost of his order would be gigantic. I convinced him that he needed to be on the other side of that demand for liquidity. When the market was selling off, he needed to be the one supplying the liquidity. We worked out a system where every day he would give me a small order to buy below the market. If it was filled, there was another order right behind for an even larger amount. If that was also filled, there was an even larger order right below, and so on. On the big down days, we were the only bid into the panic. This client ended up being a career maker for me as I did 90%+ of his massive rebalance into equities. He later told me he expected other brokers to figure it out, and thought to himself he would have to reduce the amount he was paying my firm, but instead of trying to use him for liquidity on the way down, other brokers continued to show him big offers up above the market. Much to my benefit, they were all too greedy.
My suspicion is there is a similar type order at work in the US stock market. Instead of buying on big down days, I think they buy when it hits the 100 day moving average. We already know Central Banks are buying more and more equities. These types of government institutions don’t just randomly buy when they think the market is headed higher. They have to justify their purchases and there needs to be logic behind their buy levels.
Traders already suspect the Bank of Japan follows the 1% rule (which is more like my previous client’s strategy). From the WSJ:
TOKYO—As Tokyo shares fall back from their recent highs, the Bank of Japan has been significantly stepping up its purchases of domestic exchange traded funds.
While the central bank is well known for its massive purchases of Japanese government bonds as a part of its monetary easing program, it also buys ETFs—albeit in much smaller quantities—that track the Nikkei Stock Average and the broader Topix index.
Through a trustee, the central bank purchased a combined ¥92.4 billion ($904.2 million) in ETFs over the first six business days of August. That’s the BOJ’s longest and largest consecutive buying streak since it started purchasing ETFs in December 2010.
Many traders suspect that it may not be a coincidence that the central bank is scooping up ETFs at a time when both the Nikkei and the Topix are spending considerable amounts of time in negative territory. Speculation is rife that the BOJ is following an unwritten rule, called “the 1% rule” by traders, where it buys ETFs after the Topix index falls around 1% in the morning session.
While the BOJ doesn’t disclose what criteria it uses when it makes ETF purchases, two market participants say that they thought the central bank was following that rule last week when it actively bought ETFs.
Whatever the rule, I am convinced the Central Banks have one. And this 100 day moving average has held too often for it to be a coincidence. Although I might be assigning too much credence in a technical indicator, I think this current decline under the 100 day average is not the time to be short. It wouldn’t surprise me at all if the stock market gets a “mysterious bid” in the next couple of days…
More reason to be careful on the shorts
Another reason to be careful on the short side of the equity market is that the VXV/VIX ratio has entered a region where stocks often bounce.
The VXV is the 3 month VIX, and when the ratio declines, it signifies that traders are paying up for near term protection. This can often mark the bottom in the stock market decline.
Gold/S&P 500 ratio
Yesterday’s big move down in the S&P 500 prompted me to dust off my Gold/S&P 500 ratio chart:
So far the range of the past few months is still holding. Although I might be advocating being careful on stock market shorts over the next few days, longer term, I think this ratio is a screaming buy.
I know it is trendy in the financial twitter community to shit all over the gold bulls, but this trend is getting long in the tooth.
Do you really want to be betting on this trend continuing? Maybe you do. Maybe you think this fad of Central Banks buying equities and corporations issuing tons of debt to lever up the balance sheet with equity buybacks can continue forever. Maybe you think this will all end well. Maybe you are a believer Central Banks know what they are doing. Then by all means, keep shorting gold and buying equities. It is lonely, but I will be there to show you a bid…
Chinese yield curve
Before the days of ZIRP (zero interest rate policy) and QE (quantitative easing), market strategists used to look towards the yield curve as a reliable signal about future economic activity. This indicator has been bastardized from all the Central Bank manipulations, so I am not sure about its usefulness anymore. Yet not all countries have zero or negative interest rates.
Although Chinese debt markets are young and not fully developed, we can still monitor their yield curve movements. Recently there is a lot of concern about the slowing Chinese economy. More than one person emailed yesterday to suggest last week’s Chinese stock market decline was more important than Greece. I too share in this concern. There doesn’t seem to be any signs that their economy is bottoming. Have a look at the latest “Chinese worry of the day.”
But if there is something to be hopeful about, it is the recent movement of the Chinese yield curve.
The curve is steepening. That is a good sign.
We are now almost as steep as right after the 2008 credit crisis.
I am still worried about China, don’t get me wrong. But maybe the curve is telling us the PBOC is on top of it…
Thanks for reading,