Swimming Naked
A favourite Buffet-ism is the one about bear markets - "you only find out who's swimming naked when the tide goes out". It twins with the phrase coined by the great 1960s technician, Joe Granville who called them "Bag-holders", as in "the ones left holding the...'
But how do we tell in advance when we are swimming naked? What 'tells' do we need to look for? Clues are always there in hindsight. Many technicians use breadth and momentum measures to 'time' the market. For me, the concept of volume confirmation has always held a special appeal for a very personal reason.
Bull markets give off many clues that presage their demise. Of course, they only reveal themselves after one has sifted through the ashes of a market that has undergone a severe correction or bear phase.
In a previous blog I have mentioned a great friend and mentor of mine, Pat Taylor. He was unknown to most of Bay Street, having toiled at a now defunct retail brokerage, Brawley Cathers, before going out on his own. It was his work on volume confirmation the informs my thinking on market dynamics to this day.
Strangely enough, he was in turn a disciple of Granville, who invented techniques Pat adopted after tweaking them and improving their forecasting abilities. Volume in markets is similar to votes in an election. You may win an election, but lose the popular vote. Just look south for how that sits with people.
The original thinking on volume that drives the theory of "non-confirmation" was actually proposed by Granville in the early sixties. However, without the advantages of electronic data manipulation, he actually had to 'dumb-down' the indicator to what we now know as On Balance Volume. Pat cleverly developed a program in the DOS computer days (yes, I actually got his data on floppy discs!) to refine the calculation. In so doing, his readings more closely reflected Granville's original thinking on the volume confirmation of price action.
In it's simplest terms, when the volume fails to confirm the price, start looking for the exits. After a period of downward price action, Pat would often come into my office and, grinning like a Cheshire cat, simply say "get in!". His volume lines failed to confirm the downside move of the market and thus gave a buy signal.
As for the 'tops' of markets, there was a few calls that I will never forget. One year, after the markets were cresting following a three year run, he came in one day and simply said "get out!" That was in May of 1987. He was similarly nervous all through 2007. I found his objectivity and coldly calculated approach to markets a constant source of comfort during the turmoil of those years.
O yah, he also came in one day in March of 2009, the week of the ultimate bear market low and said "get in". It was the same week of my "Martians with ray-guns" rant. Now you know my secret.
Unfortunately, we lost Pat to a rare disease a few years back and I really don't have a replacement to offer. His methodology and market feel has been been forever lost to us. Unfortunately, I have a feeling that, in the next few months, I may miss him even more than ever.
I have been using a technical indicator, the Chaikin MFI (Money Flow Index), to help with my risk appetite as it roughly corresponds to the Taylor's work. The evidence is starting to build supporting a market top forming as we make new highs. The global liquidity removal process has begun to affect markets. The Volume confirmation of price just isn't there. Look at the pattern of the QQQs, a proxy for the NASDAQ from back in 2006 as compared to today. Scary similarities are developing.
Volume Non-Con 2007
Notice how the November 2007 top was non-conned (failed to make a higher high) by the MFI indicator. The March 2009 bottom was also unconfirmed by a lower low, negating the breakdown in late Q1 2009.
The action of the market is now setting up for a similar lack of volume confirmation. The latest rise to new highs has had pathetic volume, signalling a risk-off bias to the move.
Volume Non-Con 2018
I leave it to you to continue to look for fundamental confirmation of the case for a continuation of owning equities. For me, I'm taking the summer off.
Market prices might seem to be winning the election but the popular vote says look out below. As Pat would say - "GET OUT!".
RISK MODEL: 3/5 - Risk On
The recent run in stocks, has produced a slight overbought reading with a lack of sentiment confirmation. Although the Vix (3m $VXV) is quiescent, the market seems to have levitated with a lack of sellers evident. This is typical of pre-quarter-end positioning and the window dressing effect ( holding winners - shedding losers) may be quite pronounced in the upcoming two weeks. Reversals often follow these artificial rallies, especially at the half-year milepost.
The FED hike tomorrow is widely expected so look carefully at the changes in wording for clues. By the time they are be forced to change their tune about 2019 rate hikes, it may be too late. We will be one 'risk off' bond rally away from a completely flat yield curve. The Italian election scare last week was preview of what that looks like. Bonds are still a very crowded short in spec-land.