Thursday, August 27, 2015

All quiet . . . in the eye of the storm

Top JPMorgan Quant Warns Second Market Crash May Be Imminent

by ZeroHedge • August 27, 2015

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Last Friday, when the market was down only 2%, we presented readers with a note which promptly became the most read piece across Wall Street trading desks, which was written by JPM’s head quant Marko Kolanovic, who correctly calculated the option gamma hedging imbalance into the close, and just as correctly predicted the closing dump on Friday which according to many catalyzed Monday’s “limit down” open.


Given that the market is already down ~2%, we expect the market selloff to accelerate after 3:30PM into the close with peak hedging pressure ~3:45PM. The magnitude of the negative price impact could be ~30-60bps in the absence of any other fundamental buying or selling pressure into the close.

We bring it up because Kolanovic is out with another note, one which may be even more unpleasant for bulls who, looking at nothing but price action, were convinced that after the biggest two day market jump in history, the worst is behind us.

In the just released note, the head JPM quant warns that a large pool of assets controlled by price-insensitive managers including derivatives hedgers, Trend Following strategies (CTAs), Risk Parity portfolios and Volatility Managed strategies, which is programmatically trading equities regardless of underlying fundamentals, is about to start selling equities, “and will negatively affect market in coming days and weeks.” For good measure, he casually tosses the word “crash” in the note as well.

By way of reference, JPM notes that a good example of how price-insensitive sellers can cause market a disruption/crash is the price action on the US Monday open. It says that technical selling related to various hedging programs, in an environment of low (pre-market) liquidity indeed caused a ‘flash crash’ on Monday’s open. S&P 500 futures hit a 5% limit down preopen, and then a 7% limit low at 9:31 and 9:33. The inability of hedgers to short futures spilled over into large cap stocks that were still trading and could be used as a proxy hedge. Had it not been for the futures limit down event, the selloff would likely have been worse as indicated by the price of the index implied by individual stocks. The figure below shows the S&P 500 futures, SPY ETF and S&P 500 replicated from
the largest stocks that were trading near the market open.

Kolanovic correctly takes credit for his prediction and notes that “in our Friday note we forecasted end-of-the-day selling pressure due to option gamma hedging. We saw similar price impacts on Thursday, Friday, and Monday (pushing the market lower into the close) and an upside squeeze on Wednesday. Our estimate is that up to 20% of market volume was driven by hedging of various derivative exposures such as options, dynamic delta hedging programs, levered ETF stop loss orders, and other related products and strategies (note that levered ETFs have gamma exposure of only ~$1bn per 1%, i.e., much smaller than that of S&P 500 options). We estimate the cumulative selling pressure from options hedging during the market selloff to be ~$100bn. Options gamma is expected to remain substantially (in excess of $20bn) tilted towards puts while the S&P 500 is between 1850 and 2000.

The figure below shows Put-Call Gamma assuming current open interest and different spot prices. JPM expects high volatility to persist (should we stay in this price range) and cause quick intraday moves up or down, particularly towards the end of the trading day.

According to the quant, it is not only derivative hedgers who are pushing the market around like a toy with barely any resistance: :in fact, there is a much larger pool of assets that is programmatically trading equities regardless of underlying fundamentals.”

It is these investors who, “in the current environment” are selling equities and “will negatively impact the market over the coming days and weeks.

Trend Following strategies (CTAs), Risk Parity portfolios, and Volatility Managed strategies all invest in equities based on past price performance and volatility. For instance, in our June market commentary we showed that if the equity indices fall 10%, these trend followers may need to subsequently sell ~$100bn of equity exposure. These types of ‘price insensitive’ flows are starting to materialize, and our goal is to estimate their likely size and timing. These technical flows are determined by algorithms and risk limits, and can hence push the market away from fundamentals.

This is where it gets scary for the bulls who thought we may be out of the woods, and that the crash was behind us. If Marko is right, as of this moment we are merely in the eye of the hurricane:

The obvious risk is if these technical flows outsize fundamental buyers. In the current environment of low liquidity, they may cause a market crash such as the one we saw at the US market open on Monday. We attempt to estimate the amount of these flows from three groups of investors: Trend Following strategies (CTA), Risk Parity portfolios, and Volatility Managed strategies. These investors follow different signals and have different rebalancing time frames. The time frame is important as it may give us an estimate of how much longer we may see selling pressure.

So, how much longer may we see the selling pressure?

1. Volatility Target (or Volatility Control) strategies provide the most immediate selling as a reaction to the increase in volatility. These strategies adjust equity leverage based on short-term realized volatility. Typical signals are 1-, 2-, or 3-month realized volatility. Volatility target products are provided by many dealers, index providers and asset managers. Volatility targeting strategies also became very popular with the insurance industry. After the 2008 financial crisis, many Variable Annuity (VA) providers moved from hedging their equity exposure with options to investing directly in volatility target indices (e.g., 10% volatility target S&P 500). It is estimated that VA issuers have ~$360bn in strategies that are managing volatility; some of these use options to manage tail risk, some buy low volatility stocks, and some invest in volatility target strategies. We estimate that strategies that are targeting a particular level of  volatility or managing to an equity floor could have $100-$200bn of assets.

Assuming that, on average, these strategies follow a 2-month realized volatility signal, we can estimate their selling pressure. 2M realized volatility increased over the past week from ~10% to ~20% (i.e., doubled), so these strategies need to reduce equity exposure by up to ~50% to keep volatility constant. This could lead to $50-$100bn of selling, and it likely started already this week. There is often a delay of 1-3 days between when a signal is triggered and trade implementation, and positions are often reduced over several days. We think  this could have contributed to the ‘unexpected’ selloff that happened in the last hour of Tuesday’s trading session. While these flows may continue to have a negative impact over the next few days, they would be the first to reverse (start buying the market) when volatility declines.

2. Trend Following strategies/CTA funds have an estimated ~$350bn in AUM. We modelled CTA exposures in our May and June commentaries, and estimated flows under different scenarios for asset prices. In particular, under a 10% down scenario in equites we estimated CTAs need to sell ~$100bn of equities. In our model, the bulk of selling was in US markets, some in Japan and relatively little in Europe. S&P 500 futures did underperform Europe (by ~3%) and Japan (by ~2%) over the last two trading sessions (European hours), which may indicate that CTA flows have started to impact equity markets. The rebalance time frame for CTA strategies is typically longer than for volatility control strategies. CTA funds may act on their signal in a period that ranges from several days to a month. We believe that selling from CTAs may have just started and will continue over the next several days/weeks.

3. Risk Parity is one of the most popular and (historically) successful portfolio construction methodologies. Risk Parity allocates portfolio weights in proportion to assets’ total contribution to risk (a simplified version, called Equal Marginal Volatility allocates inversely proportional to the asset’s realized volatility). In a survey of quantitative investment managers (~800 clients in US and Europe), we found that ~50% prefer a Risk Parity approach (vs. 15% for traditional fixed weights (e.g., 60/40), 20% Markowitz MVO, and ~20% active asset timing). Estimated assets in Risk Parity strategies are ~$500bn and ~40% of these assets may be allocated to equities. Risk Parity portfolios may also incorporate leverage, often 1-2x. Risk parity funds often rebalance at a lower frequency (e.g., monthly, vs. daily for volatility target) and use slower moving signals (e.g. 6M or 1Y realized volatility). The increase in equity volatility and correlation would cause Risk Parity portfolios to reduce equity exposure. For instance, 6M realized volatility increased from 11% to 15% and a modest increase in correlations would result in approximately a ~20% reduction of equity exposure. Based on our estimate of Risk Parity equity exposure, this could translate into $50bn-$100bn of selling over the coming weeks.

In summary, JPM estimates that “the combined selling of Volatility Target strategies, CTAs and Risk Parity portfolios could be $150-$300bn over the next several weeks. Rebalancing of these funds may appear as a persistent and fundamentally unjustified selling pressure as these funds execute their programs. In addition, there may be a positive feedback loop between all of these sellers – Gamma hedging of derivatives causes higher market volatility, which in turn leads to selling in Risk Parity portfolios, and the resulting downward price action invites further CTA shorting. All of these flows pose risk for fundamental investors eager to buy the market dip. Fundamental investors may wish to time their market entry to coincide with the abatement of these technical selling pressures.”

* * *

In other words, if JPM is right, yesterday and today are merely the eye of the hurricane – enjoy them; tomorrow is when the winds return full force.

$INDU--Time to sell the rip?

I think so.  TVIX is up almost 1.00 since the low today.  The relief rally is ending.  SPX filled its gap at 1970, and everyone on TV is shouting the correction is over.  GL

Visit to see more great charts.

Someone saw this coming

Contra Corner Gets Some Company——-The NYT Highlights Four Who Saw it Coming

by David Stockman • August 26, 2015

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From the looks of the graph below its obvious that Wall Street did not see it coming. As of yesterday’s close, the S&P 500 was down 12.5% from its May 19 high, and most of that loss occurred in the last four trading days.

^SPX Chart

^SPX data by YCharts

So at 1868 the S&P index sits at the October 15th low which triggered the Bullard Rip last fall, and also at a point it first crossed nearly 500 days ago in April 2014. What happened in the interim is that time after time the hedge funds and robo-traders bought the dip. Each time they were rewarded with what seemed like an endless succession of “new highs”.

What happened yesterday is something relatively new. The scorching opening ramp of nearly 500 points on the Dow futures wilted to 300 points at the cash open, and then skidded to negative 200 points at the close. But do not be troubled, they will be back again and again—-as they are today—– attempting to ramp the averages back toward their old highs.

Indeed, any time soon now a central banker—perhaps Stanley Fischer at his upcoming Jackson Hole speech—–will parse a phrase or drop a headline that sounds like more monetary heroin is on the way. Within nanoseconds the robo-machines will rage, the indices will erupt toward the old chart points and the talking heads of bubble vision will come rushing forth to announce that the “correction” is done.

But this will prove to be the rigor mortis of the bulls——-a series of diminishing market spasms reflecting the buy-the-dip algorithm wired into the machines. Eventually, the chart-running bots will be reprogramed and the ritual incantations of the bullish commentators will go radio silent.

The reason this time is different is not only that the key support lines—the 50DMA and 200DMA——have been decisively crushed. More importantly, the great global credit boom is now fracturing, and the central banks which created it during the last 20 years are powerless to reverse the downward deflationary spiral.

The Fed has nothing left in its arsenal except to pathetically delay and equivocate with increasingly juvenile incoherence the “lift-off” date for letting the money market off the zero bound.  But a few more months of delay—–beyond the 80 month string now in place—– will do nothing to reverse the global deflation that will tip the US economy into recession in the next year or two.

And if the Fed should revert back to full-bore QE with a new bond buying spree all monetary hell would break loose. It would be a stark, devastating admission that the last six years of radical monetary policy have failed; and that all this time there was nothing behind the screen except a printing press that fed Wall Street speculators with free money for the carry trades.

The same condition of dead-end impotence is true for the other central banks as well.  The PBOC has shot its wad and is now desperately struggling to prevent a massive outflow of flight capital and an internal deflation of its giant credit bubble——a freakish financial deformation that has turned red capitalism into an incendiary rampage of digging, building, borrowing and speculating.

Similarly, the BOJ’s latest massive money printing campaign has ended in yet another recession, and Draghi’s $1.2 trillion bond buying campaign has left most of Europe still mired in its long-standing socialist stupor.

But hope apparently runs eternal, and it will take time for the casino to be weaned from its unwarranted faith in central bank omnipotence.

In the interim, a new paradigm will emerge. Money will be made no longer by buying the dips; the new formula will be to sell the rips. Once the robo machines lock on to that algorithm, the bull will be long and truly dead.

Moreover, the trend change now upon us will be reinforced by the growing visibility of the great global deflation currently well underway. This is the backside of the 20-year money printing spree by the central banks that took global credit market debt outstanding from $40 trillion to $200 trillion, and thereby left the household sector of the DM world buried in peak debt, and the production sector of the EM world drowning in excess capacity.

At Contra Corner we have been talking about these themes for many months now——as have many others who have a decent regard for the laws of market capitalism and sound finance. Today one of the more astute New York Times reporters took up a theme which will be rapidly gaining resonance.

That is, why didn’t the money printers at the Fed and the gamblers in the casino see it coming? Like in previous bubble cycles, some observers actually did as Landon Thomas relates below:

By Landon Thomas Jr. at The New York Times

As investors scramble to make sense of the wild market swings in recent days, a number of financial experts argue that, for more than a year now, signs pointing to an equity crisis were there for all to see.

The data points range from the obvious to the obscure, encompassing stock market and credit bubbles in China, the strength of the dollar relative to emerging market currencies, a commodity rout and a sudden halt to global earnings growth.

While it would have been impossible to predict the precise timing of the last week’s downturn, this array of economic and financial indicators led to an inescapable conclusion, these analysts say: The United States economy would only be able to avoid for so long the deflationary forces that have taken root in China.

And if the bull market had made it to April, it would have become the second-longest equity rally in United States history.

The one common theme binding all these measures together is the risk that they pose to the economic recovery in the United States. The Federal Reserve has said that it expects to raise interest rates sometime soon, given evidence over the last year that economic growth is picking up.

But more and more analysts are now pointing to problems in China and other markets as posing a real threat to the American economy.

“The global G.D.P. pie is shrinking,” said Raoul Pal, a former Goldman Sachs executive, now based in the Cayman Islands, who produces the Global Macro Investor, a monthly financial report that caters to hedge funds and other sophisticated investors.

Of the hundreds of indicators that Mr. Pal follows, the most crucial over the last year, in his view, has been the relentless upward move of the dollar against just about all emerging-market currencies. The dollar rally began in January 2014, when the Fed signaled that it would raise interest rates.

But the greenback’s strength against currencies like the Russian ruble, the Turkish lira and the Brazilian real began to gather steam a year ago. Veterans of past emerging-market booms and busts will tell you that the party always ends — as it did in Latin America in the 1980s and Southeast Asia in the 1990s — when the dollar takes off against these monetary units.

Suddenly, loans in relatively cheap dollars that financed real estate and consumption booms were no longer available and the ultimate result was always a growth slowdown.

Any discerning investor could have taken note of this trend.

For example, through the year ending on Aug. 19, the worst-performing investments in dollar terms were the following, according to Merrill Lynch: Brazilian equities, down 45 percent; Russian bonds, down 43 percent; Indonesian equities, down 26 percent; Turkish and Korean equities, down 25 percent; and Mexican equities, down 22 percent.

During this same period, United States equities returned 8.7 percent — the fourth-best return delivered by any major class of assets.

In effect, investors in the United States were saying that what happened in Russia, Turkey and Indonesia need not have any effect on stocks of companies based in the United States.

This would turn out to be a major miscalculation.

What was driving weakness in all these countries was the gradual slowdown in the Chinese economy. As China bought less steel from Brazil, iron ore from Australia (its stock market was down by 22 percent during this time frame) and less mineral fuel and oil from Indonesia, the effect on these economies was immediate.

When it comes to warning indicators from China, there are many from which to choose. One is that, according to their 2014 balance sheets, four out of five of the world’s largest banks are Chinese. Or one could choose the Chinese debt ratio, which McKinsey & Company has estimated to be over 280 percent of the country’s total economic output.

But for Albert Edwards, a strategist at Société Générale in London, what really confirmed in his mind that the Chinese growth engine was sputtering to a halt was the government’s naked support of the country’s stock market bubble. Among the government interventions were lending state entities money to buy stocks and restricting shareholders from selling large positions. Before the market collapsed, Chinese stocks reached a market capitalization of close to $10 trillion — making it the second-most valuable exchange in the world.

“Once you encourage an equity bubble, it will collapse — and then you are really in trouble,” Mr. Edwards said. “This was utter madness.”

Long before China’s decision to devalue its currency this month, Mr. Edwards said that it was the sharp reduction in value of the Japanese yen against the dollar in autumn 2014 that also set off alarm bells.

Because Japanese exports compete aggressively with currencies in Thailand and Korea, this was, in effect, a precursor to the Chinese currency move. He also noted that one of the causes of the Asian emerging market crisis in 1997 was that countries in the region broke their peg with the yen.

“It just rippled across the whole region,” he recalled.

The bottom line though, is that investors in American stocks recognized too late in the game that a global contraction was sneaking up on them.

For Jeffrey Sherman, a portfolio manager at the bond investment firm DoubleLine, the big cautionary sign was the correction in the high-yield corporate bond market. In summer 2014, as stocks of United States companies continued to push upward, the yields on risky corporations started to spike.

As many of these companies were in the energy sector, mostly digging for shale oil, they were hard-hit by the sharp drop in oil prices. Still, the fact that these bonds were entering their own bear market should have been seen by equity investors as a warning sign, Mr. Sherman said.

“These bonds have been very weak,” Mr. Sherman said. “There has been a huge divergence between high yield bonds and the stock market.”

Taken together with slow growth in China, the result, as he sees it, is that the outlook for growth in the United States is extremely fragile and not in a good position to survive an increase in interest rates from the Fed.

David A. Stockman, a former budget director under Ronald Reagan, has spent the last three years closely examining the excesses of the Chinese investment boom and warning on his contrarian blog of their consequences.

He points out, for example, that in the late 1990s, China had the capacity to manufacture 100 million tons of steel. That figure today is 1.1 billion tons — almost twice the amount of annual demand for steel in China.

The China steelmaking boom also sent the price for iron ore up to nearly $200 a ton in 2011, from around $30 in 2008. Like all commodity prices, it has fallen sharply, to just under $100, a correction that creates problems for big iron ore-producing countries like Australia, which made huge investments to keep supplying these raw materials to China.

The China steelmaking boom also sent the price for iron ore up to nearly $200 a ton in 2011, from around $30 in 2008. Like all commodity prices, it has fallen sharply, to just under $100, a correction that creates problems for big iron ore-producing countries like Australia, which made huge investments to keep supplying these raw materials to China.

“Iron ore is the canary in the steel shaft if you will,” Mr. Stockman said. “It is a real measure of the violence of global deflation that is currently underway.”

Recession? It ain’t happening

CNN Tells Americans That The Stock Market Is Not Going To Crash

By Michael Snyder, on August 26th, 2015

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CNN Newsroom - Photo by Doug WaldronOn Wednesday we witnessed the third largest single day point gain for the Dow Jones Industrial Average ever.  That sounds like great news until you realize that the two largest were in October 2008 – right in the middle of the last financial crisis.  This is a perfect example of what I wrote about yesterday.  Every time the market crashes, there are huge up days, huge down days and giant waves of market momentum.  Even though the Dow was up 619 points on Wednesday, overall we are still down more than 2,000 points from the peak of the market.  During the weeks and months to come, we are going to see many more wild market swings, but the overall direction of the market will be down.

Sadly, the mainstream media is still peddling the lie that everything is going to be just fine.  So millions upon and millions of Americans are just going to sit there while their investments get wiped out.  In the six trading days leading up to Wednesday, Americans lost a staggering 2.1 trillion dollars as stocks plunged, and the truth is that this nightmare is only just beginning.

Early on Wednesday morning, CNN published an article entitled “Why U.S. stocks aren’t headed for a crash“.  I had to laugh when I saw that headline.  If CNN is going to make this kind of a claim, they better have something very solid to base it on.  But instead, these are the five reasons we were given for why the stock market is not going to collapse…

1. “The U.S. economy isn’t on the verge of a recession.”

This is exactly what all of the “experts” told us back in 2007 and 2008 too.  In America today, the homeownership rate is at a 48 year low, 46 million Americans go to food banks, and economic growth has slowed to a standstill (and that is if you actually buy the highly manipulated official numbers).  The truth, of course, is that things continue to progressively get worse as our long-term economic decline continues to unfold.  For much more on this, please see my previous article entitled “12 Ways The Economy Is Already In Worse Shape Than It Was During The Depths Of The Last Recession“.

2. “China’s effect on U.S. is limited.”

Really? Go to just about any major retail store and start reading labels.  You will likely find far more things that were “made in China” than you will American-made products.  The global economy is more interconnected than ever before, and the Chinese stock market is the second largest on the entire planet.  Of course what is happening in China is going to affect us.

3. “American businesses are doing pretty well (outside of energy).”

Actually, they were doing pretty well for a while, but now things are turning.  Many large corporations are reporting declining orders, declining revenues and declining profits.  Unsold inventories are beginning to pile up and the pace of layoffs is starting to increase.  All of the things that we would expect to see just prior to another recession are happening.

4. “The Federal Reserve sounds cautious.”

This is laughable.  Ultimately, it isn’t going to matter much at all whether the Federal Reserve barely raises rates or not.  The era of “central bank omnipotence” is at an end.  Just look at what is happening over in Europe.  All of the quantitative easing that the ECB has been doing has not kept their markets from crashing in recent days.  Those that believe that the Federal Reserve can somehow miraculously keep the stock market from crashing this time around are going to end up deeply, deeply disappointed.

5. “Stock prices aren’t crazy high anymore.”

There is some truth to this last point.  Instead of stock prices being really, really, really crazy now they are just really, really crazy.  But as I have pointed out in many previous articles, the technical indicators are very clearly telling us that U.S. stocks still have a long, long way to go down.

But let’s hope that CNN is actually right – at least in the short-term.

Let’s hope that markets settle down and that things stabilize for at least a few weeks.

In order for that to happen, markets need to become a lot less volatile than they are right now.  The rollercoaster ride that we have been on in recent days has been extraordinary

The Dow traveled another 1,600 points during Tuesday’s trading session, adding to the 4,900 points the index traveled in down and up moves on Monday.

Markets tend to go up slowly and steadily when things are calm, and they tend to go down rapidly when things are volatile.

If you are rooting for a return of the bull market, you should be hoping for nice, boring trading days where the Dow goes up by about 100 points or so.  Wild swings like we have seen on Friday, Monday, Tuesday and Wednesday are very strong indicators that we have entered a bear market.

What we have been witnessing over the past week is almost unprecedented.  Just check out this piece of analysis from Bloomberg

By one metric, investors would have to go back 75 years to find the last time the S&P 500’s losses were this abrupt.

Bespoke Investment Group observed that the S&P 500 has closed more than four standard deviations below its 50-day moving average for the third consecutive session. That’s only the second time this has happened in the history of the index.

Of course after such a dramatic plunge it was inevitable that we were going to have a “bounce back day” where there was lots of panic buying.  Initially it looked like it would be Tuesday, but it turned out to be Wednesday instead.

But if you think that the big gain on Wednesday somehow means that the crisis is “over”, you are going to be sorely mistaken.

Personally, I am hoping that we at least see a bit of a pause in the action, but there is absolutely no guarantee that we will even get that.

As the markets have been flying around, more and more Americans are becoming curious about the potential for a full-blown stock market crash.  The following comes from Business Insider

This one’s pretty easy: according to Google search trends, more Americans are searching for “stock market crash” now that at any point since the last crash.

Right now, search traffic for the term “stock market crash” is hitting about 70% of the most volume this term has ever gotten through Google search.

And so while this data doesn’t convey absolute search volume for the term, we do know that Americans appear to be looking for information about a stock market crash at the highest level in about 7 years.

Very interesting.

In addition, Americans are also becoming more pessimistic about the overall economy.  According to Gallup, the level of confidence that Americans have about the future performance of the U.S. economy is the lowest that it has been in about a year.

And remember – it isn’t just U.S. markets that are starting to go crazy.  All over the planet stocks are crashing and recessions are starting.  In fact, I can’t remember a time when there has been this much economic chaos erupting all over the world all at once.

So can the U.S. resist the overall trend and pull out of this market crash?

Precious Metals going higher

I think we are putting a bottom in precious metals and that a nice rally will ensue for the next couple of months.  GL

Correction of wave iii is ending

In the chart above—if my count is right—wave v down is about to start.  GL

Wednesday, August 26, 2015

While you were sleeping last night, the PBOC . . .

Here Comes The Red Cavalry——Goldman Says Back-Up The Trucks, Again!

by David Stockman • August 25, 2015

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Wee! This is becoming a weird form of time travel.

Twenty-five trading days ago the S&P 500 was just 0.1% below its all-time high of 2131 recorded on May 21. Since then we have traveled backwards about 415 days!

That’s right. Yesterday’s 1893 close was down 11.2% from the all-time high, and marked the chart point first crossed way back on May 22, 2014.
^SPX Chart

^SPX data by YCharts

Do not fret, however. Beijing has called in the Red Cavalry—otherwise known as the PBOC.

In standard central bank fashion, the latter injected (even) more credit into the Chinese economy via a 25 bps rate cut, reduction of bank reserve requirements by 50 bps and mainlining about $25 billion directly into the banks via reverse repos. Under the latter procedure, the PBOC takes collateral and gives banks cash for a few weeks and then rinses and repeats—over and over, for as long as it takes.

Of course, in recent weeks China’s officialdom has also been feverishly trying to prop-up its currency in order to forestall a tsunami of capital flight. In the last six quarters more than $800 billion of private capital outflows had Beijing scared silly. They were actually sending the paddy wagons out to arrest people for attempting to sneak their capital out of the land of red capitalist miracles.

In fact, according to Soc Gen today’s PBOC actions will inject about $106 billion of fresh cash into the banking system, including bank reserves freed up by the RRR cut.  Apparently, however, during recent weeks China had drawn down its FX reserves in attempting to prop-up the yuan by an even great amount. That means they drained the banking system first, and have now flushed the same liquidity back in.

Push, pull. Tighten, ease.

These are acts of desperate, stupid madness, and here’s why.

Twenty-five years ago, Mr. Deng discovered the printing press in the basement at the PBOC and let it rip——including a 60% devaluation of the RMB in one fell swoop. Soon the world was flooded with cheap Chinese goods.

As its subsequent giant trade surpluses materialized, however, rather than letting the exchange rate rise in a clean float as Nixon and his guru, Milton Friedman, had prescribed when they trashed Bretton Woods back in August 1971, the communist bosses in Beijing ran the dirtiest float ever conceived.

During  the last two decades the PBOC and its sovereign wealth management affiliates accumulated dollar, euro and other major currency reserves like there was no tomorrow. But as they stuffed the PBOC’s vaults with $4.2 trillion of US treasury notes, Fannie Mae paper  and other so-called FX reserves in the conduct of their currency pegging operation, they perforce expanded their domestic banking and credit system by an equivalent amount of RMB.

At length, the suzerains of Beijing turned China into a credit-fueled house of cards. In the short time of two decades, they morphed a debt-free, quasi-subsistence federation of communes, collectives and state factories into a $28 trillion mountain of IOUs that funded the greatest spree of economically mindless land grabs, construction spending, economic gambling and state corruption in recorded history.

In other words, China is a tottering freak of economic nature. But never mind the deformed foundation upon which the miracle of red capitalism was erected. The Wall Street brokers nearly without exception view it as just one more big economy that can be continuously inflated by deft central bank intervention and other state actions designed to insure stability and growth.

As Nixon might have said, they are all Keynesians now. The job of central banks everywhere and always is to goose trouble-prone economies with printing press money so that households and business will spend more, the GDP will rise more and the stock bourses will be worth more.

Under this regime, there is no reason why economies should ever falter or stock markets should tumble; the state and its central banking branch can purportedly cure any deviations.

Thus, on July 7th Goldman’s China equity strategist gave the all clear signal right after the proceeding 20-day, $3.5 trillion meltdown of the China stock market. Completely ignoring the fact that China’s newly affluent classes have opened 287 million trading accounts, mostly in recent months, and mostly amounting to highly margined table stakes at its red chip casinos,  Goldman saw nothing but blue skies ahead:

Goldman Sachs Says There’s No China Stock Bubble, Sees Rally

Kinger Lau, the bank’s China strategist in Hong Kong, predicts the large-cap CSI 300 Index will rally 27 percent from Tuesday’s close over the next 12 months as government support measures boost investor confidence and monetary easing spurs economic growth. Leveraged positions aren’t big enough to trigger a market collapse, Lau says, and valuations have room to climb.

Goldman Sachs is sticking with its optimistic forecast in the face of record foreign outflows, the biggest-ever selloff by Chinese margin traders and a chorus of bubble warnings from international peers. The call hinges on the success of unprecedented government efforts to revive confidence among individual investors who watched equity values tumble by $3.2 trillion over the past three weeks……“It’s not in a bubble yet,” Lau said in an interview. “China’s government has a lot of tools to support the market.”

Well, not exactly. The Shanghai composite is down 21% since then, and a staggering 43% from the levels attained in late March.  That amounts to a $4 trillion “wealth” implosion in less than 100 trading days.

^SSEC Chart

^SSEC data by YCharts

Did Goldman fire this clown yet? No it didn’t.

Why? Because Goldman’s house economic model is essentially statist, and its agents——Dudley at the Fed, Carney at the BOE, Draghi at the ECB—–are strategically placed to execute that model.

So not surprisingly, Goldman’s chief equity strategist is out this morning with a buy-the-dip note, assuring its clients that the storm is over and that the S&P 500 will be back to its old highs in a jiffy:

…….Concern about China economic growth was the immediate catalyst for the correction. (But) we expect the US economy will avoid contagion and continue to expand. S&P 500 will rise by 11% to reach 2100 at year-end. Such a rebound would echo the trading pattern exhibited in 1998 when US equities rallied and largely ignored the Asian financial crisis. ………

Ultimately, the US economy was relatively unaffected by overseas financial market gyrations in 1998 and we believe a similar situation will occur in 2015. Our analysis of the geographic revenue exposure of S&P 500 constituents reveals that the US accounts for 67% of aggregate sales. Approximately 8% of revenues stemmed from the Asia-Pacific region with 1% disclosed as coming specifically from Japan and 2% from China. From an economics perspective, US exports account for roughly 13% of total US GDP, which  includes 5% to emerging markets and less than 1% to China.

That is just plain gibberish. Goldman’s statist economic model renders it utterly blind to the booby-traps planted everywhere in the world economy. For goodness sakes, this is not 1998!

Back then China had less than $2 trillion of debt outstanding and a minor presence in the world economy. Since then its credit market debt outstanding has exploded by 14X, its steel industry has expanded by 6X, its auto sales by 25X and its exports have risen by 1300%.
China Exports of Goods and Services Chart

China Exports of Goods and Services data by YCharts

In the interim, in fact, it has paved its landscape with a vast excess of everything——60 million empty high rise apartments that function as piggy-banks for speculators; dozens of ghost cities, empty malls and see through office buildings; scores of steel, machinery and auto plants that will soon be shutdown; mountains of copper and iron ore inventories that are hocked to foreign lenders; and trillions worth of high speed rails that are unsafe, airports that have no traffic and roads and bridges to nowhere.

This did not happen in isolation behind a red curtain. The wild west boom of red capitalism now sucks in $2 trillion more per year of imports of energy, raw materials, intermediate components, capital equipment and luxury goods than it did in 1998 when Alan Greenspan panicked in the face of the LTCM meltdown and slashed interest rates three times.

Indeed, Greenspan’s foolish action triggered a spree of coordinated money printing by the worlds central banks, including the PBOC, that was literally unimaginable by even the most wild eyed Keynesian economist at the time Goldman now identified as pivotal to our current prospects.

To wit, the combined central banks of the world sported a collective balance sheet of less than $2 trillion in September 1998—–reflecting a century’s worth of slow and steady build-up. Today that figure is $22 trillion, meaning that the world economy has been hyper-stimulated by a 11X increase in high powered central bank credit.

It is downright foolish, therefore, to claim that the US economy is decoupled from China and the rest of the world. In fact, it is inextricably bound to the global financial bubble and its leading edge in the form of red capitalism.

It might be wondered how stupid Goldman believes its mullet clients actually are. With respect to its non sequitir that China accounts for only 1% of US exports would it not occur to a reasonably alert observer that Caterpillar did not export its giant mining equipment to China; it went there indirectly by way of Australia’s booming iron ore provinces.

Likewise, the US did not export oil to China, but China’s vast, credit-inflated demand on the world market did artificially lift oil prices above $100 per barrel, thereby touching off the US shale boom that is now crashing in Texas, North Dakota, Oklahoma and three other states. And is it not the fact that every net new job created in the US since 2008 is actually in these same six shale states?

Similarly,  US exports to Europe have tripled to nearly $1 trillion annually since 1998, while European exports to China have more than quintupled. Might there possibly be some linkages?

Never mind the obvious, however. All the brokers were out this morning with the decoupling story—–even if it ended-up insufficient to prevent another down day in the market.

But let’s see. According to the Wall Street brokers, housing and employment will carry the US economy steadily upward.

Really? In the face of an unprecedented global collapse of the greatest phony boom known to economic history, here is housing and labor hours employed in the US economy.

Is this a plausible engine of continued expansion for the purportedly “uncoupled” US economy?
US Residential Fixed Investment Chart

US Residential Fixed Investment data by YCharts

Or this?

Tuesday, August 25, 2015

Everything on track

During Every Market Crash There Are Big Ups, Big Downs And Giant Waves Of Momentum

The Economic Collapse by Michael Snyder  /  5h  //  keep unread  //  hide  //  preview

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Tsunami Tidal Wave - Public DomainThis is exactly the type of market behavior that we would expect to see during the early stages of a major financial crisis.  In every major market downturn throughout history there were big ups, big downs and giant waves of momentum, and this time around will not be any different.  As I have explained repeatedly, markets tend to go up when things are calm, and they tend to go down when things get really choppy.  During a market meltdown, we fully expect to see days when the stock market absolutely soars.  Waves of panic selling are often followed by waves of panic buying.  As you will see below, six of the ten best single day gains for the Dow Jones Industrial Average happened during the financial crisis of 2008 and 2009.  So don’t be fooled for a moment by a very positive day for stocks like we are seeing on Tuesday.  It is all part of the dance.

At one point on Tuesday, the Dow was up over 400 points, and many of the talking heads on television were proclaiming that the stock market had “recovered”.  This is something that I predicted would happen yesterday

And if stocks go up tomorrow (which they probably should), all of those same “experts” will be proclaiming that the “correction” is over and that everything is now fine.

No, everything is not “fine” now.  The extreme volatility that we are witnessing just tells us that more trouble is coming.  Early on Tuesday the market was “burning up energy” as short-term investors sought to “buy the dip”.  But now that wave of panic buying is subsiding and the Dow is only up 240 points as I write this.

Overall, the Dow is still down more than 2,200 points from the peak of the market.  Even though I specifically warned that a market crash was coming, I didn’t expect the Dow to be down this far in late August.  Even after the “rally” we witnessed today, we are still way ahead of schedule.

The truth is that what we have seen so far is just the warm up act.

The main event will unfold during the months of September through December, and right now most people could not even conceive of the things that we are going to see in 2016.

But all along, there are going to be days when stocks fly higher.  As I mentioned above, many of the “best days” in stock market history occurred right in the middle of the financial crisis of 2008 and 2009.  This is a point that Jim Quinn has made very eloquently…

Six of the ten largest point gains in the history of the stock market occurred between September 2008 and March 2009. That’s right. During one of the greatest market collapses in history, the market soared by 5% to 11% in one day, six times. Here are the data points:

2008-10-13: +936.42

2008-10-28: +889.35

2008-11-13: +552.59

2009-03-23: +497.48

2008-11-21: +494.13

2008-09-30: +485.21

Do you think these factoids will be shared with the public today on the stock bubble networks? Not a chance.

And all of the technical indicators are still screaming that U.S. stocks have a long, long way to fall.  For example, just check out this chart.  The long-term analysis has not changed one bit.

Often, it is the short-term news that drives markets on any particular day.  Tuesday began with another massive stock selloff in Asia

The Shanghai Composite, China’s main stock exchange, fell 7.6% on Tuesday – after losing 8.5% on what state media have called China’s “Black Monday”.

It was the worst fall since 2007 and caused sharp drops in markets in the US and Europe

Tokyo’s Nikkei index had a volatile day, closing 4% lower.

In another desperate attempt to stop the bleeding, the Chinese decided to cut interest rates

The People’s Bank of China has lowered its interest rate for the fifth time since November. The one-year lending has been reduced by 25 basis points to 4.6 percent; the one-year deposit rate has been cut by 25 basis points to 1.75 percent. The change comes into force on Wednesday.

This reduction in interest rates was cheered by investors all over the planet, and as a result there was a wave of panic buying in Europe and in the United States.

But none of the short-term activity changes the fact that global financial markets are absolutely primed for a giant crash.  I like how Bill Fleckenstein put it during a recent interview with King World News

I have no idea how this is going to play out, other than I know we are headed considerably lower. The fact that so few seem to understand what the actual problem is makes me even more confident about that point. It would seem that everyone is using the easy answer and blaming China, but that was just the catalyst. The market has been trading in a heavy sideways fashion for some time, expectations are way higher than can be met, the technical action has now deteriorated, and bad news actually matters at the same time that speculation has run rampant. As I have stated many times (and also noted the reasons why), you couldn’t create a more crash-prone environment if you specifically set out to do so.

What we can’t account for are “black swan events” which could greatly accelerate this financial crisis.

A war in the Middle East, a major natural disaster or a terror attack involving weapons of mass destruction are all examples of the kinds of things that could turn this market crash into full-blown market implosion.

As we move into the critical month of September 2015, I think that it is safe to say that we should all be ready to expect the unexpected.  Our world is becoming increasingly unstable, and I am extremely concerned about the period of time that we are heading into.

The nice, comfortable period of relative stability that we have been experiencing for the past few years has come to an end.  I hope that you have enjoyed the good times while you still had them.

Now we are moving into a time of tremendous chaos and rapidly shifting conditions, and it is imperative that we all work very hard to get prepared for it while we still can.

$INDU--Wave 5 has commenced

Wave 5 for $INDU started today in roughly the last hour.  I expect it to be technically weak.  When INDU gets below yesterday's low, the dip-buyers will--remembering the old days--take out their billfolds and look for places to buy.  When they do, that will be the bottom of intermediate wave 1.  Wave 2 should be substantial--at least back to today's high.  This market is very over sold AND there are not a lot of believers in this bear.  However, when wave 2 is complete, a devastating wave 3 will take us down thousands of points, painfully creating believers.  GL

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Hussman on Risk

Risk Turns Risky: Unpleasant Skew, Scale Dilation, And Broken Lines

Aug. 24, 2015 8:58 AM ET   by: John Hussman

Over the years, I’ve observed that overvalued, overbought, overbullish market conditions have historically been accompanied by what I call “unpleasant skew” – a succession of small but persistent marginal new highs, followed by a vertical collapse in which weeks or months of gains are wiped out in a handful of sessions. Provided that investors are in a risk-seeking mood (which we infer from the behavior of market internals), sufficiently aggressive monetary easing can delay this tendency, by starving investors of every source of safe return, and actively encouraging further yield-seeking speculation even when valuations are obscene. Once investors become risk-averse, as deteriorating market internals have suggested in recent months, vertical declines much more extreme than last week's loss are quite ordinary.

The way to understand the bubbles and collapses of the past 15 years, and those throughout history, is to learn the right lesson. That lesson is not that overvaluation can be ignored indefinitely – we know different from the collapses that have regularly followed extreme valuations. The lesson is not that easy monetary policy reliably supports stock prices – persistent and aggressive easing did nothing to keep stocks from losing more than half their value in 2000-2002 and 2007-2009. Rather, the key lesson to draw from recent market cycles, and those across a century of history, is this:

Valuations are the main driver of long-term returns, but the main driver of market returns over shorter horizons is the attitude of investors toward risk, and the most reliable way to measure this is through the uniformity or divergence of market internals. When market internals are uniformly favorable, overvaluation has little effect, and monetary easing can encourage further risk-seeking speculation. Conversely, when deterioration in market internals signals a shift toward risk-aversion among investors, monetary easing has little effect, and overvaluation can suddenly matter with a vengeance.

Last week’s decline, while seemingly significant, was actually a rather run-of-the-mill example of “unpleasant skew” that has regularly followed similar market conditions throughout history. I’ve updated the chart I presented last week, which shows how contained last week’s market loss actually was in the context of present conditions. As I wrote a week ago, “It's the 8% of history that matches current conditions where most market crashes have occurred. The chart below shows the cumulative total return of the S&P 500 restricted to this subset of history. The chart is on log scale, so each horizontal line represents a 50% loss. The vertical lines straight down are actually 2-3 week air pockets, free-falls and crashes where stocks experienced losses of as much as 25%, often with continued (but less predictable) follow-on losses after exiting this particular return/risk profile. The past several months appear as a little congestion area in the lower right of the graph. Investors should emphatically not rule out progressive losses – even a straight line down – under present conditions.”

(click to enlarge)

The 8% subset of history matching present conditions captures a cumulative loss in the S&P 500 equivalent to turning a dollar into less than 7 cents. Conversely, the remaining 92% of market history captures a cumulative gain in the S&P 500 of more than (1/.07=) 14 times the overall return in the index across history. You’ll note that I’ve added an additional segment below 0.0625 as a reminder that each horizontal bar lower represents a further 50% market loss. We’re probably going to need that extra room.

The good news is that we’re not going to stay in this 8% subset of historical conditions indefinitely, and the current market return/risk profile is the only one where severe market losses should be strongly expected. Another 32% of return/risk conditions we identify are associated with relatively flat expected market returns (generally near or below Treasury bill yields, on average, but including both positive and negative fluctuations). In those conditions, significant market risk isn’t worth taking because the weak average returns still come with the potential for sizable interim losses. That sort of condition encourages a neutral investment stance, or one that is “constructive with a safety net.” The remaining 60% of market conditions we identify are associated with strongly positive expected return/risk profiles, where an unhedged or aggressive outlook is reasonable. Our shift to that outlook will likely occur at the point when a material retreat in valuations is joined by an improvement in market internals.

No specific forecasts or projections are required here. Our approach is to align our investment outlook with the prevailing return/risk classification we identify at each point in time. We’ll adjust our outlook as the observable evidence shifts.

Causes versus Triggers

We should distinguish between causes and triggers here. If you roll a wheelbarrow of dynamite into a crowd of fire jugglers, there’s not much chance things will end well. The cause of the inevitable wreckage is the dynamite, but the trigger is the guy who drops his torch. Likewise, once extreme valuations are established as a result of yield-seeking speculation that is enabled (1997-2000), encouraged (2004-2007), or actively promoted (2010-2014) by the Federal Reserve, an eventual collapse is inevitable. By starving investors of safe return, activist Fed policy has promoted repeated valuation bubbles, and inevitable collapses, in risky assets. On the basis of valuation measures having the strongest correlation with actual subsequent market returns, we fully expect the S&P 500 to decline by 40-55% over the completion of the current market cycle. The only uncertainty has been the triggers.

We know that obscene valuation is the ultimate cause of the rather inevitable market loss we can expect over the completion of the present market cycle. We also know that conditions are most permissive for market collapses when overextended market conditions are joined by deterioration in market internals (signaling increased risk-aversion among investors). But what triggered the timing of last week’s abrupt decline?

My impression is that trigger of last week’s market loss was not China’s yuan devaluation or even concern about the potential for a Federal Reserve rate hike. Rather, the trigger was most likely the sudden deterioration of leading economic measures, energy prices, and industrial commodities, both in the U.S. and globally. This weakness first became evident in February (see Market Action Suggests Abrupt Slowing in Global Economic Activity). After a brief rebound, the data has deteriorated abruptly once again. While extraordinary monetary interventions across the globe have certainly distorted the financial markets, they have done little to support the real economy, and developing economic weakness in the U.S. and abroad is beginning to clarify that ineffectiveness.

Based on reports available through Friday, the chart below of regional Fed and purchasing manager surveys shows the fresh deterioration we observe here.

(click to enlarge)

Remember the sequence I described in February, as credit spreads widened and industrial commodity prices fell: “Generally speaking, joint market action like this provides the earliest signal of potential economic strains, followed by the new orders and production components of regional purchasing managers indices and Fed surveys, followed by real sales, followed by real production, followed by real income, followed by new claims for unemployment, and confirmed much later by payroll employment.”

The charts below illustrate this sequence. First, order surpluses lead output. The chart below measures order surplus as new orders plus backlogs, minus inventories, based on standardized values of regional Federal Reserve and purchasing managers surveys, compared with the “headline” indices of these surveys three months later. The recent dropoff in order surpluses is an important economic concern here.

(click to enlarge)

Similarly, it’s clear that the overall change in these regional surveys over the prior 9 month period tends to lead changes in employment. The chart below compares the 9 month standardized change in these surveys with the average change in payroll employment over the following 3 month period (measured as an increase or decrease from the pace of the prior 9 months). The recent deterioration in regional economic surveys is consistent with a shortfall of about 200,000 jobs from the average rate of job creation over the past 9 months. Since non-farm payrolls have been increasing by about 250,000 new jobs per month, it appears reasonable to expect substantially lower but still somewhat positive job growth in the coming quarter.

Depending on the outcome, weaker employment growth may reduce the willingness of the Federal Reserve to raise interest rates, but the primary factor to monitor with respect to the stock market will not be the words or behavior of the Fed per se, but rather, whether market internals change in a way that indicates a shift toward greater risk-seeking by investors. Based on the response of investors during economic downturns after 2000 and 2007, we shouldn’t count on that.

(click to enlarge)

Scale Dilation

Among the features that make our world recognizable is that many things have the same basic shape, and the same basic movement patterns, regardless of their resolution. Trees, snowflakes, fern leaves and other objects often feature “self-similarity”; the smaller component parts look much like the whole. Likewise, a minute-by-minute chart of the stock market looks much like an hour-by-hour chart or a month-by-month chart. It’s just that the movements are on a different scale. Self-similarity is where the smaller parts of something resemble the whole.

A similar concept in geometry is the idea of “scale dilation.” But in this case, the relationship isn’t between the whole and its parts. Rather, scale dilation simply increases the size of the existing object by stretching it out. Here’s a nice example of scale dilation:

In my view, one of the reasons that market plunges feel so chaotic and disruptive is that investors don’t anticipate the scale dilation that typically occurs as risk premiums spike higher. In the stock market, this happens with regularity in every cycle. Put simply, the day-to-day market declines that investors have come to believe are significant today are child’s play relative to the range of movement that they should expect as the scale dilates over the completion of the current market cycle.

In 30 years as a professional investor, I’ve watched many of those dilations in real time, including those that followed the 1987, 2000 and 2007 peaks. What happens is this: as the scale dilates, investors seem to mentally cling to their experience of smaller fluctuations, so the large initial declines of a bear market are frightening, but also seem extremely enticing, because the rebounds after those initial declines also tend to be large and encouraging. That’s often why investors are lured into “buying the dip” early in a bear market. Those initial declines can end up looking quite small once the full scope of the market loss unfolds.

The following charts will give you a good idea of what I’m calling “scale dilation.” The first is from the 1987 market peak. What happened in 1987 was an abrupt spike in risk premiums. It was preceded by an extended period of overvalued, overbought, overbullish conditions that was joined by deterioration in market internals (conveying a shift toward greater risk-aversion among investors). The initial losses from the August peak seemed incredibly large, but the subsequent recovery into the first week of October gave the market the look of “resilience.” The red arrow shows that same point in early October from a broader perspective, after the scale dilation.

Note in the lower chart how tiny those pre-October daily bars look like relative to the daily bars during and after the crash. Since the lower chart covers more time, it’s obvious that the bars will be closer together in that panel. The thing to compare is the range of daily fluctuations and the amount of ground covered before and after the scale dilation, as risk premiums and volatility spiked higher.

(click to enlarge)

The next chart shows the same scale dilation after the 2000 market peak, on the way to 777 on the S&P 500. At the time, a 12% retreat in the S&P 500 seemed like a steep correction. The actual market loss would take the S&P 500 down by half.

(click to enlarge)

In 2008, the market experienced a similar scale dilation as risk premiums spiked higher. After an initial selloff from the October 2007 highs, the market recovered within 10% of its peak by May 2008. In hindsight, the seemingly wide pre-May market range was nothing compared with the extreme market fluctuations – even day-to-day fluctuations – that would eventually take the S&P 500 below the 700 level, wiping out more than 55% of the market’s value.

(click to enlarge)

While we can't rule out an improvement in market internals that might reduce our immediate downside concerns, my impression is that the relatively contained, low-volatility environment we’ve observed in recent months is not likely to persist. Over the completion of this market cycle, investors are likely to observe significant scale dilation – as risk premiums normalize in spikes and volatility increases. The dilation from contained losses to vertical losses is one of the primary causes of investor panic, because the dilated movements feel so out-of-character with recent experience. Factor this sort of behavior into your expectations. That’s not an encouragement to sell, provided you’re following a disciplined investment program and your risk exposures are carefully aligned with your investment objectives and horizon. Still, I very much hope that investors who are accepting market risk here are actually able to tolerate that risk.

Dow Theory: The Line Breaks

For nearly a year, we’ve observed a sideways congestion area in the market, characterized by extreme valuations, deteriorating internals, and widening credit spreads. In our view, recent trading activity has represented the distribution of stock from value-conscious and economically-sensitive sellers, with accumulation by price-insensitive corporate buyback programs and reflexive dip-buyers convinced that stocks can go nowhere but higher. Though every share sold must also be purchased, it is the relative eagerness of the buyer or the seller that determines which way prices move. For that reason, breaks out of these congestion areas are often viewed as significant, particularly when the breaks are confirmed by multiple averages.

Century-old writings by Charles Dow, Robert Rhea, William Peter Hamilton, and others associated these narrow ranges with potential reversals in the major trend, where the balance between different groups of investors shifts from greater eagerness to accumulate shares to greater eagerness to distribute them (or vice versa, when the market enters a congestion area at depressed valuations after extended losses). We don’t use Dow Theory explicitly in our own work, largely because we find that the broad uniformity and divergence of market internals across numerous individual securities, industries, sectors, and security types are more informative than using only the Dow Industrials and the Dow Transports. Still, investors should be wary of simplistic “tests” of Dow Theory (such as comparing the performance of the Transports to the Industrials, as if that alone is meaningful). Having codified and tested our own interpretation of Dow Theory, I’m convinced that the underlying principles are useful.

The essence of Dow Theory is to consider both valuation and market action – particularly joint new highs, joint new lows, and joint violations of prior support or resistance levels. On Friday, after an extended period of extreme valuations, both the Industrials and Transports jointly broke the initial correction lows that followed their joint bull market highs. Under our interpretation of Dow Theory, the major trend has turned negative.

Dow Theory is often misunderstood as a purely "technical" approach. Charles Dow would disagree. More than a century ago, he wrote “The best way of reading the market is to read from the standpoint of values. The market is not like a balloon plunging hither and thither in the wind. To know values is to comprehend the meaning of the movements of the market. Stocks fluctuate together, but prices are controlled by values in the long run.”

With regard to market action, the central consideration of Dow Theory is the uniformity of fluctuations across multiple indices, specifically the Dow Industrials and the Dow Transports. The basic idea is that confirmation by both indices is indicative of a robust trend, while non-confirmation and divergence should put investors on alert for changes in market direction. A joint high by both indices, followed by corrections of several percent in each, subsequent rebounds in each, and then a joint break below the prior correction lows, is the essential sequence that defines a trend shift.

As William Peter Hamilton wrote in 1922: “We can satisfy ourselves from examples that a period of trading within a narrow range – what we have called a ‘line’ – gaining significance as the number of trading days increases, can only mean accumulation or distribution, and that the subsequent price movement shows whether the market has become bare of stocks or saturated with an oversupply.”

Notably, it’s essential for strength or deterioration to be confirmed across multiple indices. Robert Rhea emphasized this concept in 1932: “Conclusions drawn from the movement of one average, not confirmed by the other, generally prove to be incorrect.”

The same lesson has been learned and re-learned by investors across a century of market cycles. When a previously overvalued, overbought, overbullish market is joined by internal deterioration – with numerous securities, sectors, industries and securities simultaneously breaking down, accepting market risk is typically not rewarded, and stocks instead become vulnerable to air-pockets, free-falls, and crashes. Range-bound markets, particularly at elevated valuations, often offer a false sense of security; making investors believe that their risk is low because day-to-day volatility is contained. Last week's market loss was initial and quite contained from the standpoint of current valuations. My view is that under the market conditions we presently observe, investors face the continued potential for steep, vertical losses. That outlook will change as market conditions change.

I’ll emphasize, as usual, that the message here is not “sell everything.” The message is to understand where we are in the market cycle from the standpoint of a century of reliable evidence, and to act in a way that meets your investment objectives. Align your portfolio with careful consideration for your tolerance for losses over the market cycle; with your willingness to miss out on interim market gains should they emerge; with the horizon over which you will actually need to spend from your investments; with the extent that you believe that history is actually informative for making investment decisions; with the extent to which alternative investment outlooks are supported by evidence, ideally spanning numerous market cycles. I am not encouraging buy-and-hold investors to depart from well-considered investment plans or to abandon their discipline; only that they take every step to ensure their portfolio is actually aligned with their true risk tolerance and investment horizon.