We came to this juncture where the spread in between the 5 yr bonds and credit growth is narrowing down to the levels where a market correction starts. For me, the best indication of the market direction has been the commercial credit growth. The world economy is so industrialized that the small investors' money don't matter, the savings don't matter, the cash level of the funds don't matter since everything has to be financed to produce a competetive product and create the real earnings.
The real earnings or the economic profits will drive the growth, the spending and stock market gains via the corporate buybacks, increases in the 401k savings that will eventually flow into the markets, but the spread in between the commercial credit growth rate and the bond market will always lead the economy by a clear 9 months. I call this "the liquidity spread", I don't know whether this was studied in the exact way I did in the literature, I am sure somebody did somewhere. I learned that some track the spread in between the junk yields and the treasuries yields, but these did not really give me enough correlations about the amount of liquidity flowing into the markets out there, but my research goes on...
The liquidity spread can grow either by increased economic activity, strong growth, or reduced financing costs, or lower interest rates. When the commercial borrowing increases and the interest rates are relatively high, you have to be aware that it is an inflationary blow off. Similarly, when the rates are low and the commercial borrowing increases, it is a bear market or correction bottom. The interest rates are driven by the currency rates, when the currency is weak, you can not expect the interest rates to come down significantly, instead you have to watch whether the liquidity out there is capable to grow through borrowing or the inflation that begets more inflation...
The speculation comes when the spread grows much faster than the 5 yr bond yields forecasts the inflation. It is a natural phenomenon, people will always abuse the system. Do not blame it on the bulls or the bears. I also believe that the bearishness has to do with the free cash the people have, while the bullishness has to do with the easy credit. When the people are bullish in the United States, you can bet they are abusing the easy credit and that they are getting burried in debt. While the bearishness increases when the rates go up and they can hardly pay that debt...
Given this knowledge, why the market itself don't act on this liquidity spread when it turns? Simple, there is not enough money created yet. However, the market will probably turn around abruptly when this liquidity spread starts to increase since it means new liquidity is being and will be created and eventually the compounding effect will trigger and feed onto itself. This is how the financing based economies work, do not be scared of the debt as long as you can grow faster and keep the inflation under the control, this is the premise...
I've been posting many examples about the liquidity spread and predicting the IT top by March --since we still don't know yet whether it is in and the energy didn't still break down, but I don't know why it is the dominant 9 months (40 wks) similar to the Hurst cycles and not 7 or 10, it is not perfect but I believe this might be the response rate of the economy and it also explains why the stock market leads the economy by about 6 months at least. It has momentum and cyclical components and strong intermediate term implications.
Once the liquidity spread starts to change, I look at the sector rotations to understand whether the liquidity is producing real growth or rather mostly inflation.
Here's how I track the S&P's 9 major sectors. The financials and the consumer discretionary reacts to the lower rates or inflation first. This is the most profitable phase due to the significant growth opportunities in the liquidity spread. Whether the rates are low or not compared to the inflation, the next economic sector to benefit from the liquidity spread is the technology, it marks the beginning of the true bull trends since the technology lowers the cost and increases the efficiency and extends the lifespan of the bull markets.
The industrial indices and the service sectors start to outperform later as the technology starts to fade off and these are generally inflationary issues. The financials should generally start to underperform from this point on. The industrial sectors will increase the resource utilization while the salary increases in the service jobs will be generally permanently inflationary until a recession or deflation takes place. So, the material and energy sectors and the health care sectors usually rally at the end of the bull markets and mark the inflationary tops.
It is important to track the last significant economic sector or utilities during the declines, if the utilities decline with the corrections, they usually mean reduced resource utilization and less need for energy etc, this usually signals a recession or extended correction. The cycle starts again when the financials starts to outperform the markets. This usually coincides again with the lower rates and the increasing liquidity spread.
Technically, it is also important to notice that the sector structure is a fractal pattern that will repeat at the lower time frames, but the randomness will also increase due to the news or out of the ordinary events. These are better tracked by the frequency and phase changes in the cyclical tools for the market timing purposes according to my observation.
I have only one consistent observation about the options market. The market will tend to close above the dollar weighted median prices of the open interest (max pain) during the uptrends and below it during the downtrends. But I would look at the months ahead, not to the front month since it is mostly used for hedging. The max pain only makes sense in terms of the changes and not in the absolute amounts, so I only observe the change of the spread in between the current prices and max pain points and the changes in the open interest whether it occurs in the direction of the major trend. When you see a lot of volume in the options and not much change or a decline in the open interest, that's usually a warning about a pending trend change...
In the longest time frames, the tech topped in 2000 and we are seeing the top of the commodity and resource issues since last May. If the utilities correct significantly over the next several months, you can bet that the bear market that has been going on, whether some of the indices are making new highs or not since 2000, will end with a deflation with or without a strong bounce or new highs into 2008-2009. Otherwise, this major trading range since 2000 will continue until the techs find their true bottom and increase the economic profits exponentially again. I find the current consumer products not significantly improving the economic profits such as lower energy costs, more productive hours or other revolutionarily better factors than it did in the last decade.
My guess is a major low will come around 2012-2013 for the multi-decade bull market or at the 9 yr cycle low of the Hurst Cycles, you may call it the beginning of the 3 of 3 or whatever. We have talked about these several times, they are all in the archives. In the mean time, I believe the harder the indices try to escape with these inflationary blow offs, the harder they will fall back and this market has certainly tried too much of the former lately...
About the crash calls for 2007, it will not come before the market exhausts all of its inflationary powers or the breath deterioration. I think even if the market corrects in the IT sense until April around 5-6% on the SPX basis, it will still take several weeks after that until the breath makes a divergent top (lower or higher high) around early May. I think a decline can severely accelerate if the liquidity spread does not turn around significantly by a summer bottom around 12% discount from the current prices or 1270-1280 on the SPX basis. Then, perhaps a crash thereafter, but I don't think a 20-30% decline is in the cards right here, I consider it as the lower odds. Ideally, I am predicting an AB=CD symmetric decline toward 12% until the middle to late summer and about 3-4% bounce from early April until May.
In any case, the volatility will expand or the entire hedge fund industry that is most active in the derivatives market and provide significant price stability will completely migrate to London, they will not let that happen...
Finally, why did I post all of this? Well, the time passes, the needs change and I might go away for a long time from the board with the approaching birthday of our second baby. Don't think that I am leaving the good fight, hell not! I learned a lot here, but my conclusion is the pure technical analysis is somewhat a woodoo when not considered in the proper economic context whatever style you use. After all, the composite price (or index) patterns are only the ripples at the surface of the big economic ocean, try to understand the waters, before surfing its waves...
Agree or disagree, just make sure to comment!!!
Good luck,
- kisa
Very well written, articulate, and generous; a great contribution to everyone here. Many thanks. Good for study. This post should be in Investor's University with all it's information.
