Short Term Observations: 19 October

Short Term Observations: 19 October 2007
And Another Hindenberg Sighting (Does It Matter...?)

The losers among the major sectors I watch are numerous, with the majority of them showing losses greater than 1%, including the important financials. The banking sector is severely oversold at this point. The BKX Banking Index has closed in negative territory for seven consecutive days, the first time since the July 2002 low that it has done so. Over the last 14 years, this has happened only four times other than currently. The 10-day return going forward was positive all four times with an average return of +3.2%. The maximum gain during the next two weeks averaged +7.2% compared to an average drawdown (i.e. maximum loss) of -4.3%. Here are the dates: 09/21/93, 08/05/99, 06/14/01, 07/22/02.

We get somewhat similar results when looking at the hugely negative 10-day rate of return in that index (it has dropped about 7% in the past two weeks), and with that index testing its August lows, I'm starting to look for a bounce from that group— not necessarily a major low, but at least a bounce.

If banks do bounce, then that would almost certainly help prop up the broader market, which seems in dire need of some propping up. Earlier this week, I noted a handful of short-term positives, but those were mostly sucked up in Wednesday's gap up open. We've done nothing but flop around since getting some short-term oversold signals a few days ago, and that is not typical behavior during strong, healthy up-trends.

What makes this more disturbing is that this loss of momentum is coming on the heels of a barrage of "excessive optimism" readings from some of the more intermediate-term indicators— with examples ranging from small options traders to newsletter writers to Rydex traders, all showing extreme readings.

I'd like to touch on another potential negative, simply because it is getting quite a bit of attention. It is called the Hindenberg Omen. This market crash signal is generated when there is a big split in the market, with at least 2.2% of all stocks traded on the NYSE hitting a new 52-week high, and another 2.2% (or more) hitting a fresh 52-week low. (There are some other parameters involved to validate the signal, depending on the expounder.)

I have some issues with data like this because it crosses the border into data-mining. Give me enough computer power, and I'll find a combination of indicators that has predicted 100% of the market crashes...but would be meaningless going forward.

The thing with the Hindenberg Omen is that it has been around, in real-time trading, for decades, and has continued to have a moderate-to-good success ratio at preceding (severe?) market weakness. The last time we got two consecutive days with a Hindenberg Omen (we got three in a row this week, by the way) was July 23rd of this year, which was obviously an excellent sell signal. Going back to 1965 and looking for any unique period when we had two straight days with a Hindenberg Omen, I can find 20 occurrences. Returns going forward were modestly weak in the short-term, up to 10 days later, but became successively weaker as I went further out, up to three months later. Looking at those three-month returns, the S&P 500 was positive only 6 of the 20 times (30%), with an overall average return of -1.9%. The maximum gain during those months averaged +4.9% compared to an average drawdown of -8.7%. There were two big failures, in October 1995 and January 1998, but other than those two one would have been well-advised to exercise caution after these signals. The max loss / max gain ratio without those two instances was 3-to-1.

Again, I have some trouble staking an investment outlook on this signal because of its origination and the various ad hoc rules surrounding it, but it has proved itself over time to be somewhat better than chance at successfully highlighting periods of questionable market performance. It's another thing to add to the other potential negatives.

I have substantially pulled back from trading positions, based on seasonality, the inability of the market to rally well from short-term oversold conditions, and various other negatives. I'm still looking to buy into severely oversold conditions, but I also want to be a more aggressive seller of overbought ones. Currently, in the short-term, we have neither and I am standing pat, waiting for the next possible opportunity.

Why a [Further] Fed Ease Might Not Mean What You Think

The most talked- and written-about event in recent memory is the upcoming FOMC meeting. On Tuesday, the Federal Reserve will announce whether they plan on making a change to their short-term interest rate target. FWIW, my bet is with the consensus; a further ¼ point easing. I am still looking for strong stocks and a rebound in the dollar (negative for gold) in the coming year.

BOTTOM LINE:

• There have been eight Fed easings in the past 30 years.


• Those easings have been good for stocks and the U.S. Dollar.


• The easings have not been good for gold or commodities in general.


• Before making snap judgments, it's always best to look for historical precedents.

Based on historical movements between current short-term market rates and Fed target rates, it's clear that we should expect a cut on Tuesday, but times are strange.

According to the consensus, there seems to be no question that when the Fed cuts rates, stocks will rise, the U.S. Dollar will fall and gold will rise. There is so much consensus on that opinion that it seems a foregone conclusion.

The idea that stocks will rise I can understand— that argument has a solid historical precedent. But the other two are anti-historical! Surely, the current situation is different from others over the past 30 years (it always is), but it isn't just interest rate differentials that drive currency movements.

There have been eight instances since 1971 when the Fed lowered the discount rate after a period of raising them, or going more than a year with no changes. I used the discount rate as opposed to the federal funds rate because, until recently, the discount rate was the primary tool of the Fed, and that historical data is much more precise.

Not only that, but the two rates have moved pretty much in lockstep. In some instances, the Fed data is somewhat ambiguous, with no actual date given of the Fed action, so I had to make an educated guess as to the precise date of their change.

It's pretty clear what the general trends were. The following table shows the average returns and average maximum gains/losses in each category over all the instances:

                         1-Year        Max          Max
  Index                  Return        Gain         Loss
  DJIA                   +18.8%       +25.0%       - 5.7%
  US Dollar              + 4.5%       + 9.0%       - 3.0%
  Gold                   - 5.4%       +10.0%       -16.2%
  CRB                    - 6.2%       + 4.3%       -11.0%
Conclusion:  Fed Ease Good for Stocks, Dollar; Bad for Gold, Commodities

While it's always dangerous to make gross generalizations based on history, ignoring that same history is even more dangerous. From the precedents that we have of prior Fed easings after a prolonged period of not doing so, the conclusion (as noted) is clear.

Long-term Treasury Bonds had a very mixed record. Half the time they went up, half the time they went down, and there was no clear bias either way.

The idea that a cut in short-term interest rates might be good for the Dollar and bad for gold is absolute heresy, according to the received truth of our financial gurus. And maybe that will be the case this time. But instead of relying on someone's unsupported notions, it's a good thing to check the record first, and that exercise illustrates that making such a snap judgment might not be the brightest of ideas.