Technical Backlash

The year has been challenging for technicians. That’s the abbreviated term for technical analysts who attempt to predict market moves based on chart patterns. In the old days – twenty years ago – I use to kid that technical analysts did two things well; 1) they always provided an explanation as to why markets did not move as expected and 2) they knew where to buy graph paper cheap! Today of course that’s all changed… most technical work is done on a computer!

Generally, technicians can find a plethora of chart patterns on which to make directional calls. Not so much this year, with markets seemingly gyrating in random patterns. To that point, consider last weeks’ tale of the tape, with Monday ending virtually flat followed by a two day 210 point sell-off on Tuesday and Wednesday. Thursday saw the Dow rally 180+ points, and Friday was yet another retracement of the triple digit variety. Random behavioral theorists would have been proud.

What we know from these events is that markets are being driven by sentiment much as they have been for most of the year. In short, traders are exercising an emotional response to daily snippets of information that may or may not have longer term implications.

Japan falls 20% over a three week period after having rallied more than 77% over the previous six months. The rally was the result of the massive amounts of liquidity being pumped into the Japanese economy in an effort to stimulate economic activity. In other words, the Japanese economy was being primed in the same way as the US economy and most of Europe. And the Japanese market was responding in kind.

If you look at this from a longer term perspective – i.e. longer than 20 minutes – the 20% sell off was a typical pullback after an unprecedented rally. Noteworthy is the fact that Japan had never before seen a 77% rally over any six month period. Even more telling was that among mature industrialized economies a rally of that magnitude over such a short time line had occurred only once before… 1933 when the US economy was in the middle of the great depression. For history buffs, that 1933 rally ended badly.

I suspect that it is not so much about the rallies and ensuing sell-offs, it is about the speed at which these events are taking place. Sharp hits to the pocketbook with no clear explanation about cause and effect – typically the mantra of technicians – means that traders, notably momentum driven hedge fund managers, are trying to navigate an unmarked road without a GPS. Typically, hedge fund managers follow the path of least resistance, which in this case means ratcheting back on the scale of their investments or, more likely, moving to the sidelines. Neither strategy is good for the market because it reduces liquidity, which amplifies day to day movements.

If I am right there are a couple of takeaways. The first is to recognize that we are seeing a spike in volatility which is good for options as higher volatility increases the amount of premium you receive when writing covered calls, cash secured puts or put spreads. I suspect this increase in volatility will be the one constant within an asymmetrical market.

The second is to reinforce the view that the best strategy is to hold Canadian blue chip dividend paying stocks, which minimize the impact of volatility. The dividends add stability, providing a foundation beneath the stock price, and by investing in Canadian companies you are working within an environment where returns are being dictated by economic activity rather than central bank induced liquidity. In other words, you have a built in GPS from which to navigate.

The Fundamental Line

When we think about fundamentals, it is about focusing on macro events that may succumb to day to day noise, but from our perspective have broader implications that affect longer term tends. And on that front, there are an inordinate number of cross currents driving the global markets, not the least of which is Japan, slowing growth in China and continued problems in the Eurozone.

Japan impacts us from two perspectives; 1) short term sharp selloffs in a Japanese stocks and 2) unprecedented gyrations in the currency markets. Both of which are tied directly to actions by the Bank of Japan.

China is a significant storyline because of the size of their economy. Traders see China as a secondary backstop should growth in the US begin to slow. The problem is that economists have been hard pressed to get a good read on China because of questions surrounding the reliability of the data.

Certainly, Japan and China are major issues that have longer term implications, but short term unanticipated shocks to the global financial system are most likely to come from the Eurozone. Yields have been rising among peripheral nations, notably Greece where yield on ten year bonds spiked to 10.6% (up from 8.5%) and Portugal, whose sovereign debt has spiked to 6.7% up from 4.5% earlier in the year.

Greece and Portugal provide talking points, but the real issue is growth, or lack thereof, and that affects all of the peripheral countries within the Eurozone. Without lower production costs, these regions cannot compete with countries like Germany, which itself is beginning to slow.

That backdrop is a two edged sword, as any reduction in worker compensation in the peripheral nations will slow domestic growth, which makes it difficult to sustain the current debt load. Choosing between a non-competitive environment, which is akin to death by a thousand pin pricks, and the political / economic implications of default sets up a no win scenario. It’s like filling a balloon with water… at some point something has to give. The resulting explosion will not end well and will likely come when least expected, leaving little time to react.

Despite these cross-currents, US stocks continue to climb a wall of worry. But that too offers little comfort, as it implies that US stocks are simply the best house on a bad street. The risk is that as volatility magnifies, the wall is harder to climb. At least that’s the halfhearted explanation posited by technicians.