The Daily Reckoning UK

Have We Seen This All Before?

Darren Sinden

by

Posted 9th May 2017

As you know, I try to do as much background reading as I can on the markets.

This allows me to provide a fundamental narrative for the signals generated by my trading model (which is based on technical analysis).

Well, one thing that has struck a chord with me over the last week or so and that is how much market analysts and commentators are looking back in time.

In their view, we’ve entered a time tunnel and, depending upon which market strategy pieces you read recently, the current state of the markets is looking “a lot like the late 1990s”, or “a lot like 2007”.

Neither of which sounds like good news to me, because at both of these junctures we saw devastating corrections in global markets that came “out of the blue“, after prolonged periods of calm.

So just what are the similarities between now and the 1990s and 2007? Can or will history repeat itself? And if it does, what will mean for investors?

Firstly let’s be clear; the world today is a very different place from what it was twenty, or even ten, years ago.

For example, we now have the European single currency, which we didn’t have before 1999.

We also have a much more developed, active, and globally integrated Chinese economy – which has been the powerhouse of world economic growth for much of the 21st Century.

In fact, international trade and markets, in their widest sense, are far more engaged now than at any prior point in history.

And, of course, we can’t ignore the fact that we have also had a decade of loose monetary policy, culminating in negative interest rates in both Japan and the Eurozone, as well as in Sweden, Denmark & Switzerland.

All of this alongside eight years, and counting, of Quantitative Easing – during which trillions of US Dollars’ worth of money has been conjured out of thin air and pumped into the global financial system (that may yet turn out to be liability rather than an asset).

Given the differences above, let’s now examine the similarities with those historic situations mentioned above…

Are we in the calm before another storm?

Firstly, as we have noted, the markets are very docile at the moment. In fact, it wouldn’t be an exaggeration to say that lately you could “hear a pin drop” in the London markets.

For example, the average FTSE 250 stock has, at the time of writing, traded less than 25% of its average daily volume and changed price by +0.46%.

Of course, that’s just a snapshot of one moment in time in one particular market… but it is emblematic of what’s happening across the board.

In fact, it’s just one of the reasons why trading ideas have been a little bit thin on the ground recently – though there may be some upcoming action on one particular stock…

To find out which stock that is – and what action you’ll need to take to potentially bag a decent profit – you’ll need to become a member of my Trading Point Pro service.

Which you can do by clicking right here.

The level of investor apathy (or is it complacency?) can be said to be reflected in the level of volatility, or fear of loss, within the markets (a subject that we will look at in more detail in the future).

Suffice to say, equity volatility indices such as the CBOE VIX, are testing back to levels not seen since the mid-1990s or just before things hit the fan in 2007.

In fact, this week the VIX closed at levels only seen ten times since 1990.

Indeed Bank of America observed that realised, or actual, levels of volatility in the US markets had only been lower than current levels in a miniscule 3% of the time elapsed since 1928.

True, the bank also flagged that broader measures of global risk were faring better, though they were still towards the bottom end of their ranges.

Of course, just because we are revisiting some of these historic lows, doesn’t definitely mean we are teetering on a cliff edge – like we were in the 1990s and in 2007.

Yet research by strategists at Goldman Sachs drew further parallels with 2007 this week in a report that looked at the performance of stock market indices and the degree of correlation between them.

[Think of correlation as the tendency of a stock, index, currency or commodity to move in line with a price move in a peer – be it positively or negatively. Such that a change in the value of A results in a predictable change in the value of B.]

What’s interesting is, despite stock indices around the globe largely moving in the same direction (upward) in 2017, Goldman notes that the degree of correlation between these indices has been falling.

And that this degree of correlation has fallen to lows last seen in – you guessed it – 2007 and prior to that, in 2000.

Neither year ended positively for stock valuations.

Is it all just a coincidence? Or something more…?

Of course this could all be coincidental, or just a function of human nature. After all, as a species we are notorious for seeking and finding patterns and repetitive behaviour – even when in reality there are none.

My own personal belief is that repeating patterns of behaviour do exist and can be found in the markets. Though I must acknowledge that much depends on the timescales they are measured over and the metaphorical viewing point of the observer.

But, leaving the philosophy to one side for the moment, what we can say for certain is that falling correlations and rising equity indices does represent divergence.

Something that, in my experience, often means trouble ahead…

Looking through the indicators in my trading model, I find there is divergence between the S&P 500 Index and the NYSE 10 Day Advance Decline Line (the Advance Decline Line measures the number of stocks going up or down on the NYSE over a rolling 10 day period):


Click image to enlarge.

As we can see from the chart above, the Advance Decline Line (in blue) has moved away from the S&P 500 Index (in green).

Now, I must concede that the Advance Decline Line has had bigger moves lower (and larger divergence from the S&P) in both March and April this year and the world didn’t end.

Yet this type of divergence proved to be a very timely warning signal, ahead of sharp downturns in the summer of 2015.

So, for all of the reasons above, I will be looking out for more echoes from the markets of the past that may be relevant to us today.

 

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