Complacency Is Back | Stock Market Investing

Sunday, May 18, 2008 | Home | Andy Mayo

Rising stock prices are feeding a remarkable level of complacency in the market despite ominous signs of greater inflation ahead.  Historically, inflation has not been good for stock prices.

First the complacency.  The put/call ratio has dropped precipitously (heavy blue line, top graph) as the S&P 500 Index has risen since the March lows.  This indicates investors believe stock prices will rise in the future and is a contrary indicator.  The good news is that the upward trend that began in October has been broken.  But  as the many peaks in the graph demonstrate, reversals are inevitable.  A low in the put/call ratio would seem to be a risky time to become a buyer of stocks.


A longer-term view of the Volatility Index (VIX) shows that it too has dropped significantly, a sure sign of complacency in the market.  Tops occur when investors are complacent.  Peaks in the VIX, on the other hand, indicate bottoms in stock prices. 

However, if this decline signals a trend, we could be looking at a months-long rise in stock prices, as the first green arrow on the chart in Newsletter shows occurred in 2006.

So the question is -- are we in a similar situation to 2006?  From a fundamental position, certainly not.  We're in a recession with rising inflation.  How is the market behaving vis-a-vis 2006?   One way to compare is looking at the volume in advancing stocks versus the volume in stocks whose prices are declining.  It's a measure of market breadth.  The charts are here.

In both 2006 and 2008 the Advance-Decline Volume formed a triangle pattern.  In 2006 stocks broke to the upside.  The difference is that in 2006 the 10-day moving average rose from the July low in the market to its take-off in late August.  Today, the moving average is clearly sideways.  Rising prices without rising volume spells a weak rally, at least so far.

But there is no question that prices have risen, and other indicators of market breadth have improved with price.  The percentage of S&P 500 stocks trading above their 50-week moving average broke solidly above its 50-week moving average last week, and the percentage of stocks in a bullish point-and-figure pattern also advanced well-beyond it moving average.

Two problems confront the market:  Inflation and the Financials.  The exchange-traded fund for Broker-Dealers, IAI, appears locked in a trading range between 40 and 43.  Historically, Broker-Dealer stocks have been bellwethers.

Bank stocks do not offer any rosier of a scenario.  But the difference between the big bank index (BKX) and the regional bank index (KRX) is striking.  Big banks, of course, participated in the "asset"-backed derivative junk -- CDOs, SIVs, CLOs -- which the financial engineers fantastically claimed was reducing risk by spreading it around further.  Those guys hadn't heard of moral hazard, I guess.

We have negative divergences in place between both bank indexes and the broad market, as these charts comparing BKX and KRX to the Wilshire 5000 show.  It seems like a time to be cautious.

And a good reason to be cautious about stock prices is inflation.  One inflation measure is the ratio of the price of lumber to the price of the long US bond.  This ratio has turned around dramatically and closed on Friday right t its 50-week moving average.  Quite a reversal up.  As you would expect, the yield on the long bond (TYX) has also advanced, driving bond prices lower.

Finally, there's gold.  I've talked recently about the head and shoulders pattern in the exchange-traded fund GLD.  That pattern appears to have failed.  As this chart shows, GLD broke well above the neckline and closed just below its 50-week moving average on Friday.  So higher gold prices seem likely.  Commodities (CCI) also have maintained their upward trend after breaking out of a triangle pattern earlier this month.

Historically, the period between June and a presidential election day has been positive for stocks and it may hold true this year as well.  But that doesn't change the negatives hanging over this market -- weakness in the financials, rising interest rates and inflation.

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