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By Jason Pearce

Prices in the North Could Head South

Everybody loves a good market bubble story!  If that’s you, you’re in luck because it looks like we may have one in play just over the border.  Although it doesn’t grab all the headlines here in the US, the housing market up in Canada is certainly a hot topic.

There are some analysts who liken the current Canadian housing market situation to that of the US housing market a little over a decade ago.  That’s not entirely accurate, though.  Don’t expect to see a foreign version of The Big Short in theaters anytime soon.

On the other hand, there are enough parallels between the US housing market demise and the current situation in the Canadian housing market that that one has to wonder if a major shakeup is imminent.

To the Moon

We all remember how ridiculous the housing prices got when the bubble in the US peaked in 2005.  But did you know that Canadian housing prices experienced a run-up, too?  Even better, the Canadian market did not collapse when ours did.  It stayed elevated until 2007 before the financial crisis finally pulled the rug out from under everything.

Fast forward to a few years later and the Canadian housing market has fully recovered.  It surpassed the prior peak by a country mile.  Here’s the real kicker: Canadian housing prices have exceeded the 2005 US housing prices by a large margin!

 

Some might immediately think that the higher price reflects the exchange rate.  The Canadian dollar is significantly lower than the US dollar, so Canadian houses should naturally show a higher price tag.  But when you compare the average house prices for Canada and the U.S. with both denominated in U.S. dollars, it reveals just how expensive the Canadian housing market is.  It has surpassed the U.S. bubble’s peak.

 

Adjusted for inflation, not only has the Canadian housing market blown past the peak of the US housing bubble, but it has now matched the real estate bubble of Japan from the 1980s.  That certainly didn’t end well.

The Lead Sled Dogs

Vancouver and Toronto are the two Canadian markets leading the charge in this housing bubble.  Their price gains out-paced the rest of the country.  So you can’t say that someplace like Ottawa is just as frothy as Toronto.  However, these top growth markets are still having an impact on the entire Canadian housing market.

 

To get a feel for how far things have gone, compare the Vancouver and Toronto markets to places like Miami or San Francisco during the US housing bubble.  You quickly surmise that these two Canadian cities have outperformed the cities that led the charge during the US boom.

The Bigger They Are…

Since Vancouver and Toronto went up more than the rest of the metro areas, it stands to reason that they should also go down the most.  But that does not mean the other areas will not also go down decline.

But it is possible that the negative psychological effect of a falling housing market could increase the rate that other metro areas go down with Vancouver and Toronto.

What we are talking about here is beta.  For example, if one metro area went up 50% as much as Vancouver and Toronto, we’d say it has a beta of 0.5.  But what if the beta increases to 0.6 or 0.7 during a decline?  It would mean declines of 60% or 70% as much as Vancouver and Toronto.  It’s certainly not a guarantee that we would see a beta increase, but you can’t rule it out either.

No Subprime Crisis

One major difference between the US housing bubble and the current Canadian housing market is that Canada doesn’t have a major chunk of the real estate market tied up in subprime garbage.  The higher lending standards of the Canadian banks are the whole reason that they didn’t suffer the same fate as the US when the last housing bubble popped.

 

Currently, subprime loans make up about 5% of all mortgages issued in Canada.  When the crisis hit the US market, roughly 21% of all U.S. mortgages were subprime.  Therefore, the Canadian housing market is not quite as risky as the US housing market was a little over a decade ago.

But notice that I did not say that the Canadian housing market is risk free.

Home Owners Are Stretched

Predicting where a bubble will peak is a tough business.  But you can get a sense of how mature the run is when the buying capacity is stretched.  When there’s no one left to buy, there’s no more upside for the market.

 

Right now, buying capacity is spread pretty thin.  The Canadian household debt-to-income ratio is well beyond what it was at the 2007 peak.  Ominously, the Canadian household debt-to-income ratio of nearly 170% is getting awfully close to where the US household debt-to-income ratio peaked during the US housing bubble.

The household debt-to-income ratio does not take mortgage fraud into account, either.  Lending agency Equifax Canada reported that the number of “suspicious” mortgages have increased 52% over the last three years.  With two-thirds of the mortgages in Ontario flagged as “suspicious” it is conceivable that households are stretched even further than the official numbers state.

Wheels Set In Motion

The housing market may have finally peaked as the government took action to douse the speculative frenzy.  Last summer, British Columbia passed a law to make foreign buyers of Vancouver real estate pay a 15% tax.   Furthermore, the federal government changed the rules for all insured mortgages that make it more difficult for buyers to qualify.

 

Not surprisingly, the changes in Vancouver had a major impact on the market.  Over the last 12 months, home sales have plunged 40 percent and home prices have started softening as well.

The Next Shoe

Ontario has yet to reign in the out-of-control housing market.  Therefore, prices in Toronto are up nearly 23% from a year ago and supply is only half of what it was then.  Ironically, experts are saying that the crisis is actually the shortage of supply!

Despite the supply shortage, you have to wonder how much more housing prices can increase if there is not a corresponding increase in the buyer’s income.  As we’ve already seen, buyers are already stretched thin with a household debt-to-income ratio that rivals that of the US household debt-to-income ratio at the peak of the housing bubble.

History Repeats

When the Toronto housing market bubble finally pops, it won’t be a new experience for homeowners.  If history is any guide, it will not be a pleasant event.

Toronto housing prices peaked in 1958, softened for years, and finally bottomed out in 1964.  In 1966, prices finally returned to the 1958 peak.  That was an eight-year round trip.

The next major top occurred in 1974.  Housing went into an eleven year bear market and posted the final low in 1985.  It wasn’t until 1987 when the housing market finally matched the prior peak.  That’s a thirteen-year wait to breakeven for Canadian homeowners who bought in 1974.

The rebound off the 1985 low turned into a full-blown bubble.  It finally popped in 1989 and began a multi-year decline that didn’t end until 1996.  Adjusted for inflation, this decline knocked a whopping 40% off the housing prices.  Furthermore, it took a little over twenty years for the Toronto housing market to return to the 1989 peak.

 

Adjusted for inflation, current Toronto housing prices are substantially higher than where the last bubble peaked.  If history were to repeat, this will be followed by a multi-year bear market.  Investors who believe that “It’s different this time” are in for a rude awakening.

Nothing to Worry About

Logically, more housing market price gains similar to what has already occurred are economically unsustainable.  Besides, the housing market in Vancouver –one of the leaders in this bubble- is already slowing down significantly.

Despite these facts, there still isn’t much concern for the potential downside.  When people aren’t prepared for an adverse an event, that’s when they are the most vulnerable.

 

For example, while saying that the Canadian housing market growth may slow down, Moody’s Analytics said nothing about the growth actually stopping or even reversing.  Their big warning is that national house price growth will drop to from about 8% right now to about 2% by the end of 2018.

This is unsettling.  It reminds of the summer of 2005 when Ben Bernanke, the Chairman of the Council of Economic Advisers, said,” Housing prices are up quite a bit; I think it’s important to note that fundamentals are also very strong. We’ve got a growing economy, jobs, incomes. We’ve got very low mortgage rates. We’ve got demographics supporting housing growth. We’ve got restricted supply in some places. So it’s certainly understandable that prices would go up some. I don’t know whether prices are exactly where they should be, but I think it’s fair to say that much of what’s happened is supported by the strength of the economy.”

 

Then in February 2006 when he was the new Fed chairman, Bernanke said, “The housing market has been very strong for the past few years . . . . It seems to be the case, there are some straws in the wind, that housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise, but not at the pace that they had been rising. So we expect the housing market to cool, but not to change very sharply.”

So much for the assuring words of the experts…

More Potential Catalysts

We already covered the reasons that the Canadian housing market bubble may have started to deflate.  Heck, it could even pop.  But what we did not get into are the other potential events that could raze the Canadian housing market.

What if the bull market in stocks pauses or even comes to an end?  Household wealth levels would decline.  Home values would likely get dragged down with it.

Canada is a big-time commodity producer.  Another break in the price of crude oil, gold, or the grain markets would have an adverse effect on Canada’s economy.  Housing markets would likely feel the impact.

If Ontario finally wakes up to the danger of the housing market bubble and changes the rules like BC did, we should expect the same outcome: a drop in both home sales and home prices.

 

What if the economy, the stock market, and commodities all stay strong and the boom times last?  Eventually, that could drive the Bank of Canada to decide that tighter monetary policy makes sense.  An increase in interest rates could become the proverbial straw that breaks the camel’s back.

How to Play It

It’s not like a trader or investor can “go short” on a Toronto condo or a Vancouver house.  And although the CME has futures contracts on major US cities like Miami, San Francisco, New York, Las Vegas, etc. there currently aren’t any for Canadian cities.  But perhaps one way to trade a decline in the Canadian housing market is to short their banks.

Right now, this may sound crazy.  Moody’s Investor Service says the Canadian banks would perform better in a housing market downturn than the US banks did.  The big Canadian banks have been around forever.  They have weathered the prior financial crises and came out on the other side.  Furthermore, they pay generous dividends and most of them have recently reported increased income.  What investor would want to sell their shares in a bank with such a great track record?

But that doesn’t mean that they haven’t experienced setbacks.  And it sure doesn’t mean that they won’t in the future.

According to the Toronto Stock Exchange, Canada’s banks are already being heavily shorted right now and in a much bigger way than similar-sized companies.  But according to the stock price of these banks, the short positions have been mostly wrong for months.  Why?  Because the price has been trending higher for months.

Trend Change Afoot

Despite the case for the Canadian housing bubble to pop, a trader should look for price confirmation before acting on any theories.  This is that timing part of the equation.

Right now, we may be finally getting that confirmation as many Canadian bank stocks have started to deteriorate over the last couple of weeks.

 

First off, some of the banks stocks may be establishing a classic Double Top pattern by trading within pennies of their prior highs and then stating to pullback.  Royal Bank of Canada (RY) and Bank of Montreal (BMO) both fit this bill as they neared the 2014 record highs and retreated.

 

Both of these stocks are now dangling just above technical support between their rising 50-day Moving Average and last month’s low.  A close below the 50-day MA and a break of a prior month’s low –neither of which have happened since November- could put further pressure on the stocks and drive it down to the widely-watched 200-day Moving Averages.  This could increase the odds that a major top is in place.

 

Toronto Dominion (TD) is even more intriguing.  This stock surpassed the 2014 record high by nearly $1-per-share and then pulled back sharply.  This is what I have coined the Wash & Rinse sell pattern.  By definition, this is a failed breakout pattern where a prior high is surpassed and then the market quickly reverses lower.  The Wash & Rinse can often lead to major declines.

 

Furthermore, Toronto Dominion got crushed on Friday as it dropped 5.31% and broke the rising 50-day Moving Average for the first time in five months.  The stock also plunged below a prior month’s low for the first time in nine months.  Ideally, a bounce back to last month’s low or the 50-day MA (old support, once it is broken, becomes new resistance) would materialize and allow for a nice entry point.  If successful, the position size could be increased aggressively if new corrective lows follow.

 

Finally, there are a couple of stocks that never got close to their prior highs.  They become short sale candidates by virtue of comparative weakness.  They are the worst-performing of the bunch and vulnerable to getting hit the hardest.  Bank of Nova Scotia (BNS) and CIBC (CM) are the two that I am talking about.  Is it any coincidence that CIBC has the highest real estate exposure and it’s one of the worst looking Canadian bank stocks?!

 

Bank of Nova Scotia already cracked support at the 50-day Moving Average and prior month’s low, while CIBC has not.  This means that Bank of Nova Scotia is currently more qualified for a short sale than CIBC.  Once CIBC has violated these same technical levels, it will show that it is also ripe for the picking.

Be Smart

Sometimes, traders think they’ve found the once-on-a-lifetime trading opportunity.  One that’s almost a sure thing.  One that could create the kind of fortune that lasts for generations.  Maybe shorting Canadian banks will be the most talked about trade next year and you’ll hear all the stories of the next John Paulson’s of Canada who made billions of dollars betting on it.

If you get into a trade and it starts to go your way, great!  You can short even more Canadian bank stocks if they keep dropping and your current positions are all showing open profits.  The winners take care of themselves so we don’t need to go too deep into a detailed discussion.

The problem, however, is that we could always be early.  Worse yet, we could even be completely wrong.  One never knows that a trading opportunity is a sure thing until it has gone on the record books as a matter of history.

How many people were shorting European bonds once the yields dropped to near zero percent?  Here we are a few years later and yields are now negative.  Although it seemed like a no-brainer at the time to bet on rising yields, it was completely wrong.  A lot of good traders broke their axe on that stone.

 

So do the smart thing and focus on managing your risk.  This should be your top priority.  There’s a great Wall saying, “Bulls make money, bears make money, but pigs get slaughtered.”  Don’t ever bet the farm on any trade idea and don’t add to a losing position.  As a matter of fact, the only thing you should do with a losing position is liquidate it.

 

 

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victor.sperandeo

In this episode, Michael Martin speaks with faculty member Victor Sperandeo about US Interest Rates and the upcoming elections in Europe. Sperandeo teaches the in-person Master Class was featured in New Market Wizards by Jack Schwager and has been trading since the late 1960s.

Go here to get notified the Master Class.

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themis trading

We have long been concerned about the information that is leaked through proprietary exchange data feeds. One suggestion that we have made to fix this problem is to limit the amount of information that these data feeds are allowed to distribute. This can be accomplished by requiring exchanges to obtain an “opt-in” from their customers before they include sensitive information (such as information on individual order cancellations and revisions) in their data feeds. Another way to limit information leakage is to aggregate orders by price level rather than distribute order by order information. This is exactly what IEX has just proposed. In a February 28th filing, IEX proposed:

“The Exchange proposes to amend Rule 11.330(a)(3) to describe a new market data product to be known as DEEP. Currently, the Exchange offers TOPS, an uncompressed data feed that provides aggregated top of book quotations for all displayed orders resting on the Order Book and execution information (i.e., last sale information) for executions on the Exchange…As proposed, DEEP will disseminate, on a real-time basis, aggregated depth of book quotations for all displayed orders resting on the Order Book at each price level for securities traded on IEX (i.e., displayed top of book and full depth of book quotations) and execution information (i.e., last sale information) for executions on the Exchange. DEEP will be provided free of charge.”

The IEX depth of book feed is different from other exchange data feeds in two significant ways:

1) No information about individual orders is disseminated through the IEX feed. Only aggregated quantities for ten price levels will be distributed. An aggregated view provides information about displayed supply and demand but does not sacrifice individual order information. Other exchanges that provide individual order feeds are distributing information that could be gamed. In addition to blatant leakage examples like the Retail Attribution identifier, other data feeds provide constantly changing quotes and queue position on their depth of book feeds. These flickering quotes are often representative of HFT and electronic market maker quotes. And by deduction, orders that do not have retail attribution or are not flickering must be institutional.

2) There is no charge for the IEX data feed. This differs dramatically from the other major exchanges that have turned data feeds into substantial profit centers.

IEX continues to innovate and provide the market with investor friendly tools as opposed to the other exchanges that only seem to care about their own bottom line. While other exchanges try to appease their HFT clients with new order types and more favorable rebate schedules, IEX continues to focus on the traditional investor. While other exchanges try to sneak proposals past the SEC like Nasdaq’s failed Retail Post-Only order, IEX continues to try to level the playing field. While other exchanges try tricks like an inverted fee schedule, IEX maintains a conflict-free flat take/take fee schedule.

Other exchanges are trying to copy IEX with speed bumps of their own but they don’t seem to understand that copying a speed bump alone doesn’t make you an investor-friendly and trustworthy stock exchange. To gain this status, they would need to rid themselves of all their other conflicted products such as colocation and individual order data feeds. And we just don’t see them giving away that type of revenue.

This is a guest post by Sal Arnuk and Joe Saluzzi of Themis Trading LLC. It is published here with their permission. All emphasis is by original authors.

I can’t think of two guys who have been more at forefront of fairness in trading. This effects everyone who trades now and who will trade going forward. Along with their partner Paul, Joe and Sal have been relentless in their campaign to fight HFTs and charlatanism in trade execution.

Follow Joe Saluzzi on Twitter

Follow Sal Arnuk on Twitter

My own take is that the exchanges have become cable companies: they distribute entertainment. You subscribe to the exchange data feed like you would for HBO or Showtime, but you still have exchange clearing fees and execution fees to pay on top of that. That’s like subscribing to a premium channel such as HBO and still having to pay a Pay-Per-View fee on top for each show you watch on HBO.

Decimalization was supposed to cut the cost of trading by eliminating pricing in 1/8ths and fractions that had been the mechanism since forever and thereby decreasing the bid-ask spread. But technology and capitalism have evolved in step with decimalization.

If the exchanges want to continue to colocate servers and provide an edge to the HFTs on execution, then they ought to give away real-time quotes to trader/subscribers since they will undoubtably lose a great deal of capital due to slippage and skid caused by the very traders who have been sold the trading edge by being allowed to colocate their server.

Given these changes, it’s time for the exchanges to stop double-dipping and significantly lower or cut the “live” exchange data fees.

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call delta

The following is an excerpt from Managing Expectations by Tony Saliba

Option Delta

 

The risks related to options are many and include path dependency, implied volatility, and the passage of time. These risks can be calculated with figures produced by simple mathematical formulas known as greeks, as most use greek letters as designations. Each greek estimates the risk for one particular variable.

Delta is the sensitivity of an option’s price with regards to the movement of the related underlying future or security. It is expressed both as a percentage and a total. A call option with an estimated 25 delta suggests that the call option is one-quarter as sensitive as compared to the corresponding underlying. It implies that you would need 4 25 delta options to replicate the performance of a one-point move in the underlying.

• Professional traders think of an option’s delta as a hedge ratio; to what extent the option offsets or emulates the underlying. Professional traders learn very quickly that an option’s delta is only useful for a fractional move within that precise snapshot of time which it is calculated. An option’s delta can and does lose its relevance when there are changes in time, movement, and implied volatility.

• From a pedestrian viewpoint, it appears logical to envision an option’s delta using a simple equiprobable decision tree (i.e. a 50% chance of either an up or down move in the underlying) to price a call option. Yet this mind thought is dangerously flawed due to the conceptual problem of linking the resultant delta value with a probability.

Probabilities are beneficial when assessing risk with defined and limited outcomes. Applying probability or overemphasizing them in a financial world chock-full of infinite combinations can be dangerous indeed. Delta is a best-guess estimate at a given point of time and place – it’s nothing more and nothing less.

Delta Details – Positive & Negative

 

To reiterate, an option’s delta is a mathematical expression that estimates how much the theoretical value of an option will change with a 1-point move in the corresponding underlying. It is the amount whereby an options trader would consider himself “dollar-neutral” compared to the underlying.

The delta of a call option spans from 0.00 to 1.00; the delta of a put option spans from 0 to (-1.00). Positive delta means that the option is estimated to rise in value if the asset price rises and is estimated to drop in value if the asset price falls. Negative delta means that the option position will theoretically rise in value if the asset price falls and theoretically drop in value if the asset price rises.

• Long (purchased) calls always have a positive delta; short (sold) calls always have negative delta.

• Long (purchased) puts always have a negative delta; short (sold) puts always have a positive delta.

• Long (purchased) underlying always have a positive delta; short (sold) underlying always have a negative delta.

• The nearer an option’s delta is to 1.00 or (-1.00), the more the price of the option responds like the actual long or short underlying when the underlying price moves.

Delta Details – Changes in Volatility & Time

 

Delta is a best-guess estimate – susceptible to changes in volatility and time to expiration. The delta of at the money options (i.e. .50 delta call or put) is relatively invulnerable to changes in time and volatility. This means that at the money options with six months remaining to expiration compared to at the money options with one-month to expiration both have deltas very similar to .50.

However, the further divergence away from the money an option is, the more susceptible its delta will be to alterations in volatility or time to expiration. Fewer days to expiration or a decrease in volatility push the deltas of in the money calls closer to 1.00 (-1.00 for puts) and the deltas of out of the money options closer to 0.00.

Consequently an in the money option with 10 days to expiration and a delta of .80 could see its delta grow to .90 (or more) with only a couple days to expiration without any movement in the underlying.

Similarly, an out-of-the-money option with 10 days to expiration and a delta of .15 could see its delta drop to a .10 delta without any movement in the underlying. Lastly, an at the money option with 10 days to expiration and a delta of .50 will see its delta remain at .50 up through and including expiration day.

Delta & Synthetic Relationships

 

Synthetic long underlying is constructed with a long call and short a put at the same strike price in the same month. Therefore, the delta of a long call plus the delta of a short put (at the same strike in the same month) must equal the delta of long underlying. Conversely, synthetic short underlying is short a call and long a put at the same strike in the same month.

It must be recognized that options delta can be calculated with various input formulas. Using the Black-Scholes model for European style options, the total of the absolute values of the call and put is equal to
1.0.

Using varied input models for American style options and other exclusive circumstances, the sum of the absolute values of the call and put (at the same strike in the same month) can be marginally more or slightly less than 1.00.

Options Portfolio & Position Delta

 

Realistically speaking an option’s delta becomes more complex – less reliable – with the complexity of a position. A successful trader will view their delta holistically – balancing it with the risks of time and volatility.

That said, a trader can add, subtract, and multiply deltas to determine the “net delta” of a position and underlying. The position delta is a way to estimate the risk/reward character of your position in terms of sensitivity to the underlying. The calculation is very straightforward:

Position Delta = Option’s Theoretical Delta x Amount of Options Contracts

A trader owns five of the ABC June 60 calls, each with an estimated delta of +.40, and short (sold) one hundred shares of ABC stock. The traders position delta would be +100 or (short 100 shares of ABC or
-100 deltas, long 5 +.40 delta = +.40 delta x 5 – 100 = +100).

What does +100 mean? The mathematics estimates that if ABC stock should increase by $1.00, the trader will earn $100. On the other hand, if ABC drops $1.00, the trader will lose $100. Once again, it is imperative to realize that these numbers are mere approximations. Remember that delta is relevant for insignificant moves and for brief time periods. Beyond that it gets fuzzy fairly quickly.

The Relationship between Volatility and Delta

 

As mentioned earlier in this chapter, delta is an estimate and that estimate is partially produced on the trader’s assumption about implied volatility levels.

At its core, options implied volatility embodies the degree of uncertainty in the market and the extent to which the prices of the underlying asset are expected to change over time. When there is relatively more uncertainty, people will pay more for options – thus raising the level of implied volatility.

In August 2015, for example, as the markets reflected on China and its currency devaluation, participants became fearful and bid up the prices of options or the implied volatility. But when people feel more secure, they tend to collect option premium through the sale of options. This would cause implied volatility levels to drop.

The Change in Delta with Changes in Implied Volatility

 

All other factors (movement, time to expiry) being constant, an increase in implied volatility causes all option deltas to converge towards .50. In fact, during the unprecedented volatility spike of “Black Monday” (1987) option models did produce .50 deltas for every strike available for trading!

During a rising implied volatility environment, in-the-money call option deltas will decrease towards .50 while out-of-the-money call options will increase towards .50. Reiterating our Chapter 2 discussion on synthetics would imply the opposite would hold true for put deltas. Other words, in a rising volatility environment, in the money put option deltas will decrease towards -.50 while out of the money put options delta would increase towards -.50.

This should begin to make sense, for when ambiguity increases (the reason for higher implied volatility levels) it becomes less clear where the underlying will wind up at expiration. Thus, the absolute value of an in the money option delta will decrease, the absolute value of an out of the money option delta will increase, while an at the money option delta will always remain near a .50 delta.

A somewhat drastic yet helpful approach to understanding this is to look at expiration. At expiry, volatility is 0; all deltas are either 0 or 1, finishing either out of the money or in the money. Any increase in volatility – like an increase in time – causes probabilities to move away from 0 and 1, reflecting a higher level of uncertainty.

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By Jason Pearce

Anos de los Muertos

Every year at the end of October, Mexico has a three-day festival known as Dia de los Muertos.  This Day of the Dead is a celebration where the people remember and honor those who have departed.

This year, you may want to prepare for Anos de los Muertos, which translates to Year of the Dead.  It is not going to be a celebration, either.  You see, the odds are higher-than-normal that the multi-year equities bull market could come to an end in 2017.

In this post, I am going to reveal a convergence of data that could be pointing to a major disruption, maybe even an abrupt end, to the current bull market.  But let’s get one thing straight right up front: this is not a prediction of what will happen in 2017; it is an assessment of the most probable outcome of what will happen in 2017.  We cannot know the future.  We can only know the likelihood of what’s to come.  There is an important difference.

Let’s go ahead and revise a prior statement to read “It’s not going to be a celebration for most people.”  After all, some people –hopefully you are one of them! – will be well-prepared and positioned on the right side of the market if/when that time comes.

It Ain’t Cheap

The P/E ratio of the S&P 500 recently hit 27:1.  Think about that for a second.  If you bought the companies in the S&P 500 and wanted to pay it off from what those companies currently earn, it will take you one quarter of a century to get your initial investment back.

Just how patient are you?

Patience isn’t the main issue, either.  Investors need to consider the size of the return their getting on their money.  Warren Buffett has reminded investors time and time again that “the price you pay determines your rate of return.”

The historical average P/E ratio for the S&P 500 is 16:1.  That means that the current P/E ratio of nearly 27:1 is 69% above the average.  Based on Buffett’s logic, this historically high-priced market should lead to a period of historically low returns.

Looking at nearly 150 years of stock market history, there are only a handful of times when the P/E ratio hit 25:1 or higher:  Around the Panic of 1893, the start of the Roaring Twenties, the Great Depression in the early 1930s, the end of the Dot Com bubble in 2000, and during the Great Financial Crisis of 2008-2009.  As we all know, these were not optimal times to be invested in the stock market.

Furthermore, let’s remember that price was plunging during these bear markets, even though the P/E ratio soared.  The reason for this was because earnings dropped at an even faster rate than the price!  As a matter of fact, earnings were negative in Q4 of 2008 for the first time in history.  This is why the P/E ratio rocketed into triple-digit territory for the first time ever.

Accounting for Inflation

Economist Robert Shiller decided that the P/E ratio can sometimes be misleading because it does not reflect where the market is in the business cycle.  In response, he created a ratio that measures the current prices to average earnings over the past 10 years adjusted for inflation.  His Cyclically Adjusted Price/Earnings (CAPE) ratio reveals a market that is even frothier that what the standard P/E ratio shows!

Currently, the CAPE ratio stands at a nosebleed level of 29:1.  Going back to 1881, there are only two other times when the CAPE ratio was at 29:1 or higher: Right at the end of the Roaring Twenties in 1929 and right at the end of the Dot Com bubble in December 1999.  I would not consider this to be a good omen for today’s stock market.

In light of the current P/E valuation, I think it’s an understatement to say that the stock market is certainly not a bargain for investors right now.  One could even say it’s getting into overpriced territory.

It is important to remember, though, that the P/E ratio only tells us about the market’s value.  It does not tell us anything about timing.  We need to look elsewhere for that.

Dog Years and Bull Years

The equities bull market that began off the March 6, 2009 low celebrated its 8th birthday on Monday.  Eight years may not sound like much, but in dog years the bull market would be a mature 56. It’s certainly not young anymore.

But we’re not talking about a dog here.  We’re talking about a bull.  And in bull market years this one is beyond old; it’s now ancient!

Over the last 130 years, there have been 15 different bull markets in the US.  The average lifespan of these fifteen bull markets was 2 years and 11 months.  Therefore, our eight-year-old bull market is nearly 175% longer than the average.

As a matter of fact, the current bull market is the third-longest in history.  It will move up the ranks to being the second-longest bull market if it can last beyond St. Patrick’s Day on March 17.

As a note of interest, the current bull market duration ranked in the #2 spot ended in September of 1929.  We all know that wasn’t exactly a gentle landing.

Maybe this current bull market is destined to match the nearly nine and a half year record bull market duration that peaked at the Dot Com bubble top of 2000.  Heck, it could even set a new record.  But knowing the typical lifespan of prior bull markets, you can see that the odds are against it.

Sizes Really Does Matter

In addition to the maturity of the bull market, we also need to consider how big it is.  So far, this bull market has gained 260% from the lows.  That’s an average annual return of roughly 18%!

When we examine those 15 US equity bull markets that have occurred since 1888, we discover that the average size of a bull market is 120%.  Therefore, the current bull market is a little more than double the average size.

As far as rankings go, the 260% gain from the 2009 low is the fourth-largest in history.  If the S&P 500 just adds another 46 points to the current record high of 2400.98, it will match the 267% gain of the 1949-1956 run that occurred during the Nifty Fifties.  All it would take to make that happen is a favorable Tweet from the President!

The largest and second-largest bull markets in history were substantially bigger than the current one.  The second-largest was the 427% advance off the 1990 low that ended when the Dot Com bubble burst.

The largest bull market in history was a mind-blowing 504% gain that ended with the 1929 stock market crash.

The takeaway from this study is a paradox of sorts.  On the one hand, most bull markets don’t gain much more than our current one.  Therefore, we should not be complacent or unrealistic in our expectations going forward.  Average annual returns of 18% don’t last forever.

At the same time, we know that in the couple of instances when the current size of gains was trounced, it was done by a huge margin.  Why?  Because some bull markets experience a blow-off stage at the end where prices go parabolic.

You have to remember that the improbable is not the same as the impossible.  The informed trader/investor needs to bet with the odds, yet not fight the trend.

Will the Honeymoon Be Over This Summer?

Another potential headwind for equities right now is where we are in relation to the Presidential Election Cycle.

The S&P 500 is up nearly 13% since the Friday before the election as Donald Trump is supposed to be the best thing since sliced bread for the US economy.  Stocks have not been shy about pricing that in.

However, history indicates that the market could hit a rough patch in the second half of 2017.

Looking at the stock market since 1897, the typical year following the US Presidential election is bullish for the first half.  But the second half of the year is where the trouble begins…

On average, the stock market peaked out in the summer after the Presidential election.  It then declined sharply into November and wiped out several months’ worth of gains.  After a bit of a recovery, the market was then locked into a choppy trading range for nearly a year.  At best, it would stabilize and then tread water for nearly a year.

Using a shorter data set makes this pattern look even uglier.

If we start the data at 1928 instead of 1897, the summer peak and November bottom still show up.  However, the final low does not hit until autumn of the following year.

If the data set begins with 1965, the stock market once again peaked in the summer and dropped into November.  This time, however, the market hit new lows for the year before it finally bounced off a November low.

No matter how you cut it, the Presidential election cycle indicates that prices will peak this year when the temperatures peak.  A bottom would not be expected until November at the earliest.

Not-So-Lucky “7”

An additional cycle that investors and traders need to be aware of is the Decennial Cycle.  Everyone either remembers or has at least read stories about the Crash of 1987.  But do you know what happened in many of the other “7” years?  For some reason, the US stock market has a bad history with the “7” years.  Consider the following list:

2007 – Although the financial crisis occurred in 2008, the market peaked in October of 2007.  It dropped nearly 58% over the following eighteen months before all was said and done.

1997 – Although it was a short-lived event of just a few weeks, the stock market still experienced an “unlucky” 13% drop from the top during the Asian Contagion in October of 1997.

1987 – This infamous stock market crash racked up a 36% loss in just two months.

1977 – A modest 20% bear market was torturous, due to the fact that it stretched out for nearly a year and a half before it was finally over.

1957 – The stock market lost 20% over a three-month timeframe.

1937 – Stocks dropped a whopping 46%.  The wipeout lasted for nine months.

1917 – After peaking in 1917, the bears dominated for thirteen months and knocked 40% off the stock market.

1907 – This was the start of a 45% price markdown that lasted for ten months.

Amazingly, this Decennial Cycle even had an influence in the 1800s!  The stock market lost 50% after the peak of 1857 and it lost 53% from the 1807 top.  These bear markets lasted nine months and thirteen months, respectively.

Despite how this year has started out, history indicates that 2017 could have some bad juju in store for investors.  But if you prepare yourself ahead of time and know what to look for, you can sidestep disaster.  If you play your cards right, you could even be in a position to profit from it!  There’s certainly wisdom in the old saying, “One man’s misfortune is another man’s fortune.”

Synergy Effect

We are only days out from becoming the second-longest bull market in US history.  The age factor alone suggests that it could be nearing the end of the line.

Furthermore, the size of this bull market also indicates that there may not be a whole lot of upside left.  Add another 60 points or so to the current S&P 500 high and this will rank as the third-largest bull market in history.  Although there were a couple of prior bull markets that were substantially larger than the current one, that’s precisely the point: Only two of them in history gained more than this!

In addition, the US Presidential cycle indicates that the “Trump rally” could reach its completion this summer.  From there, sizable reversals tend to follow.  This was corroborated by data with three different starting points.

Finally, the Decennial cycle is casting a dark shadow over the stock market this year.  There are way too many “7” years that have experienced corrections, bear markets, and even crashes to ignore or dismiss as mere coincidence.  In five of the last six decades, the “7” years handed out double-digit losses to investors.  Don’t bet against this streak.

When you know the valuation history of a market, you can determine what levels are unsustainable because of being too expensive or too cheap.

When you have a metric, such as the historical sizes and durations of prior market moves over the last century, you can calculate the probabilities of what may occur in the future.

When you have seasonal or cyclical patterns, you can also begin to draw out a market roadmap that’s a bit better than a random guess.

But when you put all of this data together and find that they are all pointing to the same thing, you have a synergy effect.  With several non-redundant measurements coming to the same conclusion, it seems that the probabilities set by a unanimous consensus of the group are higher than the probabilities of each metric on their own.

Those probabilities are pointing to a bearish event in 2017.  So even if you agree with the current bullish market fundamentals or you have a positive outlook based on President Trump’s agenda for the country, you should not dismiss the unanimous conclusion compiled from several decades of data.  Caution is definitely warranted here.

Watch the Weather

Despite all the dark clouds looming on the horizon, the market price behavior should be the final judge and jury of whether or not the bear market comes out of hibernation.  Don’t liquidate your stocks, buy portfolio insurance, put on hedges, and/or go short unless the price indicates that it is the right time to do so.  Being right but early can have the same effect on your account as being dead wrong.

A couple of things that one could use to gauge the weather in the current market environment are the market’s price structure and the trend relative to moving averages.

On the long-term timeframe, the price structure is bullish.  The S&P 500 has made higher monthly highs for five consecutive months and it has not broken a prior month’s low since November.  A series of higher highs and higher lows is an uptrend.

On the daily timeframe, the market is well above the most widely-watched moving averages.  The day after the election, the S&P 500 rocketed higher and has closed above the rising 50-day Moving Average every single day since.  In addition, the market has only closed below the 200-day Moving Average once in nearly a year.  (That was the short-lived break right after the Brexit vote.)  Staying above the moving averages and posting a string of new record highs is not what you see in a market that’s bearish.

The combination of P/E ratios, market stats of prior size and duration, and market cycles are forecasting a major storm ahead.  But when we observe the current price behavior of the market, there’s nothing in sight but blue skies.

Our first indication that the storm clouds are moving in would be a close below the 50-day Moving Average.  Once that happens, a trader could start looking for setups on the short side.

A break below the 200-day Moving Average (one of Paul Tudor Jones’ favorite metrics) would tell us that we’re in a downpour.  You don’t want to have any long exposure when that happens.  Also, a break of a prior month’s low would be a lightning strike.  If it hits at the right place and time, major damage can occur.

As storms start rolling out across the US this spring, remember that the deadliest storms for the stock market are expected to hit in the second half of the year.  When it rains, it pours.  So it’s best to start prepping for it now!

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