Tuesday, November 1, 2016

Swoon Factor At High Danger Level

In trying to anticipate any dangerous stock market collapses, I keep an eye on leading economic indicators, as I've written about before. But the truth is, no matter how much you study these things, the market has studied it more and will beat you to the punch about every time. I am a great believer in the efficient market theory, so I pay more attention to market behavior than anything else.

One such market behavior is breadth, what all the small stocks are doing that are not seen in the major averages we all look at. Smaller stocks seem to be more efficient in seeing things coming for whatever reasons. Maybe it's because there are more of them and they are less moved by en masse trading, ETFs and so on. So they discount information better as a group. Low breadth, when the smaller stocks are not doing as well as larger index stocks, happens often, but not always, in conjunction with major market declines:

This Business Insider chart from the article "The Stock Market's Breadth Is Unusually Shallow"  shows the red zone breadth levels occurring with the 2000 market top, the choppy, weak 2004 market, the 2007/2008 market top, the 2011 top, and it's showing up now. We are far in excess of the one standard deviation away from the 30 year average. But this condition also showed up several other times with nothing especially bad happening.

All the breadth calculations put moving averages, etc. into a formula and crank out a number. But another way to approach this is with the "eyeball" method. You can survey a set period of a stock's behavior, say 5 months, and classify it as normal or an abnormal swoon. This is somewhat subjective. But I did some surveying of the smaller stocks and used some rules for identifying an unusual swoon:

  • A steady change of slope of the 140 day ema from up to down
  • A persistent negative slope the whole period with widening divergence with the 200 ema
  • A change in trading behavior to high volume, sharp down moves below the 140 ema
  • A sudden large gap move down with no recovery breaking a normal pattern
  • A trading volume average of at least 2000 shares a day - a market participant
All this simply shows a profound weakening in a stock's condition. At any given time in the market, you will have a large population of stocks doing swoons, of course. But this population grows to a certain level just in front of rapid market declines, while the major indexes look fine.

I used this "swoon" consideration to look at small stocks in a steady, good market, mid 2005, and got a normal/swoon ratio of 5.6 showing the weakness level of my rules is a pretty small minority of stocks in a good market. Looking at a bad, but not catastrophic market, mid 2004, I get a normal/swoon ratio of 2.0 suggesting a non-precrash average of something like 4 normal to every swoon case.

To look at how this ratio foreshadows historic crashes, I look at the months just before the crash becomes evident, before there is anything looking scary. For the 2002 sharp crash, I viewed January to mid May when the market indexes looked fine. But the population of these breakdown cases amongst the small stocks was very elevated. You could tell something ugly was brewing by noting how frequently they were showing up. I got a 1.2 ratio there. This was after the recession was over. It was primarily a massive margin debt unwind, not a reaction to a recession.

Looking at 2008, I looked at mid year, while the major indexes looked very normal and get a 1.1 ratio. Looking at our present market, the Dow and Russell look nice. The economic indicators keep dancing between sluggish and pre-recession and have been for years. Since we are in an unprecedented period of weak but not recessionary numbers, I looked at 2014 to see if this was inducing any more swoon phenomena than normal. No, I get a 4.1 ratio there, perfectly normal. But looking at the previous 5 months this year, I am getting a 1.2 ratio - same as it was in front of the 2002 decline and about the same as it was in front of the 2008 decline. We now have the worst of both of these past two worlds - a market margin debt at record high levels and a brewing recession.

Does this mean the market must decline? No, these things can clear up and no one gets hurt. But until it does clear up. I, for one, am being very careful. It could be that we are morphing into a new no growth age for the global economy and this will dictate a vastly diminished population of the small stocks. There is a big difference in how levered small stocks are to economic growth vs the big stocks. If central banks are attempting to do away with economic cycles, and are accidentally shooting economic growth in the head in the process, then the huge population of small stocks will be whittled down over the years from here on. Maybe this is the beginning of that. The state of technical decay in nearly half the small stock world is an unstable condition and can't go on forever.