T2108 Update – February 3, 2012 (The tipping point has arrived)

(T2108 measures the percentage of stocks trading above their respective 40-day moving averages [DMAs]. To learn more about it, see my T2108 Resource Page. You can follow real-time T2108 commentary on twitter using the #T2108 hashtag. T2108-related trades and other trades are posted on twitter using the #120trade hashtag)

T2108 Status: 88% (overbought day #23)
VIX Status: 17.1
General (Short-term) Trading Call: Close more bullish positions. Begin but do NOT expand an existing bearish position.

Reference Charts (click for view of last 6 months from Stockcharts.com):
S&P 500 or SPY
SDS (ProShares UltraShort S&P500)
U.S. Dollar Index (volatility index)
VIX (volatility index)
VXX (iPath S&P 500 VIX Short-Term Futures ETN)
EWG (iShares MSCI Germany Index Fund)

Commentary
T2108 closed at near 2 1/2 year highs in what has become an extraordinary run at over-extended, overbought conditions. The S&P 500 is experiencing a strong rally where the specific value of T2108 no longer matters. The only thing to track here is the duration of the overbought period. At 23 days, this overbought period has almost reached the 92nd percentile. The S&P 500’s 5.3% gain since the close of the first overbought day ranks as #13 of the maximum returns of all overbought periods since 1986. Based on the historical relationship between duration and maximum return, this overbought period has now reached a tipping point that suggests this period will last longer and generate higher (maximum) returns before it is over.

Moreover, the volatility index, the VIX, continues to fall. At 17.1, the VIX is back to July’s levels right before the August swoon. A friend pointed out to me a great reference demonstrating that periods of low volatility typically lead to positive returns. According to “Is the Market Getting Too Quiet?“:

“…quiet markets can precede tumultuous ones, but on average they do not…market conditions like the present situation have, historically, offered better returns than the ‘any time’ average one, two, and three months later…

…If the past is any guide, the odds favor better than average upside returns in the near future, even if those returns are achieved at a somewhat more volatile pace.”

In the context of T2108, I interpret these findings to mean that we should expect a series of over-bought periods before we ever get to oversold conditions again. Included on my long to-do list is a more detailed analysis of what tends to happen between overbought periods. Currently, my only statistic is that the average duration for T2108 to spend below 70% is 31 days; the median is 7 days.

Of course, first, the S&P 500 must overtake 2011’s key resistance levels. The index is just one rally day away (1.4%) from retesting the intra-day high from May 1, 2011 which was then a 3-year high. Such a milestone seems very achievable given other amazing milestones already in the bag:

1. The S&P 500’s 6.9% year-to-date gain is the best start of a year for the index since 1989 (heard on Nightly Business Report)
2. The NASDAQ is now at levels last seen in late 2000, an over 11-year high. Seems quite fitting given the current hype about Facebook’s IPO.

This run has placed me in a very schizophrenic position. I am leaving the T2108 portfolio in a bearish setup. The shares in SDS are at 75% of my allocation, and I will apply the last 25% only once/if the S&P 500 reaches 10% returns for the overbought period. Only five overbought periods since 1986 have finished with gains at or above 10%. All of these periods lasted over 50 trading days. Only nine overbought periods have finished with 5% or more gains. All but one lasted longer than 32 days. The average and median returns are essentially zero over the course of an overbought period – meaning that these periods represent poor period for deciding to buy and hold (buy the dips!).

In the meantime, I continue to hunt for special, niche, short-term bullish trading opportunities. In a market like this, stocks are given the benefit of the doubt, even shallow dips are quickly bought, crappy stocks become undervalued steals, and hype and hyperbole become fashionable. These dynamics produce many opportunities to get in and out of trades quickly before my discomfort rebuilds due to the over-extended market conditions. These trades are not part of the T2108 portfolio given they do not follow any T2108 rules. The latest such trade, a post-earnings trade in Amazon.com (AMZN), has already worked much better than I could have hoped. I have now sold down the position to a February call spread. I will soon write a separate follow-up post on this trade.

Finally, I have written in earlier posts about the poor trading volume that characterizes this rally. This low volume continues to tell us that participation in the stock market is poor. Moreover, we can expect sell-offs to be steep when they occur as a lack of conviction encourages quick sell triggers whenever the right catalyst appears. In “A Contrarian’s Dream“, Doug Kass produces the following statistics on individual investors:

“According to the Investment Company Institute, in 2011 retail investors liquidated $130 billion of domestic equity mutual funds, accumulated $1.7 billion of international stock mutual funds, purchased $120 billion of bond funds and bought $8.4 billion of high-yield funds. Since the beginning of 2007 (through 2011), retail investors liquidated over $450 billion of domestic equity funds, accumulated $130 billion of international stock mutual funds and purchased $930 billion of bond funds. The near-$1.4-trillion swing out of domestic equity mutual funds and into bond mutual funds is unprecedented.

Since 2001, as measured by stock holdings as a percentage of total financial assets, individual investors’ share of stocks has declined from 25% to only 18%. In the same time frame, stock mutual funds have dipped from 79% of total mutual fund assets (excluding money market funds) to only 65% at year-end 2011.”

The irony of calling this a contrarian signal is that, for the most part, these unenthusiastic retail investors have gotten things right for the past several years. They have done very well to abandon stocks and even better to buy bonds instead. I am in no position to guess whether 2012 will finally be the year these wary investors get things wrong, but at least we know why it volume is so low on the rallies (and so strong on the sell-offs).

Weekly T2108

*All charts created using freestockcharts.com unless otherwise stated

Related links:
The T2108 Resource Page
Expanded daily chart of T2108 versus the S&P 500
Expanded weekly chart of T2108

Be careful out there!

Full disclosure: long SDS and VXX; long AMZN call spread