Virtual Entities

Oct. 28, 2018


Humans think in stories rather than in facts, numbers, or equations, and the simpler the story, the better.---Yuval Harari in 21 Lessons for the 21st Century


And the stories don't even have to be true.  In fact, there is good evidence that Homo Sapiens evolved from being a rather unremarkable ape to dominating the planet because they were able to 'make stuff up'.  The ability to create, and just as importantly, share virtual realities (stories) allowed early members of our species to cooperate in increasingly large numbers; if members from different tribes can share and believe in the same stories, then conflict is reduced and cooperation is increased.  Cooperation accomplishes much more than conflict does, and common stories have optimized the former and minimized the latter.  It is why religion is so ancient and enduring.

The idea of a corporation is itself a virtual entity that allows humans to cooperate in large numbers--it is a useful made-up story around which large numbers of people are organized.  For instance, what is Google?  Is it the buildings?  Is it the people?  Is it the information they possess?  If all the buildings were sold, would Google cease to exist?  How about if it got rid of all its employees, or declared bankruptcy?  Even though any of these changes would result in a less successful corporation, the virtual entity called Google could still exist. From the beginning, it was just a made-up story and as long as somebody believes the story, Google would continue to exist.

The entire stock market is a virtual entity.  It exists only because the participants have enough confidence in the story to operate and take risks within its parameters.  The stock market, however, has stories-within-stories which makes it incredibly complex and hard to understand.  It can be especially confusing when some of the sub-stories contradict each other--stocks are overvalued, stocks are not overvalued.  However, over the 40-years that we have spent reading the stock market story, we have come to two realizations:

News, of any kind, does not affect the market in any consistent and reproducible way.

Fear is the dominant emotion in humans and the only constant in the market through time.

Fear drives the market, and fundamentals support the market.  At this point, the level of fear is too high and the fundamentals too strong for this to be the start of a bear market.




The AAII bull sentiment is well below the 50% threshold, and the bear sentiment is above the 30% threshold that correlates with market tops.  This is unlikely to be more than a normal correction.


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The put-to-call ratio has a strong negative-correlation with the SPX; down-spikes in the 8-week MA indicate local market tops, while up-spikes indicate local bottoms. The average has made two short-term up-spikes and a third is in the process of forming.  The pink square on chart 4, outlines the peak in the nominal (not the average) put-to-call ratio which generally precedes the peak in the 8-week MA.  If this continues, then we expect a local bottom in the SPX.



The chart below shows the put-to-call ratio at the daily-scale with the 8-day MA highlighted. The vertical blue dashed-lines mark the up-spikes in the 8-day MA which also correspond to local bottoms in the S&P 500. Since April, these up-spikes have formed a pattern of lower-highs similar to 2017 (blue solid trend-lines).

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The volatility index (VIX), by itself, has a strong inverse correlation with the S&P 500; down-spikes in the VIX correlate with market highs.

Just like the put:cal ratio, and the PE:VIX ratio, the VIX is replicating the pattern from last January's correction.  The VIX dropped slightly this week and has room to drop more next week if the SPX bounces.



Chart 9 shows the bear:bull Rydex asset allocation ratio, the Rydex bull asset level, the AAII bull sentiment, and the AAII bear sentiment.  All four indicators are in bear mode just like at the start of the January correction.




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The emerging markets (MSCI), on average, maintain a positive correlation with the S&P 500.  However, on occasion, they diverge into a negative correlation (pink dashed-arrows on chart 12).  In the last five years, this has happened four times, and in each case this has been followed by coordinated rallies for both indices.  The latest divergence started in March of this year, but at this point the two indices are falling in unison.

Chart 12

This is the same thing that happened in 2000 during the C4 correction; after the divergence, both the EMSCI and the SPX dropped during C4 (green area on chart 13), but rallied together as soon as the R5 rally started.  We are expecting something similar this time.



Technically, at the monthly-scale (chart 14), as long as the 8-month MA stays above the 12-month MA, there is no technical damage to the bullish position.

This pattern is similar to what happened during the 1998-2000 trading period (shaded areas on chart 14). All the indicators are reacting similarly to 2000 when the SPX continued rallying after a good correction.



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The stock market is driven by fear, and powered by the fundamentals.  There is evidence of fear, as presented above, and there is also evidence of a healthy economy.

The story that keeps being repeated about rising rates killing bull markets, is simply not true.  Rising rates accompany bull markets, not destroy them.  It is when rates become "too-high" that bull markets end, and what the market regards as 'too-high' has been changing over the last several decades.  We are still at least three more Fed rate hikes away before we reach the trend-line.


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According to Zacks, 16.8% of the S&P 500 companies have reported total Q3 earnings increasing +19.2% yoy, with 82.1% of them beating EPS estimates.

When Zacks looked at "earnings growth for the S&P 500 index on a rolling 4-quarter basis, to smooth out the quarter-to-quarter variation, then the growth acceleration trend remains in place through 2018 Q4 before starting to trend down next year, as the chart below shows:"



The business cycle is ramping up.  Recessions do not develop while business is growing its earnings.


Another sign that the economy is healthy is the increase in industrial production.


Even the rate of change of industrial production continues to increase.


The economy is growing, but not over-heating.  The bull market will continue to be powered by the fundamentals and driven by fear.  We are experiencing a correction, nothing more.




There are some serious cracks that have developed in the Yuan/gold patterns that we have been monitoring; the positive correlation has been lost (it is now fully negative), the stochastic no-longer is similar, and the Yuan has fallen and remains below the support/resistance zone.  To us, the biggest crack is the negative correlation between gold and the Yuan.  The trade situation with China and the US is likely to continue putting pressure on the Yuan, but if the correlation continues to run negative, gold will continue to stay strong.

With the patterns not replicating very faithfully, and with all the unknowns surrounding the Chinese Government's possible currency actions, we are not able to conclude much from the gold/Yuan relationship at the moment.


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The dollar has a strong long-term positive correlation with gold (chart 23).  There is a similarity between the 1998-2000 time-period and today's trading (green ovals).  Except for the anomalous restriction of IMF gold sales in late 1999, the dollar and gold exhibit similar patterns.

Charts 24 and 25, provide a closer look at the similar patterns.


Chart 23


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Chart 26 shows the short-term trading of gold, the dollar, and interest rates.  The bias in rates is up, but the short-term correlation of both rates and the dollar with gold are positive.  We expect rates to continue being pressured up and, therefore, expect the correlations to return to the more normal negative values.



From a dollar and interest rate perspective, we expect to see continued strength in the dollar resulting in weaker prices in gold.


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Technically, gold is slightly skewed to the downside; the RSI is elevated (although not over-bought), the stochastic is over-bought, the ADX is neutral, while the MACD remains positive.



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We wish our subscribers a profitable week ahead.


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