Transitioning to New Market Environment

Transitioning to New Market Environment

Posted on August 31, 2015

Market Update

August 31, 2015

Market State 12-A (6 Days) Transitional/Bearish: Canterbury’s studies show that a transition from a bull to a confirmed bear market doesn’t happen overnight, it is a process. A transitional phase is a period following an emotional sell-off that is large enough to trigger the Portfolio Thermostat’s bearish indicators but, in so doing, becomes so oversold and emotional that the market will produce a “kick-back” rally that is typically as strong as the sell-off.

Last week, I warned readers by saying: This is the kind of market environment that the risk of getting whipsawed is much higher than transitioning straight into a bear market. That is exactly what happened, when the S&P 500 rallied back +6.43% on Wednesday and Thursday last week.

Below is a chart that shows the sharp rally regaining 50% of the decline (far right side of the chart). Those who emotionally sold at the bottom could have made a serious mistake.

Source: AIQ Charts

Canterbury Volatility Index (CVI 106). The CVI was at 53 on August 19th. It has doubled in just 7 trading days. The Portfolio Thermostat’s “Velocity of Volatility” triggered a shift to (Transitional) Market State 6, followed by another shift, the next day, to “Transitional Bear” Market State 12-A.

The Overbought/Oversold indicator is giving a reading of 92% Oversold (Short Term Bullish). This indicator actually got to 100% oversold following the sharp drop on Tuesday.  My colleague, David Vomund at Vomund Investment Management, refers to this as a, “counter emotional indicator.” This indicator turns bullish (95% oversold or higher) when your emotions are telling you to sell. A reading of 92% oversold makes this the most bullish of our short term indicators.

Supply and Demand:

Markets are driven by the law of supply and demand, which is in turn, driven by investors’ beliefs regarding future market value. Investors tend to vacillate somewhere between two extremes, the rational “wisdom of crowds” and the irrational “madness of crowds.” The efficiency short term market pricing is a direct reflection of how strongly and emotionally investors believe their predictions will be correct.

 

The buying and selling of “rational” market participants will help maintain an orderly market and efficient market pricing. On the other hand, large swings in price are the result of the buy and sell activities of emotional and sometimes irrational investors as they react to the unexpected. Confused investors will begin to develop a “herd mentality,” by moving in the same direction at the same time. The result is inefficient and sometimes arbitrary short term pricing and high volatility.

 

Market Comment:

Last week was an example of how the actions of emotional investors can produce inefficient and arbitrary market pricing. The Dow dropped 1100 points in the first few minutes Monday and then rallied back 800 points within an hour. So why didn’t it go down 1500 points and back up 1000? Flash moves like Monday are pretty much arbitrary. They just go in one direction until they stop, then when most least expect, and quickly go back in the other direction.

 

Stocks in major companies experienced similar arbitrary pricing.  On August 21st, Apple closed at about 106 and on August 22nd, traded as low as 92, down 14 points (13%). AAPL then rallied and closed at 103. This is why it is never a good idea to buy or sell into a highly emotional market environment.

 

During volatile periods, market makers will widen the spread between the prices they are willing to buy or, willing to sell, because there is no way to know what the “intrinsic” prices are truly supposed to be. In other words, the market makers need to cover the volatility risk until prices settle down. As prices stabilize, the spreads between bid and ask prices will tighten.

 

We humans are emotional creatures. As a result, we will experience short periods of irrationality. The minute to minute pricing can vary greatly during emotional periods.  A few hours or a few days later, prices can be totally different.

 

Bottom Line:

Do not try to buy or sell in the face of an emotional market environment. Prices will settle down soon enough. Avoid listening to the media hype and don’t get caught up in the emotions of the masses. The market is going through a satiation period. It will take some time for the markets to get back to normal.

 

The Portfolio Thermostat will make the necessary adjustments as our indicators shift to reveal the new market environment.

 
Canterbury Investment Management: Tom Hardin

More About Tom Hardin

As Chief Investment Officer, Tom has more than 30 years of experience in the investment management industry and has a broad breadth of knowledge. He is known as an innovator, educator and has been revolutionary in the advancements of portfolio and risk management.

Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.