How High Can a Bumblebee Fly?

06/17/03 02:30:40 PM

by Matt Blackman

Both the fundamentals and technicals seem to agree. We are in rarely charted overbought territory. The question is where do we go from here and when?

Security: SPX
Position: Sell

There is no doubt about it, the markets are in the nosebleed section. A number of technical indicators are showing markets drastically overbought and it appears that the fundamentals are in agreement. So far, there are very few reasons why stocks should be flying so high.

Last week, trader and CNBC commentator Art Cashin labelled the current market the "Bumblebee Rally." His explanation was that from an aerodynamic standpoint, the bumblebee should not be able to fly but does so anyway since it does not understand the laws of aerodynamics. He was referring to the ability of markets to continue moving higher even though the fundamentals do not support the recent meteoric rise.

The technicals have been saying sell for a while, if you believe the momentum indicators (see "Markets Showing Strong Divergence" - Traders.com Advantage 06/02/03). And so have the fundamentals. Insiders appear to be the only ones taking advantage of the signal. In that article I wrote that insider shares sold to shares purchased had reached an incredible ratio of 60 (insider sales and planned sales) to 1 as of May 13, 2003.

I also wrote on June 12 that candlestick patterns together with the stochasticRSI were giving strong sell signals on the weekly chart of the S&P500. ("Complex Candlestick Patterns Scream 'Sell'" Traders.com Advantage - 06/12/03). A number of momentum indicators were showing strong negative divergence with price, a sign that there is a change in direction on the way. The only question is when?

Here are a few more statistics that may provide a poignant deja vu for those who traded through past peaks and troughs, according to a June 11th article by Jes Black at ForexNews.com.

The difference between bears and bulls rose to 42% on June 11, the highest differential since August 1987. Most of us remember what happened the following October, which became known as Black Monday when the market crashed 22%.

The S&P500 is trading at more than 35 times trailing earnings, which is well above the historic average of 15. As Black points out, at a price/earnings ratio of 35, prices are higher than the peaks of 2000, 1987 and 1929.

The US dollar remained stubbornly overvalued in 1987 and the Fed was battling growing trade imbalances. At present the trade deficit (as of April) stands at $42.028 billion, down from the record of $42.8 billion in March 2003 (see Figure 1). Add to the mix the expected record US Federal deficit of $400 billion this year. The US dollar has been plummeting against the other major currencies, a fact that appears to have been ignored by the stock market. In spite of the drop, the trade deficit continues to swell.

As the dollar fell in 1987, commodity prices rose and that drove interest rates up and bond prices down. As Black also points out, the record levels of consumer and corporate debt don't help the current situation. According to the Economist magazine, household debt in the US is growing at an annual rate of 10.3%, more than twice the rate of growth of disposable income.

Last but not least, remember the ratio of shares purchased to shares sold by insiders that stood at a stratospheric 60 to 1 on May 13th? It has swelled to 67 to 1 as of June 6.

Figure 1 � US Trade Deficit.

Graphic provided by: US Dept of Commerce.

As anyone who lived through the roaring nineties (1993-2000) will attest, both fundamental and technical indicators can remain overextended for prolonged periods and the market seems to just keep moving higher in spite of the fact. But at what point do traders and investors begin to listen to what the indicators are saying and act on them?

Like the bumblebee who flies in spite of what the rules say is possible, the average investor continues to buy into overly inflated markets thanks to greed and hope; greed in not wanting to be left out of any upside moves, and hope that there will always be one more sucker behind them willing to pay an even more inflated price for their stock than they did.

But unlike a bumblebee that has a relatively short life, overextended markets can go on for years. The bull market in the 90s began showing negative divergence between price and momentum indicators in 1996, yet the market did not correct in earnest until mid-2000.

Markets are on a never-ending roller coaster ride, continually torn between fear and greed. As a result they vacillate between under and overvalued, the longer the imbalance exists, the greater the force of the correction. And when this market finally begins to correct, fear, the most powerful of all investor emotions, will kick into high gear with a vengeance as john-come-latelys panic to dump their shares. How many will see it coming?

SUGGESTED READING:

Black, Jes [2003]. "Black Monday Again?" Forex News: June 11

Blackman, Matt [2003]. "Markets Showing Strong Divergence," Traders.com Advantage: June 2

Blackman, Matt [2003]. "Complex Candlestick Patterns Scream 'Sell'", Traders.com Advantage: June 12

Blackman, Matt [2002]. "10 Challenges Facing A Market Rebound," Working Money: December 17.

The Economist [2003]. "Poised for Growth?": June 12

Wall Street Journal [2003]. "Insider Spotlight": June 11

Matt Blackman

Matt Blackman is a full-time technical and financial writer and trader. He produces corporate and financial newsletters, and assists clients in getting published in the mainstream media. He is the host of TradeSystemGuru.com. Matt has earned the Chartered Market Technician (CMT) designation. Find out what stocks and futures Matt is watching on Twitter at www.twitter.com/RatioTrade

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