I was building out some internal charts recently and ended up creating a spread between the bull and bear sentiment indices (using the AAIIBULL and AAIIBEAR Index).  Basically it shows investors bullish sentiment in 6 months time (the higher the number the more bullish). 

Extreme sentiment tends to be a contra indicator, but it’s interesting to see the actual data.  Five out of the last six times the indicator was above 20 we’ve sold off over the next 6 months.  When the index was sub -30 (ie bearish) it’s a little less predictable (3 out of the last 5) and returns were much more volatile, but still interesting.  Now that we’re breaking above 20 again it could be telling.  Also, notice the one time it was wrong was early Sept ’10…when QEII changed the rules of the game.

The markets definitely seem excited about the euro-zone plan to hair-cut Greek debt and lever the EFSF (basically levering debt to solve a debt problem with money you hope to raise from Asian investors who you’re already indebted to…interesting), but the upward move past few weeks has been truly historic.  Month to date the S&P 500 and the Russell 2000 are +13.53% and +18.82% respectively.  I know there are still 2 business days in this month, but I thought I’d put the move into some historical perspective.

The S&P 500 has only closed the month greater than +13.5% once since 1940 (I only went back as far as the 40s because of the extreme volatility in the 30s; I have some mind blowing stats on the 30s below).  The only time the S&P has had a greater positive move than this month was in October 1974 when it rallied +16.3%.  What were the events leading up to the October ’74 rally?  The markets had collapsed 46% during the ’73-’74 recession before bouncing in October of ‘74.  The 70’s recession was born out the Vietnam war ending (which proved very costly), the fall of the Bretton Woods system (in Aug-71 the US terminated the convertibility of dollars into gold, basically collapsing the monetary system) and the OPEC Oil Embargo which quadrupled the price of oil (occurred when the US re-supplied the Israeli military during the Yom Kippur war).  It was also helped along by a healthy dose of stagflation (high unemployment and inflation).  Ironically, do you notice any similarities between then and now?

I highlight the Russell’s +18.82% appreciation this month because it’s the largest monthly increase in the history of the index (which began in 1979).  The previous record was +16.4% in February 2000, a month before the tech bubble imploded.  Another head scratching fact is the rally this month kicked off barely 20% from its recent high and over 60% from its lows in ’09.  In other words, we weren’t even starting from a low base.

While I’ve looked at the monthly returns from the 30s several times in the past, I’m always blown away by the sheer amount of volatility that lasted for an entire decade.  Below are the monthly returns for the S&P 500 between 1929 and 1939.  I’ve only included months that had moves +/-10%.  If you would have invested $1,000 in May 1929 you would have lost 50% of your money by the end of the decade (as well as gone through about a case of TUMs).  You wouldn’t have gotten back your initial $1,000 investment until 1952!  It’s no wonder why this decade caused many of our parents and grandparents to stay out of the equity market for years.

Bottom line, the markets are currently playing by a different set of rules and it doesn’t seem to be ending any time soon.  Patience, flexibility and focus are more important than ever.

In early September we posted a handful of charts on how historic the recent market volatility has been and how unhealthy these swings are (especially for investor psychology, see link).  The broad market S&P500 rocketed 4.2% in the last 45 minutes of trading today (that’s right, that’s nearly 10bps a minute!).  The markets continue to demonstrate how important sizing is in your risk management philosophy.  Let’s take a look at some widely held names and their intra-day moves.

Sprint gets the award for most volatile intraday move (at least in the fifty or so single stocks on my screen) with an intraday swing of 28.4% from low to high! 

Morgan Stanley led the volatility in the financial space moving 21% intraday. 

Even Apple, which on average has only moved 1.44%/day over the past month moved 7.2% today (granted it was a big news day for them).  But to put that move into market cap perspective, that’s a change in value of ~$27bln on the day (so intraday Apple lost the equivenent to the market cap of Morgan Stanley).

You can point to several areas for the recent market turmoil, European debt crisis, lack of investor confidence in politicians, hedge fund liquidations, black box trading, China slow down etc.  But regardless of the reason du jour, if the volatility continues there’s a high likelihood you could see retail investors throw in the towel and leave the market altogether (similar to the decade after the great depression).  But the question we keep asking ourselves is if the money leaves the equity markets, where will it go?

A prominent sell-side analyst reversed his call for more near term CNY appreciation this morning and has now suggested that China may re-peg around the current level.  Therefore, I thought I would resurrect a chart we’ve spoken about internally before—the CNY vs. Oil.  Note what happened to oil in June 2008 when China re-pegged then.  Obviously, with oil reaching $147, demand destruction kicked in, but the timing off the re-peg/oil price collapse is uncanny.  

Also, keep in mind, crushing commodities in 2008 allowed China to accumulate much-needed resources at lower prices.  In terms of today, although they don’t want to contribute to falling global growth, lower commodity prices would help with their current inflation pressures, allowing policymakers to possibly stimulate domestic demand (i.e. investment) once again.

Several strategists and money managers have commented recently about the historic volatility the markets have experienced over the past 30 days.  Todays intra-day moves encouraged me to take a closer look at the numbers.  Let’s start with todays rollercoaster ride.  Pre-market this morning the S&P was down 2.5% from its close on Friday.  An impressive move on its own, however what was even more astonishing was the 2.5% rally that happened between 8am-10am, then the 2% decline from 10am-2pm followed by the 2.5% rally into the close.  All of this on a day where there was virtually zero economic data or earnings announcements.  This is not how a healthy, efficient market works.

S&P Futures intra-day graph 12-Sep-11:

But to really gage the health of the markets we can’t just take one sample day.  What we find is that looking over the past 30 days requires a double dose of dramamine (and half a bottle of tums if you’re a trader in these markets).  Over this very short time frame the S&P has gone -15.74%, +9.68%, -7.21%, +9.73% and -7.69%.  To put these moves into some perspective we’d have to go back 21 years to get an average annualized return of 8% on the S&P (and that’s assuming you re-invested all your dividends!).  To put it another way, there were 5 occurences over the past 30 days where the S&P has moved at least what it has been annualizing over the past 25 years!  Again, this is not how a healthy market acts.

S&P over the last 30 trading days:

Finally, from August 1st this year through today the realized volatility on the S&P has been 45!  This means that on average the S&P has moved 2.8% a day for the past 30 trading days.  There were even 2 days in August (the 8th and 9th) where the daily peak to trough in the S&P was more than 6%!  These are historic moves.  In fact, on a weekly basis, this is the third highest level of volatility over any week that we’ve seen in over 30 years (the crash in ’87 and the credit crisis in ’08 being the only higher).

Below are some thoughts about global imbalances we’ve been talking about internally for a while now that were recently highlighted by one of the independent economists we subscribe to.   

• The pain (i.e. slowing global growth) will be felt most harshly on the creditor/surplus nations, particularly Germany, China and Japan.  This is perfectly inconsistent with the previous consensus thinking that the prudent and “savings rich” countries are more insulated.  The critical, yet fairly obvious, point missed in that logic is that these countries rely on external demand

• This is similar to the US in the 1930s – the US was the world’s largest creditor nation so it suffered the most as protectionist measures erupted, stifling global trade.  Today the inverse is true (and this explains why the recession in the US in 2007-2009 was milder than Japan, Germany and China…using reconstructed data for China of course who massages their numbers)

• Germany is doubly screwed in this adjustment process.  Not only has their “excess savings” been in vein (meaning they’re still dependent on export/external demand that’s no longer there), but they’re finally going to have to share the costs of the previous boom.  This makes sense however as they benefited greatly by the convergence (of rates under the euro), which created the external demand from Southern Europe that boosted profits of German exporters

• Germany also benefitted from China’s 13% of GDP stimulus in 2009 that cannot be replicated to the same degree

• The market seems to be finally figuring this out…as you can see below, the DAX has collapsed by over 30%