The following excerpts are from my report “A Comprehensive Approach to Equity Market Analysis:“
In 2008 the stock market experienced one of the worst bear markets in history.
My research shows that it was possible to detect a major deterioration in market conditions well before the worst part of the crash, which occurred in late 2008 and early 2009. As market developments unfolded in the first half of 2008, it was clear that the prudent course of action was to reduce equity exposure, rather than holding a fully invested position.
Note: a general principle of technical analysis is that a trend is determined by the pattern of highs and lows. An uptrend is a series of higher highs and higher lows, whereas a downtrend is a series of lower highs and lower lows.
Therefore, we can detect the end of an uptrend when, after a series of higher highs and higher lows, the market first makes a lower high and a lower low.
The 2008 market provides a good example.
… We will review the period from mid-2007 through 2008, when a bull market ended and a bear market began. We will review some of the main technical developments of this period, and see how the long-term model turned completely bearish prior to the market meltdown that occurred in late 2008.
… In these cases, numerous warning signs are usually present before the plunge occurs.
Figure 22 S&P 500 weekly Jan. 2007 – Sept. 2008
… Thus by late September 2008, conditions for the U.S. market could be summarized as follows:
1. The multi-year bull market in U.S. stocks that began in 2003 was now over, as evidenced by the fact that the S&P 500 and other indices were no longer making higher highs and higher lows. Instead they were in a downtrend, forming lower highs and lower lows.
2. The fundamental backdrop had changed dramatically. The bull market of 2003 – 2007 had been driven by the theme of strong global growth, in particular the buildout of China’s infrastructure. However by 2008 these trends had been overshadowed by very worrisome developments in the mortgage-backed securities market, causing a “Risk Off” environment.
3. Further confirmation of a change in the market’s long-term trend from bullish to bearish was provided by the money flow indicator on the S&P 500 monthly chart, which had turned negative earlier in 2008, after staying in positive territory for almost five years (see Figure 11).
4. The 200-day moving average of the S&P 500 had turned down and had now become a resistance level. When the S&P 500 rallied to that level in May 2008, it encountered heavy selling pressure and dropped sharply (Figure 22).
5. Market breadth was weak, as the advance / decline line had been falling steadily since mid-2007 (see Figure 23).
6. Market leadership had shifted dramatically. Stocks that had been the market leaders for the past several years, in sectors such as basic materials and energy, had turned down sharply. The only sectors now displaying good relative strength were “flight to safety” groups such as consumer staples, a bearish sign for the overall market.
7. The long-term market model that summarizes all these factors had dropped from a score of 90 to zero (completely bearish) by late September 2008.
Then in the week ending 10/3/08, the bottom fell out. The market plunged and went into a freefall over the next several months, as the mortgage-backed securities problems snowballed into a full-blown crisis, affecting the entire financial system and economy.
The market selloff that began in the first week of October 2008 was one of the most violent declines in market history, and 2008 was the worst year for the U.S. stock market since the 1930’s (see Figure 27).
Many high net worth investors lost a large percentage of their wealth and gave back all the gains they had made over the previous four years.
Figure 27 S&P 500 weekly 2007 – early 2009
Market conditions were already extremely bearish by September 2008, before the historic plunge. Figure 27 shows how there were at least 18 specific “sell” signals present in the months prior to the crash of late 2008.
… The value of this long-term model is that it provides us with a tool to monitor and keep track of these developments, and to monitor the changing condition of the market’s health. This is extremely valuable for asset allocation purposes.
The model tells us that by September 2008, we should be holding only minimum equity exposure (or even a short position, for a hedge fund).
This would allow us to avoid large losses in client portfolios when the market crashed.
Sector Rotation in 2008:
… sector rotation showed a number of important developments in 2008. Figure 30 shows the relative strength of the Consumer Staples sector (XLP) in 2008.
Figure 30 Consumer Staples sector (XLP) – 2008 – Relative Strength vs S&P 500
This chart shows the relative strength of the consumer staples sector in 2008. This sector is known as a safe haven, low-beta sector that tends to hold up relatively well during periods of decline in the overall market.
The sector fund (XLP) is shown in the middle bracket of the chart, while the bottom bracket shows the S&P 500. The top bracket shows the relative strength of the sector vs. the S&P 500. When this line is going up, it means the sector is outperforming the market.
As we would expect, after the market peaked in late 2007, the consumer staples sector started to outperform. It underperformed during the brief two-month market rally in April – May 2008, but then outperformed dramatically when the market plunged in the second half of 2008.
As shown in more detail in Figure 22 (above), the S&P 500 rallied in April and May of 2008, but in late May it reached several resistance levels, including its 200-day moving average and the prior lows from 2007, all of which coincided at the same level. Then in the week of 5/23/08, it turned down sharply from these resistance levels, forming a bearish engulfing pattern, a sign of major institutional selling.
This was clearly a good time to reduce equity exposure, based on principles of technical analysis. After a long uptrend from 2003 – 2007, the market was now in a downtrend, and the rally in May 2008 was the first rally to resistance in a new downtrend.
If this same chart pattern occurred on a short-term chart for trading purposes, the bearish reversal pattern after this rally to resistance would have been an ideal time to adopt a short position. The same general principles apply to long-term charts (see Figure 22, in which the week of 5/23/08 is highlighted.)
Based on this analysis, along with the knowledge that the consumer staples sector normally outperforms in a down market, the correct portfolio strategy decision as of 5/23/08 was to reduce equity exposure, and simultaneously move to overweight the consumer staples sector, in anticipation of more downside ahead.
Insights such as these can add a lot of value to the investment process beyond discussing the economic outlook, and can help to create good investment performance.