Warning Signs on the Horizon

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  • SumoMe

First the good news: The “trend” of the stock market is bullish (and least based on the particular trend-following indicators that I follow) and I am hoping for a standard issue “Santa Claus Rally.”  But hey, you’re not a real investor if you’re not worried about something.  So for the benefit of my fellow worrywarts, let me point out a few warning signs looming ominously on the horizon.

(Jay Kaeppel Interview at BetterSystemTrader.com)

Margin Debt Declines

In this article I detailed a model for using margin debt and credit balances to help identify the trend of the stock market.  The Bad News: it just turned bearish.  Does this mean we should “sell everything”?  Not necessarily.  But it is also not something to dismiss.  As you can see in Figure 1, the last two major contractions in margin debt were followed by something “nasty” in the stock market (more specifically, the 2000-2002 bear market and the 2008-2009 bear market).1Figure 1 – A warning sign from margin debt contraction

Jay’s Margin Debt and Credit Balance in Margin Accounts Model

This model is described in detail here so I’ll not take the time to spell it all out again (Sorry, it’s just my nature).  But the relevant fact is this: both margin debt and credit balances in margin accounts are below their 12-month moving averages.  Figure 2 displays the growth of $1,000 invested in the Dow Jones Industrials Average only during previous such times.2Figure 2 – Growth of $1,000 invested in Dow when margin debt and credit balances in margin accounts are BOTH below their respective 12-month MA

Do twin downtrends guarantee a stock market decline is imminent?  Not at all.  But as you can see in Figure 2, the track record isn’t too impressive.

Since December 1959:

*While one of more of these two measures is bullish the Dow has gained +2,540%

*While both of the measure is bearish the Dow has lost (-1.2%)

Also, for the sake of contrast (and to highlight the potential usefulness in tracking this data), Figure 3 displays the growth of $1,000 invested in the Dow only when both margin debt and credit balances are above their respective 12-month moving average.

3Figure 3 – Growth of $1,000 invested in Dow when margin debt and credit balances are BOTH ABOVE 12-month MA

A much “prettier picture” than the one in Figure 2, no?

Mutual Fund Cash

One “bonus thing to worry about”: the chart in Figure 4 is courtesy of Zerohedge.com (via http://www.acting-man.com/blog/media/2015/12/6-MuFu-Cash-long-term.png) and displays the % of cash held by stock mutual funds. Cash on hand can also be equated with “buying power”.

4Figure 4 – Mutual Fund cash as a percentage of portfolio (Courtesy: ZeroHedge.com via Acting-Man.com)

As you can see in Figure 4, the current level of cash held in mutual funds is near the all-time low end of the range.  While this in no way “guarantees” a bear market, more to the point, it is certainly in no way a “bullish” sign.

In the meantime, let’s hope Santa Claus comes through as this pre-election year wraps up.

Jay Kaeppel

5 thoughts on “Warning Signs on the Horizon”

  1. Hey Jay! Was just thinking about the mutual fund levels. With the appearance of so many ETFs, it seems inevitable that some of the available cash would be moved out of mutual funds and into ETFs. So a low level may just be sign of a long-term shift, rather than a market signal. Perhaps it would be more useful to track MF cash vs a moving average.

    Also, 2015 has been pretty turbulent, and investors’ reduced appetite for risk may be evident in both the margin debt levels and fund cash levels. I notice the margin debt dipped below its MA in 2011 but the market eventually picked up. So perhaps 2015 is like 2011 instead of 2008? I guess we won’t know until 2016! The economic data seem generally heading in the right direction, so I think once the Fed gets the rate increases going and the market sees it’s not the end of the world, prices will start heading upward again.

    Or the bottom will fall out and everyone but the short-sellers will be broke. Or the market will oscillate in a range and everyone will be broke. (I like to hedge my bets.)

    1. Matt, I don’t look at these things as “sure signs” that the “end is near”….still, previous top outs in margin debt have been followed by a pretty fair amount of ugliness. Also, mutual fund cash % is not so much reflective of inflows and outflows for stock mutual funds as it is a maueasre of how much cash fund managers have on hand with which to buy stocks. The present low % suggests that they do not have alot of buying power. Again, not necessarily the end of the world, but certainly not a positive sign. Jay

  2. It also may be telling for the forward 6 month’s / year’s performance if the SP 500 closes the year below it’s 10 month SMA …

    1. Agreed. The trend-following stuff I use is presently bullish. Adding in the favorable seasonal time of year I am giving the bullish case the benefit of the doubt for now. We’ll see how that works out I guess. Jay

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