market history


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“I don’t know.” That was the only answer I had to each of my dad’s questions. It was very dark as we wandered the streets near my Upper East Side apartment in the early hours of October 20th, 1987, discussing the events of the prior day, Black Monday.

I was 25 years old and had been on John Meriwether’s Arb Desk for just over a year, following two years working in Salomon’s Bond Portfolio Analysis Group. My memories from the day the US stock market dropped 22% didn’t seem very noteworthy when my friend Rich Dewey asked to interview me for an article, Black Monday Revisited, he was writing for Bloomberg to mark its 30th anniversary. After all, compared to the other people Rich was interviewing—Paul Tudor Jones, Howard Marks, Stanley Druckenmiller, Ed Thorp and my former Salomon colleagues Eric Rosenfeld and Michael Lewis— what could I add?

I’ve been thinking that my recollection of some things that didn’t happen might be interesting. First of all, Salomon’s Arb Group didn’t do a single trade on October 19th, or pretty much for that whole week. It wasn’t that we didn’t see great opportunities, but rather that it was clear to everyone that this was a crisis and a time to preserve capital. Salomon was first and foremost a financial intermediary. Our capital was limited, and it would be sorely needed for providing liquidity to clients and projecting financial strength to all our counterparties. Salomon had about $3.5 billion of capital supporting a balance sheet of $100 billion.

We borrowed money to finance our long positions in bonds primarily through the repo market, but we also had to borrow securities to support our short positions. When we shorted a bond, such as the 9.25% of 2/15/2016 that we were running a big position in at the time, we needed to borrow that specific bond from someone who held it in order to make good on the sale. We could borrow money from anyone– a client, a bank or as a last resort even the Fed. But the only party who could lend you a security was someone who owned it free and clear, and hadn’t lent it already. And the lending market was mostly overnight, so we had to roll every day.1

Our biggest fear was that clients who were lending us the securities we were short might ask for them back, forcing us to cover our shorts and unwind our trades. It’s almost axiomatic that when you’re forced to unwind a trade, you lose money on it. With these concerns in mind, John holed us up in a room off the desk, and we put our efforts into methodically triaging our portfolio. We kept the trades we’d be most able to hold to convergence, and cut the ones that were least defensible. We had been having a solidly profitable year up until October, but gave back most of our gains in the few days around Black Monday. The firm’s decision to let us keep our best positions was rewarded with a very profitable 1988.

The defensive orientation on our desk was echoed across the whole firm, and it was probably the same at Goldman, Bankers Trust and all the other trading houses on the Street. As a highly levered financial firm, dependent on short-term funding of our balance sheet, our crisis mentality was about surviving the storm, not trying to profit from it. While the most popular 1987 crash stories celebrate the trading acumen of the likes of Tudor Jones, Druckenmiller or Taleb, the less publicized story of how so much capital was constrained or frozen—an essential ingredient in all market panics– might be the more important takeaway.

Another thing that I don’t remember happening was an economic depression following the stock market crash. Well, I guess that’s because it didn’t! It was supposed to though, just as the Great Depression followed the Black Tuesday of October 1929. In fact, in December 1987, 33 prominent economists (5 with Nobel prizes) issued a statement predicting that “the next few years could be the most troubled since the 1930s.”2 The fact that we moved forward with barely a blip to the real economy makes us feel that October’s stock market crash was bogus, a market move that had nothing to do with fundamentals. But it didn’t have to turn out that way. It’s important to remember what didn’t happen: an alternative future in which the Fed didn’t act as it did (would Volcker have reacted as Greenspan did?), the stock markets fell even further, financial firms started failing, and we got a long and deep recession.3

Could it happen again? Of course it could. And it has. Extreme market moves of the magnitude of Black Monday’s 20-times normal daily move have occurred periodically since then, just not in the US equity market or on the one-day time scale. For example, two years ago, the Swiss Franc put in a 40 times daily upward move against the Euro when the Swiss National Bank suddenly abandoned the policy of capping its value.4 If we look at more arcane, but still important, markets, we find further examples, such as changes in swap spreads or long-dated equity volatility in October 1998 (what is it with October anyway?), or diversified equity momentum trading strategies that lost close to 90% in 2009, or the melt-down of equity quant strategies the week of August 6th, 2007.

Plus ça change. Humans, with all our behavioral foibles, are still important players in the markets. While the presumed cause of Black Monday, Portfolio Insurance,5 is now defunct, it has been superseded by vast amounts of capital dedicated to algorithmic trading or trend-following, both strategies expressly designed to make money, not to stabilize markets. Risk management systems based on VaR (recent volatility of positions) or a tight stop-loss discipline are inherently destabilizing too. And then we have the Volcker Rule and other post-financial crisis regulatory changes, which have the unintended consequence of dramatically reducing the ability and incentive of the banks to provide liquidity in normal market conditions, let alone in a crisis. What do we have against all this? More circuit-breakers and a tradition of Central Bank intervention to stabilize markets in every crisis since Black Monday.6 Hopefully, they will continue to do so, but we should be prepared for when they don’t.

You may wonder, how did this prepare me for another tumultuous October, eleven years later, when I was a partner at LTCM? Stay tuned, its 20th anniversary is just twelve months away.

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From Whitney Tilson:

1) It’s a sure sign of a top when I’m getting random emails like this:

 

Hello, This is [name], I am a college student that started a trading account two years ago. Over the past two years I have generated over 30% each year in stagnant market conditions.  I have given rise to a trading strategy that is low in risk, nevertheless unique in nature with a worldly view on financial markets and the efficient market theory.

At the beginning of 2016 I started off  buying and selling oil futures. Over time, my trading style has matured. The Use of derivatives and uncorrelated value investments, technical markers with event driven placement is the literary overview of on world market hypothesis.

The current global market pricing theories see the world as a bunch of moving parts that make up one whole, my current trading strategy sees the world as one whole with an assemblage of moving parts. a wise man can tell the difference.

I am in the process of registering with that state of Rhode Island and FINRA to get started with a multi strategy hedge fund. I was wondering if you and your are open to me asking questions about the overall hedge fund playing field and gaining trust from investors.

 

Thank You,

 

[Name]

 

2) Along these lines, a friend sent me this:

 

With companies such as Amazon, Netflix, Nvidia, Tesla, Google and Facebook trading at all-time highs — and I am not in any way suggesting that all of these companies are “the same” in terms of fundamentals or valuation — I am reminded of two conversations I had in February, year 2000.

 

The first conversation was in Boston.  I was marketing with the big institutional accounts for a day, and riding around between these meetings in a cab.  I was covering Internet high-fliers at the time, although not the large-caps.  I was covering the recent IPOs, the $300 million to $1 billion, mostly, companies, which seems like nothing these days, but was a real business back then.

 

The salesperson — I think I remember who it was — told me: “I know it’s been easy this last year. You’re a star. Everyone thinks you’re a genius. All of these stocks are up 100%-400% in barely a year. It won’t last. If nothing else changes, you will be swiftly forgotten once these companies crash. They way you’ll be remembered is if you come even remotely close to calling the top, telling everyone to sell. Will you do this?”

 

I said no.

 

I think it was the week after this, on a business trip to Silicon Valley, that I was having dinner with a long-time elderly friend in San Francisco — a legendary private investor whom I had gotten to know a decade prior thanks to an almost random circumstance.  He was one of the most fascinating people I have ever met.

 

We were having dinner at The Big Four on Nob Hill and he told me: “My friend, sell everything now. These valuations are insane. I’ve been in the business since the 1950s and I’ve never seen anything like it. There are simply not enough profits to support these prices. Maybe it can last a little bit longer, but it’s months — not years — away. These high-fliers will crash. Mark my words.”

 

In 2000, I had my investable portfolio almost exclusively in those small-ish high-fliers.  In the 12 or so months that followed these two conversations, I lost at least in the ballpark of 85%, if memory serves me right.  The crash started in March 2000 and by December 2000 it was as dark as it gets.  $40 stocks were trading at $2 in many cases.  My account was down to almost zero.  It was so bad so fast, that 2001 actually wasn’t a bad year at all.  The band-aid came off faster than I could blink.

 

History will not repeat itself precisely in every detail.  A lot of things are different, including market belief regarding central bank intervention.  We have been building up inflationary pressures since at least the 1990s.  Actually, 1971.  Actually, World War 2.  Actually… 1913.  You get the point — the pressure has been building for a century now, at least four full investing generations.

 

All that said, I think that we are on the cusp of having to go closer to market neutral by putting on some hedges, even if not selling (some of) these kinds of stocks outright.  The question is which ones.  Some of these companies are now very profitable, very cash-flow positive, businesses that — while not cheap or even market-average — aren’t trading in bubble territory.  Some of these companies could do reasonably well, and if you have huge gains, may not be worth selling in order to prevent a 25%-40% decline.  Better to hedge these things with some other instrument.

 

It’s pretty obvious to me that the biggest bubble in the market is Tesla.  Why?  Because it’s the company with positively the weakest fundamentals.  It’s almost comically bad.  Margins, competition, sales trajectory, capital requirements — any one of these individually would be reason to short it.  This company would be bankrupt within approximately a year or two at the most, if it couldn’t access the capital markets anymore.  Any meaningful decline in government subsidies could in turn trigger this, even aside from all the other market and technology-based variables.

 

It’s even more obvious when you talk to the bulls in the stock — from institutional investors to smaller players.  Very few have read the quarterly SEC filings or are even proficient in financial statement analysis.  Almost none have done comparative work on the other automakers, which may be Tesla’s biggest advantage with its investor base (“Look at all these robots! An assembly line! Unique!”).

 

However, we all know Tesla is up because of something else.  This is a sexy product — a car — not some dorky behind-the-scenes cloud product.  Buying the stock may even become a political statement for some.  Last December, it became a Trump stock, and so the stock went up. Then, it became an anti-Trump stock, and — you guessed it — the stock went up because of that too.  It’s all totally irrational, but nevertheless real.  It could go parabolic before it goes to zero, which it will barring a miracle.

 

It’s been an insanely good 1-2 years — in some cases more — in these stocks.  My mind is now focused on figuring out a way to lock in these gains, perhaps without selling the stocks outright.  Maybe the answer is to simply short Tesla and ride out what could still be a painful 9-18 months?  That’s the big question.

 

In the end, the history books will probably read: “Despite having seen the movie before, and having a rational argument to the contrary, he waited too long. Could have cashed in and retired, but chose the curtain and rolled the bullish dice one time too many. Rest in peace.”

 

3) Here’s a well-articulated case that the market has a lot more room to run, Bubble Watch, The Brooklyn Investor, http://brooklyninvestor.blogspot.ca/2017/05/bubble-watch.html. Excerpt:

 

Trailing P/E
Let’s put the CAPE aside for now and just look at regular trailing P/E’s. Back in 1999, that went up to 30x, and in 1987, it went up to 21.4x  (this is from the Shiller spreadsheet).

We keep hearing from the bears that the market is as expensive as it was during previous peaks, so we are in dangerous territory; they say we are in a bubble.

OK. That is possible.

But in previous posts, I argued that if 10 year rates stabilize at 4% over time (it’s at 2.3% now), it is possible that the market P/E can average 25x during that period. Maybe the market fluctuates around that average, so the market can easily trade between 18x and 33x P/E without anything being out of whack. (Buffett also said at the recent annual meeting that if rates stay around this area, then the stock market could prove to be very undervalued at current levels.)

So we have a problem. This 18-33x P/E range puts the market in bubble territory according to the bubble experts. But we are saying here that if rates stay at 4%, that’s the normal range the market should trade at.

So then, how can we tell when we are in bubble territory?

Since we are using interest rates to value the stock market, we will have to interest rate adjust our bubble levels too.

 

4) In light of Amazon’s deal to buy Whole Foods (and the role of activist Jana Partners), I think this in-depth article is particularly interesting: The Shelf Life of John Mackey, http://features.texasmonthly.com/editorial/shelf-life-john-mackey. Excerpt:

This is the conundrum that has dogged Whole Foods for much of the past ten years. It continued to grow handsomely as it added more stores and ever more in-house dining areas and special services, but eventually the competition caught up to it. “They didn’t evolve,” says Phil Lempert, a longtime food-industry analyst and the editor of supermarketguru.com. “I think the chain really had blinders on and thought they were so far ahead of everyone else that they didn’t have to pay attention to competitors. The reality is, I can go to Kroger and buy the same or similar goods at a lower price—it’s that simple.”

The situation also provides an excellent window into the mind of Mackey. A conventional solution might be to double down on growing Whole Foods into a mega-grocer. To Mackey, though, it’s a callback to his roots. “We’re going back to being a little bit more niche than we were. We are not going to be the supermarket that everybody’s going to want to shop at.”

Fair enough, but the problem with that strategy is that it’s probably not the kind of thing that’s going to satisfy Wall Street investors, who demand never-ending growth, measured in quick-fire increments every three months when the company reports its quarterly earnings. For a publicly traded company, the reality is that the market demands that you either grow or die.

 

5) Speaking of activism… When Activists Enter the Kitchen, the CFOs Feel the Heat, www.wsj.com/articles/when-activists-enter-the-kitchen-the-cfos-feel-the-heat-1497259802. Excerpt:

 

Investors cheered last month when Whole Foods Market Inc. named a chairwoman and five independent directors. After losing more than 40% since late 2013, shares rose 2.2%.

 

Charles Kantor was less impressed with a different change. The portfolio manager at Neuberger Berman Group LLC, was concerned that the finance chief the company named the same day, Keith Manbeck, lacked experience, as the company is being targeted by activist investor Jana Partners LLC. Neuberger Berman owned a  2.7% stake in the upscale grocery chain as of March 31, according to FactSet.

 

6) An in-depth look in the NYT Magazine at one of the leading short activists, Andrew Left. The Bounty Hunter of Wall Street, www.nytimes.com/2017/06/08/magazine/the-bounty-hunter-of-wall-street.html. Excerpt:

 

Short-sellers of Left’s generation are following this example but cutting out the middleman. You don’t need an office in a flashy building in the Battery, they have realized, or the validation of the press. If you build enough of a reputation, all you need are some Twitter followers and a website. Left has emerged at the forefront of this new guard. Unlike Chanos, who managed billions of dollars of other people’s money, Left invests his own, which exempts him from disclosing his holdings to the public. And now that his work has brought him national attention, he has found that others are willing to make it easier, by leaking documents to him and passing tips. In many cases, Left’s dossiers against his targets are not wholly his own but built using information from a confidential source. He is, in this sense, a bit like a journalist.

He also makes it look easy. One result of Left’s fame is that today’s younger traders believe that they, too, could be him. Wuyang Zhao, a professor at the University of Texas, Austin, who wrote his dissertation on activist short-selling, told me: “People read Andrew Left, and they’re like: ‘Oh, my God, it’s not impossibly difficult. It’s not a lot of work, and you can bring down a big company.’?” One of Left’s friends recalled a visit Left made to a university to give a lecture. In the hallways afterward, the students swarmed him. “It was like he was Mick Jagger,” the friend said.

7) A creative new form of shareholder activism!

Shareholders in a zoo near Shanghai, frustrated that they weren’t making a profit on their investment, fed a live donkey to zoo tigers as a form of protest.

Video of the scene shows the donkey pushed down a makeshift ramp into the water surrounding the tiger habitat, where it is promptly pounced upon. Tigers bite and claw the donkey as it bleeds and struggles in the water. The footage has prompted protest and outrage in China.

In a statement, shareholders who invested in Yancheng Safari Park say they held a meeting and voted in favor of feeding the live donkey to the tigers to express their frustration.

Their objections center on the zoo’s debts and legal troubles, which resulted in a court freezing the zoo’s assets. For two years, the shareholders said, they have seen no profits from the zoo. They argue that the court’s decision was unfair, and that the trial is moving too slowly.

“Shareholders are very unhappy about this,” the group of investors said in the statement. “So in a rage, a live donkey and sheep will be fed to the tigers.”

The Guardian reports that zoo officials did not intervene in time to save the donkey, but managed to prevent the shareholders from sending the sheep into the tiger enclosure.

8) Interesting: Why Is Trump Causing Chaos In Washington But Not In The Stock Market?, https://fivethirtyeight.com/features/why-is-trump-causing-chaos-in-washington-but-not-in-the-stock-market. Excerpt:

Time and again in recent months, supposed experts (including me) have suggested that turmoil and uncertainty in Washington — the Russia investigation, the travel ban, the on-again off-again health care bill — was on the verge of bringing the long stock-market rally to an end. Time and again, the markets have proved doubters wrong. (The latest grim example came Wednesday, when House Majority Whip Steve Scalise and several congressional aides were wounded by a gunman in Virginia. Stocks barely budged.)

Investors’ apparent indifference to the tumultuous start to Trump’s presidency has left some experts shaking their heads. After all, we are constantly told that markets hate uncertainty. And Trump’s first months in office have brought plenty of uncertainty: He hasn’t released specific proposals for much of his domestic agenda; he has appeared to question core elements of American foreign policy, including the U.S. commitment to NATO; and the ongoing Russia investigation has led even some Republican members of Congress to discuss the possibility of impeachment.

“Washington and Wall Street cannot both be right,” Financial Times columnist Edward Luce wrote last week. “Washington and the world are in a state of fear. On the other, Wall Street sees only blue skies ahead.”

So why aren’t investors more fearful? It’s hard to know for sure — interpreting market behavior is usually a sucker’s game. But it’s possible to lay out a few, not mutually exclusive, theories:

9) Another reasonably balanced take on Trump’s impact on the economy, How Trump’s Chaotic Presidency Threatens the Economy, www.bloomberg.com/view/articles/2017-06-01/how-trump-s-chaotic-presidency-threatens-the-economy. Excerpt:

Sure, you might think: Donald Trump isn’t exactly a competent president. But it’s a long-standing truism of U.S. politics that, at the end of the day, presidents really don’t have immediate and severe effects, for better or worse, on economic performance or jobs. Instead, what really matters are larger-scale forces — say, the growth or stall of productivity, something that politicians have very little effect on in the short term. We can all play games with economic statistics and where presidencies begin and end, but most of the claims involved are partisan fictions.

But that truism was never tested by Donald Trump.

Few seem to have adequately priced in the possibility of large, unusual downside risks from having Trump in the White House. I’m not talking about normal policy differences, such as Trump’s withdrawal from the Paris climate deal, in which some will argue (just in terms of economic development) that he’s freeing U.S. businesses while others will maintain that focusing on coal mining while the future is in renewables is a poor trade-off. I’m focused here on the possibility that his chaotic presidency could produce devastating results just because normal governing might prove impossible.

Here are the five biggest scenarios I’m aware of, and how the chances of each have changed since Trump won the presidency in November.

10) This is very unfortunate – and ironic, given that the Americans who will most be hurt by a neutered CFPB will be Trump’s core voters! Trump Administration to Call for Curbs on Consumer-Finance Regulator, www.wsj.com/articles/trump-administration-to-call-for-curbs-on-consumer-finance-regulator-1497242487. Excerpt:

The Trump administration will recommend limits on the U.S. consumer-finance regulator and a reassessment of a broad range of banking rules in a report to be released as early as Monday, according to people familiar with the matter.

…It is harshly critical of the Consumer Financial Protection Bureau and recommends that the bureau be stripped of its authority to examine financial institutions, people familiar with the matter said. By law, the bureau has the authority to enforce consumer laws as well as to examine individual firms on a continuing basis.

11) Speaking of Trump, never let it be said that I can’t say anything nice about him. It’s been nearly five long months, but that day has finally arrived. This is tremendous news! (That said, Trump’s noxious, xenophobic policies toward immigrants still places Dreamers’ families in tremendous jeopardy.) Trump Will Allow ‘Dreamers’ to Stay in U.S., Reversing Campaign Promise, www.nytimes.com/2017/06/16/us/politics/trump-will-allow-dreamers-to-stay-in-us-reversing-campaign-promise.html. Excerpt:

Immigration rights activists, who have fiercely battled Mr. Trump’s travel ban and increased enforcement of other immigration laws, hailed the decision.

“This is a big victory for Dreamers amid months of draconian and meanspirited immigration enforcement policy,” said David Leopold, an immigration lawyer. “The preservation of DACA is a tribute to the strength of the Dreamer movement and an acknowledgment — at least in part — by the Department of Homeland Security that it should not be targeting undocumented immigrants who have strong ties to their communities and have abided by the law.”

12) A great piece of investigative journalism on how FINRA is failing to rein in the worst bucket shops/boiler rooms. What a total disgrace! Wall Street’s self-regulator blocks public scrutiny of firms with tainted brokers, www.reuters.com/investigates/special-report/usa-finra-brokers. Excerpt:

 

In three years of managing investments for North Dakota farmer Richard Haus, Long Island stock broker Mike McMahon and his colleagues charged their client $267,567 in fees and interest – while losing him $261,441 on the trades, Haus said.

McMahon and others at National Securities Corporation, for instance, bought or sold between 200 and 900 shares of Apple stock for Haus nine times in about a year – racking up $27,000 in fees, according to a 2015 complaint Haus filed with the Financial Industry Regulatory Authority (FINRA).

Haus alerted the regulator to what he called improper “churning” of his account to harvest excessive fees. But the allegation could hardly have come as a surprise to FINRA, the industry’s self-regulating body, which is charged by Congress with protecting investors from unscrupulous brokers.

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May 29, 2017

When Valuations Don’t Seem to “Work”

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Reprint Policy

“Historically, when trend uniformity has been positive, stocks have generally ignored overvaluation, no matter how extreme. When the market loses that uniformity, valuations often matter suddenly and with a vengeance. This is a lesson best learned before a crash rather than after one.”

– John P. Hussman, Ph.D., October 3, 2000

“One of the best indications of the speculative willingness of investors is the ‘uniformity’ of positive market action across a broad range of internals. Probably the most important aspect of last week’s decline was the decisive negative shift in these measures. Since early October of last year, I have at least generally been able to say in these weekly comments that “market action is favorable on the basis of price trends and other market internals.” Now, it also happens that once the market reaches overvalued, overbought and overbullish conditions, stocks have historically lagged Treasury bills, on average, even when those internals have been positive (a fact which kept us hedged). Still, the favorable market internals did tell us that investors were still willing to speculate, however abruptly that willingness might end. Evidently, it just ended, and the reversal is broad-based.”

– John P. Hussman, Ph.D., July 30, 2007

When one examines market cycles across history, including the most extreme speculative bubbles, one typically finds segments where valuations were clearly elevated relative to historical norms, and yet the stock market continued to advance. Still, one also finds that the market dropped like a rock over the completion of the market cycle. Likewise, one finds that virtually every point of significant overvaluation was systematically followed by below-average total market returns over a 10-12 year horizon.

It’s precisely the failure of valuations to matter over shorter segments of the market cycle that regularly convinces investors that valuations don’t matter at all. This delusion is strikingly ingrained into investor behavior, and is almost inescapably revived during every speculative episode. As Graham and Dodd wrote in Security Analysis (1934), referring to the final advance that led to the 1929 market peak, the reason investors shifted their attention away from historically-reliable measures of valuation was “first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.” The consequence of the delusion that “old valuation measures no longer apply” was predictably wicked, as it was after the 1969, 1972, 2000 and 2007 extremes. What’s distressing is that this delusion is actively encouraged by investment professionals who ought to know better.

Valuations seem unreliable during speculative episodes because investors neglect a critical distinction. While long-term and full-cycle market outcomes are tightly determined by market valuations, the effect of valuations on outcomes over shorter segments of the market cycle depends on the psychological preference of investors toward speculation or risk aversion. When investors are inclined to speculate, they tend to be indiscriminate about it, and for that reason, we’ve found that the most reliable measure of investor psychology is the uniformity or divergence of market action across a wide range of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness.

Our own measures of market action extract a signal from the behavior of thousands of securities, and are not captured by simple indicators like 200-day moving averages or advance-decline lines. Still, as a rule-of-thumb, divergence in the behavior of a broad range of individual stocks from the behavior of the major indices tends to be a warning sign, as do widening credit spreads, or lack of uniformity in the behavior of various market sectors.

Put simply, when valuation measures are steeply elevated but investors remain inclined to speculate, as evidenced by very broad uniformity of market action and the absence of internal divergences, rich valuations often have little effect on market outcomes. However, in an environment of extreme valuations, even fairly subtle deterioration in the uniformity of market internals should be taken as a signal of increasing risk-aversion among investors, and the market becomes vulnerable to steep and abrupt losses.

Uniformity of market internals matters

My hope is that, before the current speculative episode predictably unwinds in another catastrophe, investors will learn something from my own successes and challenges over more than 30 years as a professional investor. With regard to successes, my anticipation of the 2000-2002 and 2007-2009 market collapses was based on the combination of rich valuations and deteriorating market internals, which I discussed at the time. Conversely, my adoption of a constructive or leveraged investment stance after every bear market decline in the past three decades typically reflected the combination of a material retreat in valuations coupled with an early improvement in our measures of market action (though my early measures were rather crude).

Since valuation is something I’ve never overlooked, the periodic challenges I’ve encountered in the past three decades have invariably centered on measures of market action. During the advance to the 2000 bubble peak, I became defensive too early. Still, I adapted not by abandoning valuations, but by increasing my research efforts. That research led to the recognition that uniformity across market internals could make even the most obscene levels of overvaluation temporarily irrelevant. Respecting that distinction, without disregarding overvaluation, allowed us to come out ahead over the complete market cycle, as the 2000-2002 decline wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to May 1996.

Likewise, nearly all of our challenges during the advancing half-cycle since 2009 can be traced to my 2009 decision to stress-test our market return/risk classification methods against Depression-era data, which inadvertently led us to overemphasize “overvalued, overbought, overbullish” syndromes that had reliably warned of market losses in prior market cycles across history. The very reliability of these syndromes in prior market cycles made them a complication in the period since 2009. If quantitative easing and zero-interest rate policy made anything legitimately “different” about this half-cycle, it was to disrupt that historical reliability, and to encourage investors to continue speculating even after those extreme syndromes emerged.

Most of our difficulty in the advancing half-cycle since 2009 would have been avoided by the key adaptation that we made in 2014: in the presence of zero-interest rate conditions, even the most extreme “overvalued, overbought, overbullish” syndromes were not enough. One had to wait for market internals to deteriorate explicitly before adopting a hard-negative market outlook (see Being Wrong in an Interesting Way for the full narrative).

The supports have already eroded

If one is talking about a complete market cycle, or 10-12 year investment prospects, valuations matter unconditionally. But if one is talking about a segment of the market cycle, valuations matter to the extent that they are aligned with the prevailing psychology of investors toward speculation or risk-aversion. Those preferences are best inferred from the uniformity or divergence of market internals. The result is that an undervalued market can continue to collapse until market internals demonstrate early improvement and positive divergences. Likewise, an overvalued market can continue to advance until market internals demonstrate early deterioration and negative divergences.

Those shifts of internal market action don’t always have immediate consequences, and they have to be constantly monitored as the evidence changes. Still, a shift in market internals does immediately change the return/risk profile of the market; that is, the probability distribution that describes likely subsequent returns. An overvalued market with uniformly favorable market action has a dramatically different return/risk profile than an overvalued market with deteriorating market action.

At present, we continue to identify one of the most hostile market environments we’ve observed in a century of historical data, not only because obscene valuations and extreme “overvalued, overbought, overbullish” syndromes are in place, but also because our measures of market internals remain in a deteriorating condition. That may change, in which case we will shift to a more neutral outlook. Indeed, if improvement in market internals is joined by a material retreat in valuations, we would expect to shift to a constructive or aggressive outlook (even if valuation measures were still well-above historical norms).

Presently, speculators seem not to recognize how strongly the odds are stacked against them, and how steep and abrupt market losses could become. We are not inclined to “fight” further speculation by raising our safety nets on every advance, and again, our outlook would become far more neutral if market internals were to improve. Still, given the deterioration we observe in market internals here, Wall Street’s habit of dismissing and second-guessing every historically reliable valuation measure is likely to be rewarded by steep losses, as it has following every speculative extreme in history.

Remember the key lesson

Over the weekend, my friend Jonathan Tepper sent me a note suggesting that it might be interesting to discuss the extreme position of the S&P 500 relative to its upper Bollinger bands (two standard deviations above a 20-period moving average) at monthly, weekly, and daily resolutions. Several variants I’ve constructed to identify “overvalued, overbought, overbullish” syndromes include the use of Bollinger bands. Those who fully understand the key lesson of our 2014 adaptations will also know why Jonathan’s question made me cringe.

See, prior to the advancing half-cycle that began in 2009, those “overvalued, overbought, overbullish” syndromes were regularly followed by air pockets, panics and crashes in stock prices. But in this cycle, there’s a whole block of those signals, literally for years, that were followed by further market advances, as the Federal Reserve’s deranged zero-interest rate policy encouraged continued yield-seeking speculation. One had to wait for internals to deteriorate explicitly before taking hard-defensive action in response to those signals. That single restriction (among the adaptations we introduced in 2014) is sufficient to wipe out the entire block of incorrect warnings. But the real-time challenges we experienced as a result of responding to those warnings prior to mid-2014 were ruthless to my previously lauded reputation (hence the cringe).

It may take the completion of the current market cycle for investors to recognize that we’ve already adapted. Though the gain in the S&P 500 since 2014 is likely to be wiped out rather easily, the challenge for hedged equity strategies in the interim has been the extended duration of this top formation, coupled with a feverish shift of investors toward indexing, which has benefited the capitalization-weighted indices relative to a wide range of historically effective stock-selection approaches. As I noted approaching the 2007 peak, value-tilted portfolios often lag just before extended periods of weak or negative performance for the major indices. Conversely, the best time to establish a constructive or leveraged market outlook is when a material retreat in valuations is joined by an early improvement in market action. That’s the point that observers who consider me a “permabear” may become deeply confused, but again, I’ve done the same after every bear market decline in over 30 years of investing. My inadvertent branding is an artifact of my 2009 stress-testing decision (which truncated our late-2008 constructive shift), and it will understandably take a greater portion of the market cycle to shed that.

Meanwhile, Jonathan is right – the S&P 500 is currently at extremely overvalued, overbought, overbullish levels. In the chart below, I’ve coupled one of our “Bollinger band” variants, limited to periods featuring explicit deterioration in our measures of market internals. Without that limitation, there would be a thick red block of false signals covering much of the recent half-cycle. That additional limitation also filters out a few useful warnings that preceded corrections in excess of -10% in 1998 and 1999, but it retains most of the signals in prior market cycles because “overvalued, overbought, overbullish” syndromes typically overlapped a shift toward risk-aversion by investors and a deterioration in our measures of market internals. To the extent that the Federal Reserve’s policies of quantitative easing and zero interest rates disrupted that overlap in the recent half-cycle, “this time” was legitimately “different.” But don’t fall prey to the delusion that this difference can’t be accounted for in a systematic way.

Remember the key lesson. At the personal risk of sounding like a broken record, I also recognize the far greater risk that investors face by ignoring valuations, or assuming something has “gone wrong” with historically reliable measures. The upshot is that the psychological preference of investors toward speculation (which we infer from the behavior of market internals) can temporarily defer the consequences of extreme valuations. Respect that distinction without abandoning valuations altogether, and recognize that at least for now, the combination of obscene overvaluation, extreme overvalued, overbought, overbullish conditions, and divergent market internals creates a terribly hostile return/risk profile for investors. That profile will change as market conditions do. The extent that investors are sensitive to those changes will likely determine the extent that they weather the completion of the current cycle, and benefit from future ones.

You are here

Finally, we should distinguish ignoring valuation measures from systematic research to improve them. Much of my work over the past three decades has been along those lines. For example, our effort to carefully account for the impact of foreign revenues, and to create an apples-to-apples measure of general equity valuation led us to introduce MarketCap/GVA, which is better correlated with actual subsequent 10-12 year market returns than any of scores of measures we’ve studied.

The problem is that we often see investors dismissing various measures of valuation, or proposing alternative measures, without any examination of the logic or historical validity of those measures whatsoever. Every valuation measure should be judged by a) whether it can be reasonably interpreted as a relationship between the current price and the very long-term stream of cash flows that stocks can be expected to deliver over the long-term, and b) the link between that valuation measure and actual subsequent total market returns, ideally over a period of 10-12 years (which is the horizon at which the autocorrelation profile of most valuation measures hits zero).

I’ve previously demonstrated that the correlation of the Shiller cyclically-adjusted P/E (CAPE) with subsequent market returns is substantially strengthened by considering its embedded profit margin (the denominator of the CAPE divided by S&P 500 revenues). Indeed, adjusting for that embedded profit margin boosts the correlation with subsequent 10-12 year returns to nearly 90%. I mention this because investors seem to be playing a game of “you are here”: comparing the current unadjusted CAPE of 28 with the 2000 record high of over 43, inferring that the S&P 500 could rise by over 50% before matching that 2000 extreme. The problem is that in 2000, the CAPE was elevated because the embedded profit margin was just 5.1%, compared with a historical norm of 5.4%. In contrast, current CAPE embeds a profit margin of 7.4%, which results in a lower multiple that is only valid if we require recent record profit margins to be sustained permanently. On the basis of normalized profit margins (which improves the relationship of the CAPE with actual subsequent market returns), the margin-adjusted CAPE was 41 at the 2000 bubble peak, and is above 38 today.

We observe the same thing for other historically-reliable measures such as MarketCap/GVA and the S&P 500 price/revenue ratio. Among the valuation measures having the strongest correlation with actual subsequent market returns, current levels are actually within 10% of the March 2000 extreme. There’s no question that investors have become nearly frantic in their verbal arguments about the permanence of elevated profit margins (which is something that Benjamin Graham observed at other market peaks, and warned against decades ago). We’re certainly open to systematic evidence supporting those arguments in a significant span of post-war data, ideally partitioning margins into the components that drive them. For my own analysis on this subject, see This Time is not Different, Because This Time is Always Different. Meanwhile, our best response to Wall Street’s evidence-free assertions about profit margins is to quote W. Edwards Deming: “Without data, you’re just another person with an opinion.”

Again, if our measures of market internals were to improve, we would allow for the possibility that reliable measures of market valuations could surpass their 2000 extreme, and we would not place a “cap” on how high stock prices could move. As I observed approaching the 2007 peak, “As long as investors perceive valuations to be acceptable, there is no compelling reason why the actual facts should get in their way over the short-term. That allows for the possibility that the current speculative blowoff will continue further. The implications for long-term returns remain daunting, but over the short-term, perception is reality.”

The effect a shift back to uniformly favorable market internals would be to move us to a more neutral outlook, though we would maintain our expectation of dismal full-cycle and long-term outcomes. An early improvement in market action following a material retreat in valuations would provide latitude for a constructive or aggressive outlook. Presently however, the market environment features a combination of obscene overvaluation, extreme “overvalued, overbought, overbullish” syndromes, and deteriorating market internals. The first two features of that combination create poor long-term and full-cycle prospects for the market. The last feature of that combination is what currently opens a potential abyss. Our outlook will shift as conditions change.

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The lesson to be learned was not that QE or zero interest rates are omnipotent in supporting stock prices. The lesson was not that valuations are irrelevant, or that “this time is different” in ways that investors cannot comprehend. The lesson was not that low interest rates make stocks “cheap” at any price. Rather, the lesson was that in the presence of zero interest rates, yield-seeking speculation can persist even in the face of obscene valuations and recklessly overextended conditions. So while one can become neutral, one has to defer a hard-negative market outlook until the uniformity of market internals explicitly deteriorates (signalling a shift toward increasing risk-aversion among investors).

Based on a century of market evidence, I concluded that the distinction is the psychological preference of investors toward speculation or toward risk aversion. Moreover, I found that the most reliable measure of those preferences was the uniformity or divergence of market action across a broad range of internals, including individual stocks, industry groups, sectors, and asset classes, including debt securities of varying creditworthiness. That distinction proved to be extraordinarily valuable. The combination of extreme valuations and deteriorating market internals is precisely what allowed us to anticipate the 2000-2002 and 2007-2009 market collapses.

A few more assertions about the financial markets may be useful to discuss. One with appeal to many investors is the idea that valuations may be high on an absolute basis, but that stocks are still “cheap relative to interest rates.” This too is wrong, but wrong in an interesting way.

As I’ve detailed previously (see The Most Broadly Overvalued Moment in Market History), investors often misinterpret the form, reliability, and magnitude of the relationship between valuations and interest rates, and become confused about when interest rate information is needed and when it is not. Specifically, given a set of expected future cash flows and the current price of the security, one does not need any information about interest rates at all to estimate the long-term return on that security. The price of the security and the cash flows are sufficient statistics to calculate that expected return. For example, if a security that promises to deliver a $100 cash flow in 10 years is priced at $82 today, we immediately know that the expected 10-year return is (100/82)^(1/10)-1 = 2%. Having estimated that 2% return, we can now compare it with competing returns on bonds, to judge whether we think it’s adequate, but no knowledge of interest rates is required to “adjust” the arithmetic.

One intuitive way to evaluate the impact of interest rates is to consider the effect of a given departure of interest rates from normal levels. For example, consider again a $100 cash flow that will be received 10 years from today. If the typical return on such an investment is 6%, the current price will be $55.84. But suppose we expect returns to be held down to just 4% for the first 5 years, then 6% after that. In that case, the current price will be $100/[(1.04)^5 x (1.06^5)] = $61.42. That’s 10% higher than our previous calculation. Why? Because in order to reduce the return from 6% to 4% for the initial 5 year period, the price has to increase by 2% x 5 years = 10%.

Accordingly, if you believe that market valuations should be tightly related to the level of interest rates (the correlation actually goes the wrong way outside of the 1970-1998 period, but let’s assume otherwise), it follows that if interest rates are expected to be 3% below average for the entire decade ahead, market valuations ought to be 30% higher than historical norms. The problem is that the most reliable valuation measures (those most tightly correlated with actual subsequent market returns in cycles across history) are currently between 130-160% above their respective historical norms.

An additional theory crossed my desk in recent weeks, which is that corporate profits are enjoying a “winner take all” phenomenon, which will allow large, dominant companies to retain monopoly-like profit margins indefinitely. Now, there’s no question that many internet-related companies have benefited from network effects that have substantially contributed to their size, as well as their market capitalizations. The question is whether this effect now dominates the profit margin behavior of U.S. corporations more generally. One anonymous analyst, who we like quite a bit for his (or her) analytical approach even when we wholly disagree, recently proposed that profit margins might be more broadly affected by this sort of systematic “winner take all” dynamic.

To that end, Patrick O’Shaughnessy compiled some data by separating companies into five bins based on their profit margins, and then charted the aggregate profit margins of each bin (chart below). The analyst proposed, “If our explanation is correct, then the aggregate profit margins of the higher bins should have increased more over the last few decades than the aggregated profit margins of the lower bins. Lo and behold, that’s exactly what the data shows.”

My response to this is straightforward. The conclusion is wrong, but it’s wrong in an interesting way. That’s not a criticism of either analyst, just an issue with the conclusion being drawn, and it provides an opportunity to learn something valuable. The problem here is that the analysis is an artifact of selection bias.

To illustrate, I generated 100 geometric random walks, and then sorted them into quintiles based on their ending values. It should be clear that the members of the top bin are, by definition, the ones that have benefited the most from randomness, and the members of the bottom bin are, by definition, the ones that have suffered the most from randomness. Even though the underlying paths are random going forward, grouping them by their ending values and then looking backward gives the impression that there is some systematic “winner-take-all” process at play.

That’s not to say that we can reject the possibility of a “winner-take-all” dynamic, but what’s actually required to demonstrate it is to sort the series at some point T, and then show that subsequent outcomes are systematically biased in favor of the early winners. Again, there’s no question that many internet companies benefit from this kind of dynamic (though their market capitalizations already vastly extrapolate the continued expansion of those network effects). For the market as a whole, however, I remain convinced that the main story behind profit margin expansion in recent years has been weak growth in real unit labor costs, and that this is likely to change in the years ahead, as the combined result of weak demographic growth in the labor force, substantially less slack in the U.S. labor market, and limited benefits from labor outsourcing on unit labor costs, given that lower wages often go hand-in-hand with lower productivity.

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The market call I am making could be life changing. The explosive Bull Market from 1995-2000 helped so many investors multiply their accounts many times over and we could be heading into a similar period now. The problem is most money managers are not prepared for it and the majority of investors are scared. If I am right about this call, you will need the ability to trade growth stocks and take advantage of a strong market. If you’re looking for someone with extensive experience in these areas, please contact me at: jfahmy@zorcapital.com

There is a constant theme in the financial media that this Bull Market is about to end any day now. I believe it still has a long way to go. It’s not going to continue straight up and we’ll experience plenty of corrections along the way. Ultimately, it will end with a “blow off” move to the upside where everyone just throws in the towel. I don’t know if this will happen three months or three years from now, but I am leaning towards the latter because it will take a long time for investors to change their mentality. I’m basing my thesis on technicals, fundamentals and investor sentiment. (I could write 10 pages on each of these topics but I will do my best to focus on the major points).

Technicals – Weekly volume is important to monitor because the big funds control the market. The major indexes continue to show that institutions are accumulating stock. For the most part, they are buying stock on the positive weeks and selling very little on the down weeks. This isn’t limited to the US markets. The global boom is being confirmed by new highs in many international markets. In the US, the leading growth index is the Nasdaq 100 and you can see in the chart below that it JUST broke out in July 2016 after going nowhere for almost 17 years!


Charts provided by MarketSmith

Fundamentals – The Bears’ biggest argument is that the market is overvalued. Stop with this nonsense! If you factor in the low interest rate environment, we’re trading at a reasonable valuation. If you take out Energy, the market is actually cheap! Also, the market is a discounting mechanism and trades on what will happen 6-9 months from now. Within the next two years, the economic stimulus from the new administration will help earnings grow and justify valuations. In addition, many Mega Cap companies have strong balance sheets with $20-$300 Billion in the bank. Not exactly a bubble, but I will get into this later.

Sentiment – Everyone hates this market! Even the Bulls I speak to are nervous and have one foot out the door. This constant fear is helping to drive the market higher, as many people are underestimating the power of psychology in fueling market rallies. For a while, I’ve been writing about this consistent psychological pattern in the market: An event (usually with a finite date) is over-hyped by the financial media. Since everyone is already nervous, there’s a huge rush into put hedging, shorting stocks, and buying toxic VIX products, etc. The event turns out to NOT be the end of the world and the market grinds higher, forcing many to cover their short positions and/or put cash to work.

Think of everything that’s been thrown at this market over the past few years: geopolitical concerns, dramatic elections, viruses, Brexit, terrorist attacks, etc. and guess what? The market has been INCREDIBLY resilient and literally brushes off any bad news. Now, imagine if the news over the next year or two actually turns positive. I realize the media hates Trump and will never say anything positive about him, but imagine if his team actually makes progress in tax reform, health care and the overall economy improves. This could move GDP growth from around 1% to 3% and S&P earnings can increase to $140-$150 over the next two years. Again, no one wants to consider anything positive but remember two things are almost always true: 1) The world keeps getting better and 2) The people always think it’s getting worse.

COMPARISON TO 1995

At the beginning of 1995, if someone said the Dow Jones would climb from 4,000 to almost 12,000 in the next 5 years, no one would believe it. Why? Because the crash of 1987 was still fresh in investor’s minds and the recovery was already 8 years long. Sound familiar? The correlation to today is that the Financial Crisis of 2008-09 is still fresh in people’s minds and the recovery has already lasted 8 years. Most people can’t even consider the possibility of the market going significantly higher from here because, according to the media, this 8 year recovery is “long in the tooth” and about to end. However, I have made the argument for ten months now that we resumed a NEW Bull Market in July 2016 (that really began in Jan 2013, NOT March 2009). Very few people want to talk about the Bear Market that recently happened from mid 2015 to mid 2016 where the average stock corrected over 20% and many of the leading sectors corrected between 25-50%. A similar thing happened from early 1994 to early 1995 BEFORE the market went on a strong run as shown below:

Here’s the catch: The move higher will not be easy. There will be corrections, shakeouts and pullbacks along the way. Many of them will be sharp and VERY convincing that the Bull Market is over. For example, even during the great bull market of 1995-2000, there were big corrections in 1997 and 1998 during the Asian economic and Russian debt crises. In fact, the correction in Sept/Oct 1999 had many people (including myself) thinking the bull market was over…right BEFORE it recovered and went on one of the most amazing six-month runs in market history! The biggest challenge for investors will be navigating through this. In other words, it will require a good balance of taking profits along the way up and having conviction during the corrections.

BULL MARKET SUPER CYCLE

For the past 100 years, the market’s pattern has been approximately 15-20 years of an economic boom followed by 10-15 years of a downturn or consolidation. This current cycle looks to have started with the new highs created in 2013 and could last for many years. These cyclical uptrends are usually led by new inventions that revolutionize our lives, enhance productivity, and completely change the way we do things. The new ingredient that could really add fuel to this rally is the global economy. Many companies continue to expand internationally and are seeing explosive growth overseas. We are no longer just a domestic economy as we were in the past. One sector I am specifically focusing on is the Semiconductor group. Chips are no longer just going into computers. They are found in smart phones, cars, watches, memory, sensors, machine learning, artificial intelligence, etc. The “Internet of things” is the inter-networking of all these devices and experts estimate that we will see over 50 billion connected objects by 2020.

THE FANG STOCKS

If you study the biggest stock winners throughout history, the majority of their moves end with “blow off” or climax tops. This usually involves a period of days or weeks where the stock gets extremely extended in price, sees several technical gaps, and ends with its largest point move of the entire advance. As I mentioned before, many of the Mega Cap growth leaders such as Apple, Amazon, Facebook, Home Depot, Google, Netflix, Salesforce and Priceline have a tremendous amount of cash in the bank. In addition, you rarely see companies with $50-$700B market caps growing at such amazing rates. Combine that with the Large Cap Financial stocks that have strong balance sheets and you have a potential recipe for higher prices. At some point in the next few years, I wouldn’t be surprised to see “blow off” type moves in many of today’s growth leaders.

Another factor to consider is there are fewer stocks to buy. The number of publicly traded stocks has dropped from approximately 7500 in the late 1990’s to under 3800 today. This is the result of more M&A, less IPO’s due to stricter regulations, and a more liquid private market. As money flows into the market, fund managers have fewer stocks to chose from and lower floats to work with because of all the corporate stock buybacks. In other words, less supply and more demand.

There are two final points I would like to make: 1) I am not a blind bull. If I am wrong about this call, I will simply cut losses because capital preservation is ALWAYS the number one priority for my clients. One of my biggest strengths is the ability to make decisions and change my mind when market conditions call for it. 2) If I am right about this call, this could be life changing! You will need someone who can capitalize on this move, especially if your financial advisor is bearish and doesn’t have you positioned properly. If you are looking for a money manager or would like to set up a FREE consultation, please email me. My skills at finding growth stocks and my 20 years of trading experience will allow me to take advantage of this rare, generational investing opportunity.

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Raymond James’s’s’s Andrew Adams is out with a reminder about the bear market you may have already forgotten about – it took place in 2015 in a very stealth way and effected all but the ten largest stocks in the S&P 500. The indices weren’t nearly as effected as their underlying components were, so it doesn’t show up in your favorite index ETF’s price chart, but, my friends, it was grueling.

Here’s Mr. Adams:

I’ve used this stat before, but it still astounds me that during 2015 if you had put all your capital into the largest ten companies in the U.S. stock market, you would have ended up making about 20% on the year, yet if you had held the other 490 companies in the S&P 500 instead, you would have actually been down about 3%. Talk about a strangely narrow market! Of course, that period culminated in the stealth tactical bear market in early 2016 when, at the February 11 low, the S&P 500 stocks were down an average of 26.7% from their 52-week highs and stocks in the Russell 3000 were down an astonishing 37.3%, on average. We still contend that was probably the “bear market” that many are still predicting even now, but it does not qualify in the eyes of some purists since the S&P 500 itself was “only” down about 15% from its previous all-time high instead of the requisite 20%.

Batnick and I were talking about this just now. We were screaming about this stealth bear as it was happening. Nobody cared much at the time in the financial media, because the index Bigs were holding up appearances.

But the enlightened investor takes note of this sort of thing and keeps it handy for the next time a doomer calls the present state of affairs “euphoric” or “irrationally exuberant”.

It wasn’t very long ago that the indices corrected through time, while their components corrected through price, beneath the surface.

Source:

Investment Strategy: “Charts of the Week”
Raymond James – April 19th 2017

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I’m not sure if you can actually read the individual events, but very interesting if you can. Again just looking at the 1960 – 1980 period, a period of volatility and little capital appreciation. This rather compares to the current period of 2000 – 2016.

The message from the chart, is hang on long. If you are not in the market, then despite all the evidence to the contrary, the current pullback may be an entry point.

 

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