Monday, February 10, 2014

A Secondary Education

Through the end of last year we focused on several assets and asset drivers that were stretched at such historic extremes that we felt reversionary forces would naturally play a leading role in shaping 2014. 

While we are all familiar with the notion that markets can stay the course longer than expected, even the stubborn and somewhat irrational varieties do fall on a continuum and have a keen memory of where they have been. 
Standing several weeks inside the year, those assets to which we looked for strong reversions have initiated their respective pivots - and have greatly influenced the broader temperament of the market. The key for us as participants with timeframes greater than the average news cycle is managing expectations as volatility increases and the markets invariably carve their own distinct paths. Having said that, some of our methods for gauging future expectations greatly benefit with an increase in volatility, because those respective signatures become excellent comparative bearings for us to profile and contrast from. 

Last Tuesday we took the temperature of what has become a critical equity market proxy for us as it pointed towards the interim low that was made that day and the relative range of the large retracement rally that ensued in equities in the back half of last week. Since Japan's Nikkei and yen pivoted last month reinforcing the heightened volatility in our own equity indexes, we have progressively drilled down deeper into the asset relationship to gain any greater insights. Our best guess is that the explosive nature of the rally last week accomplished the lion's share of the retracement move in EWJ and the Nikkei and that the next pivots in the equity and currency markets should help provide more clarity towards the broader equity picture - namely, the SPX.  

Generally speaking, we defer to the Meridian for shifts in our long-term expectations in the SPX and continue to look for a consolidation range to develop in the index this year. What is particularly convenient from both a tactical and strategic point of view, is that the Meridian is only ~ 10% below where the SPX currently resides. Should it threaten a close below support on a monthly basis, we would shift our outlook just as we did last spring when the market broke out above it. 
While there has been a debate brewing over the last few weeks on whether the equity markets would crash based on the perception that the markets were tracing out a similar profile with the denouement in 1929, we would advise participants to gauge the markets immediate reaction to the secondary high and then the relative proximity to both initial underlying support and the Meridian itself.  

Back in 2011 we had illustrated and described both before and after the equity markets broke down of the similarities in structure with the Meridian rejections in 1987, 1994 and what inevitably became another cascade in 2011. What they all had in common was a large measured move that immediately developed when the market strongly rejected the secondary high and broke initial underlying support. This structure was also what led us to caution Japan's equity market set-up a few weeks back at the end of January when the market strongly rejected the secondary high. 

Measured moves beyond normal distribution develop out of these kinds of set-ups because participants rush for the exits at the same time as a clear psychological rejection in price is reinforced and thus recycles downside pressures through the market. With that said, should a similar measured move arise we would speculate it would be of the 1994 variety - unless it broke long-term support provided by the Meridian. 
Below are some examples of both the previous three Meridian rejections as well as similar structured corrections arranged in progressively larger moves. For the time being we are agnostic towards the SPX until we get a better read of how the market handles the acceptance or rejection of a secondary high.