Those Who Don't Know History are Destined to Repeat It
by Jerome "Mel" Hickerson
As I have mentioned here previously, our guide to what the future may have in store for us is based on our observations of the past. This is how nature teaches living things about the world that surrounds us.
The odd thing about humans is that we often reject what our experience teaches us and overrule it with what we want to believe. Human nature gives us the ability to see only the facts that fit our preconceived expectations and be selectively blind to those facts that do not fit our perceptions of reality. So while reality shapes our perceptions, in some strange way, our perceptions also help to shape our perceptions.
As an analyst, I strive to keep an open mind and hear what the market is saying rather than simply hear what I expect to hear. Often the best way to make money is to recognize an error and correct it rather than dogmatically hoping to be correct.
So I frequently find myself reexamining my viewpoints; have circumstances changed since I last analyzed? Are there new facts to examine? Is new evidence available? Has anything new become visible that may have been unseen before?
Since March we have been watching the rally of our lifetime. We have been blessed with two rallies of a lifetime during the last few years. The previous rally of a lifetime ended in October, 2007. That is recent enough that most traders have recollections of the events and recent enough also that many of the same forces existed in a similar enough fashion as to still be relevant to us today, making it a worthwhile occurrence to examine.
When I study market rallies, even those rallies that are not of the rally of a lifetime variety, I like to examine what the indices were doing before, during, and right after the top. The idea is to try to spot signals that may help indicate rally tops real time. Calling tops is always more difficult than calling bottoms; euphoria seems to always make the market overshoot further to the upside than fear works to cause overshoots to the downside.
There are so many indices to choose from to examine but in order to simplify this, I am choosing four indices that I think are significant: Our friend the S&P 500, the Dow Jones Utility Index, the Dow Jones Transportation Index and the XLF (the Financial Sector).
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On the first chart, notice that the SPX hit the rally top early in October 2007. From that point forward, the Dow Utility Index continued higher and created yet another top early in December. It was June 2008 before the Utility Index moved below its October 2007 levels for the final time. June 2008 was a nasty time if you were long in the market and yet the Utility Index was just then beginning to move below its October 2007 levels. The Utility Index clearly lags behind the market.
Looking at the second chart, the Dow Jones Transportation Index, we see a similar pattern. The Transportation Index continued upward and made its final high at the end of May 2008 while the SPX was already moving downward from its October 2007 high. The Transportation Index also lags the market but not as much as the Utility Index. This makes the Transportation Index an excellent confirmation tool; when the SPX is setting new highs and the Transportation Index also begins to set new highs, it is often considered a buy signal.
In the third chart we take yet another look at the XLF. The XLF made its last high in June 2007, several months before the SPX topped out. The XLF began the journey into the abyss a full year before the Dow Jones Utility and Transportation Indices knew that the market had topped. The XLF is under appreciated as a bellwether for the market but for some years now it has been more of a leader than a follower.
That brings us to now. How does this analysis help us grasp our current situation? What is it we can learn from this?
Chart four illustrates that the XLF made its last high in October while the other indices are continuing to make new highs. This matches the 2007 experience precisely.
The Dow Jones Utility and Transportation indices are currently continuing to set new highs, along with the SPX. But the XLF has already taken a turn downward failing to confirm new highs. If the past is our guide, if the current experience eventually matches the 2007-2008 experience, those technicians that use the Dow Jones Utility and Transportation indices as confirmation signals will be misled into believing that new highs are ahead for the SPX while the real data is signaling that the high is more likely already in or just ahead.
Back in early March when this rally took hold, the XLF blossomed out of the starting gate and took the SPX up with it. The XLF turned upward the day before the SPX hit bottom. During the next five days, the XLF erupted for almost 30% while the SPX was jumping 10%. For the first month of the rally, the XLF jumped an amazing 59% while the SPX was moving 25%.
The XLF led; it did not follow. The Transportation and Utilities indices were followers. They remain lagging indices; they may not top out for months after the SPX has topped.
Looking at the fifth chart, we can see that the XLF has performed admirably as a bellwether for the market. Many times for several years it has accurately foreshadowed tops and bottoms at least a month ahead of time. I have found no other index that has a multiple year track record of leading the SPX as well as the XLF.
The past is an imperfect guide - it is difficult to even see the present clearly sometimes - but what we can learn from the past is superior to hunches and guesses. Therefore I look ahead by searching for signposts that resemble previous experiences. Intuition and judgment are vital human characteristics but our ability to reason out the future requires past experience as well.
I continue to believe that we may yet make another push upward because past experiences show that market momentum can carry us upward for a while longer. Another 5% upward sometime before the end of January would not surprise me at all; but further upward beyond that without the XLF turning around would greatly surprise me.
I will continue to watch and analyze; the market is not stagnant and things can turn. Meanwhile, based on evidence that I see at this point and time, this is my best judgment on where we are heading.
The top may not yet be in; but I believe we are close.
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