John Hussman, of the Hussman funds, writes a weekly article on his website that is on our required reading list (http://www.hussman.net/). In his last written piece titled Oil and Red Ink, I think Dr. Hussman may have put his finger on a tangible data point that could be at the root of that oogy feeling we’ve experienced in the wake of the mini-crash. It’s what he would call “micro volatility” in the markets, but rather than awkwardly restate what Hussman writes, here’s an excerpt from that piece:
Finally, as I've noted before, I tend to get particularly concerned when the market begins to exhibit extremely large fluctuations at ten-minute intervals. This sort of increasing "micro-volatility" is troublesome, particularly when in the context of a leadership reversal coming off of overvalued, overbought, overbullish extremes. The last time we observed similar internal dispersion coupled with a leadership reversal was at the 2007 market peak.
As I noted in the July, 30 2007 comment (Market Internals Go Negative), "This is much like what happens when a substance goes through a “phase transition,” for example, from a gas to a liquid or vice versa. Portions of the material begin to act distinctly, as if the particles are choosing between the two phases, and as the transition approaches its “critical point,” you start to observe larger clusters as one phase takes precedence and the particles that have “made a choice” affect their neighbors. You also observe fast oscillations between order and disorder in the remaining particles. So a phase transition features internal dispersion followed by leadership reversal. My impression is that this analogy also extends to the market's tendency to experience increasing volatility at 5-10 minute intervals prior to major declines."
The following chart (from Dietmar Saupe in Barnsley, the Science of Fractal Images – shown below) offers a nice illustration of how the same general pattern can feature different levels of what we can call "micro-volatility." The top panels look like what we're starting to see in intraday activity.
Currently, we continue to anticipate an oversold market rally, which may be already in progress. If technical conditions are able to firm, we will continue to play to win given our base case that there is room for another leg up in this bull market. However, we have recently acknowledged risks that are building both in some fundamentals (copper, stimulus, dollar, etc.), at the same time system-wide risks are rising (Euro situation, credit canaries). Therefore, we’ve drawn a line in the sand at 1,044 on the S&P 500. If we break it, we’ll take action and get more defensive in our portfolios. It won’t feel good if we have to sell after experiencing losses. But given some deterioration in fundamentals, a building of system risks, a clean break of an important technical level, and an oogy feel to this market, it simply seems like appropriate risk management.
