March 15, 2004
The Art of Reading Tea Leaves
Thousands of years ago, the ancient Chinese developed the practice of reading tea leaves, which would follow ceremonial tea meditation (a way of focusing mindfulness on even the smallest aspects of life). The belief was that the configuration of tea leaves remaining in the cup was a reflection of the state of the world at that particular moment.
If you're in a meditative mood, or just completely bored out of your mind, you can go ahead and try this (not that I have, but it could be fun). Brew some loose, unstrained tea in a white, large-bottomed tea cup. Sip the tea mindfully while you observe each action, and maybe meditate gently on something, like Intel's second-quarter revenue outlook or the next rate hike by the FOMC.
As you finish the cup, swirl the remaining tea a few times so the loose leaves get up along the sides of the cup, invert it over a saucer to drain the leftover liquid, then turn the cup over again and look inside.
The basic idea is that the dispersion of the tea leaves will create patterns. Patterns of tea leaves near the rim of the cup tell of events in the near future, while patterns near the bottom tell of more distant things. Fortunately, the patterns that the ancient Chinese looked for were fairly straightforward. Here are a few of them:
Good luck: bell, angel, fruit, kite, horseshoe, rainbow.
Bad luck: bear, raven, lock, tower.
Travel: boat, palm tree.
Argument: bull, closed hand.
Harmony: dove, open hand.
Financial gain or advancement: ladder, coin, fountain, whole eggs.
Financial loss or difficulty: broken eggs, Martha Stewart.
You get the picture. Anyway, there's an interesting aspect of reading tea leaves that comes straight from information theory: the best information comes from a pattern of dispersion that tells a story. If the tea in your cup always settles in a single nondescript clump at the bottom of the cup, you're not going to be able to say much that's interesting. It's the variation, dispersion, and patterns in the tea leaves that tell the richest stories.
The art of reading market action
The same is true in the financial markets. The richest and most useful information is told by variation, dispersion and patterns across a variety of measures, not by the raw and obvious trend of say, the S&P 500. At the March 2003 low, it was that sort of dispersion – some measures hitting new lows, with a variety of measures showing resilience, all on very low trading volume – that suggested a shift in the willingness of investors to accept risk. In response, we added “contingent” call option positions, to hedge against the potential that continued favorable action would force us to lift off our hedges at higher levels. As it happened, market action did just that, and the inexpensive call position we purchased at the March lows was valuable in lifting 70% of our hedges by April, when our broader measures of market action shifted to a clear positive condition.
Recently, the reverse situation has begun to appear. In recent weeks, we've seen an increase in the internal turbulence of the market, with many stocks failing to respond well to what would be considered very good news, and with increasing weakness across various industries and measures of technical market action. Importantly, this is occurring in the context of extreme valuation, unusually bullish advisory sentiment, heavy insider selling (6.7 shares sold for every share purchased, according to Vickers' tabulations of SEC reports), an abrupt flattening of the yield curve, repeated disappointments in economic statistics, and a profound U.S. savings-investment imbalance.
Probably the easiest (but certainly not only) way to see this is to examine Dow Theory. I don't use Dow Theory directly in my own work, but I do respect it, as should any analyst has carefully studied market history.
The clear expert on Dow Theory is Richard Russell of Dow Theory Letters, who writes an excellent daily market commentary. Here is essentially how Dow Theory identifies a new bear market: Following new highs in both the Dow Industrial and Transportation indices, both indices set subsequent reaction lows. Then – after a further advance in which one index generally achieves a new high not confirmed by the other – both indices break below those prior reaction lows, preferably with the breakdown in both indices (the “confirmation”) occurring simultaneously, or only a short period apart. Russell writes:
“On January 22, the D-J Transportation recorded a closing high of 3080.32. Two trading days later on January 26, the Dow rose to a high of 10702.51. Following that high, both Averages turned down. [The Dow set a “reaction” low of 10470.74 on February 4th. The Transportation average set its reaction low of 2822.11 on the same day]. On the rally that followed, the Industrial Average advanced to a new high of 10737.70 on February 11. The Transports failed by a wide margin to confirm.”
On Tuesday March 9th, the Dow broke below its reaction low of 10,470.74. The next day, Wednesday March 10th, both indices broke their respective reaction lows, signaling a new bear market from the standpoint of Dow Theory.
Again, while Dow Theory doesn't enter into our own approach, it has a much more respectable record than is widely recognized. Given the context in which this shift has occurred, the breakdown should not be brushed aside as arcane, antiquated or unimportant.
The Market Climate for stocks remains characterized by unusually unfavorable valuations and tenuously favorable market action. This holds us to a still constructive investment position, but with an important line of defense against potential market weakness.
Personally, I don't use the terms “bull market” or “bear market” in any operational sense. In my view, bull and bear markets don't exist in observable experience, but only with the aid of hindsight. Our own measures of market action have clearly deteriorated, but have not yet decidedly shifted to a negative condition. However, we've already seen enough initial divergences in recent weeks to warrant an important “contingent” position in put options.
The Strategic Growth Fund remains fully invested in a broadly diversified portfolio of stocks, with an offsetting hedge in the major indices intended to remove about 50% of our exposure to market fluctuations. In addition, our “contingent” put positions are sufficient to move the Strategic Growth Fund to a more than 90% hedged position in the event of a further sustained decline. Presently, these “contingent” put options (mostly near-the-money and June expiration) account for about 1.5% of net assets. In the event of a substantial market advance, we would lose some or all of that option value, and our investment exposure would again reflect an approximately 50% hedged position. Suffice it to say that we continue to expect to participate in market advances which might occur, but our defensiveness increased yet another notch early last week.
In short, the Market Climate, as we define it, remains tenuously favorable. However, there is significant potential for our measures of market action to turn negative, and there is a risk that a further market decline would force our hand. We already observe enough deterioration in market action to warrant a small portion of our assets in put options to hedge against the risk that we will be forced to re-establish a fully hedged position only after a decline to lower levels in the market. The put options we hold would re-establish that hedge automatically, while retaining an essentially constructive position if the market advances sufficiently to “clear” the divergences that have now developed.
Generally speaking, when the financial markets decline enough to generate a well-defined “technical breakdown,” be it a Dow Theory bear market indication, a break of some widely followed moving average, or some other event, the breakdown usually takes the market to a short-term oversold condition. As a result, the breakdown, as important as it might be for long-term investors, is generally followed by a fast, furious market advance (that is also generally prone to failure) back to some recent point of support, in order to clear that oversold condition.
For that reason, we can't rule out an explosive short-term market advance here, and there is at least some potential that our measures of market action could turn negative at higher levels rather than at lower ones. Investors certainly shouldn't rely on short-term strength, but they also should not rule it out, since it is typical action following important technical breakdowns. Clearly, we allow for all possibilities, which is the essence of risk management.
In bonds, the Market Climate remains characterized by modestly unfavorable valuations but modestly favorable market action. The Strategic Total Return Fund continues to carry a duration of just under 5 years, meaning that a 1% (100 basis point) move in interest rates would be expected to affect the value of the Fund by just under 5% on account of bond price fluctuations.
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