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Sunday, June 2, 2013
REGRESSION TO THE MEAN
There’s a reason why commercial traders are regression to the mean traders. In this business it is the one thing that you can absolutely bank on. It's like death and taxes, it never fails. All markets eventually return to the mean. An appropriate corollary to this rule is that the further an asset gets stretched above or below the mean the more violent the regression is, and the further it will move past the mean during the snapback.
You can see this clearly in the chart below.
Notice that during the bull market from 2002 -2007 the S&P never stretched extremely far above the 200 day moving average (well until the final euphoria phase in 2007). Consequently each intermediate correction halted at or slightly below the 200 day moving average.
This changed when the new cyclical bull market started in 2009. It changed because the markets were not allowed to trade naturally. They were warped by massive doses of quantitative easing. This caused markets to stretch much further above the 200 day moving average than would have occurred normally. The consequences of course were that when the corrections hit they unwound violently and moved much further below the 200 DMA than would have occurred naturally.
This bull market is much more volatile than the previous one because the market is being driven by currency debasement instead of true economic expansion.
Now we are in a situation where the stock market has been stretched ridiculously far above the mean by QE 3 & 4. Trust me, Bernanke has not abolished the forces of regression to the mean. All he has done is guarantee that the regression is going to be many multiples more violent than it should have been.
When this house of cards topples over, I think there is a pretty good chance it’s going to be even more severe than what happened in 2011.
Also notice the red arrows marking major cyclical bull and bear market turning points. Notice the Fed warped the last cyclical bull market much higher and longer in duration than should have occurred naturally (he turned a 4 year cycle into a 6 1/2 year cycle). Consequently the forces of regression responded by triggering the second worst bear market in history. The current cyclical bull market, although not stretched as long in time, is extremely stretched in magnitude so the resulting bear market will almost certainly be exceptionally violent and protracted.
Mean regression rule: Without fail liquidity eventually finds it's way into undervalued assets. An appropriate corollary to that rule would be that liquidity will eventually find it's way out of overvalued assets.
Unless Bernanke has found a way to break the natural law of regression to the mean (he hasn't) then at some point we are going to see liquidity flee the overvalued stock market. When it does it's going to look for undervalued assets to land on. Nothing is more undervalued in my opinion than commodities in general, and precious metals in particular.
Regression to the mean doesn't just apply to assets stretched to the upside. It also acts to levitate extremely depressed assets, and the same rules apply. The further an asset is stretched below the mean the more violently the regression usually is once the selling exhausts. Considering that gold is now stretched about as far below the 200 day moving average as it was in 2008 the rally when it arrives should be every bit as powerful if not more so than we saw in 2009.
In my opinion we now have the setup to drive either another C-wave as large or larger than the one out of the 2008 bottom, or this is the set up to drive the bubble phase of the bull market.