In this 07-02-21 issue of “As Good As It Gets Will Q2 Mark Peak Reporting?“
- Market Rallies To Start Q3
- As Good As It Gets
- Fully Invested Bears
- Portfolio Positioning
- Sector & Market Analysis
- 401k Plan Manager
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Market Rallies To All-Time Highs
With the 4th of July weekend upon us, this week’s newsletter will be slightly shorter than usual. Such will ensure you “pitmasters” can get to work doing what you do best.
As we discussed last week, the market not only got off the mat and rallied back to new highs. That action continued through this week.
The technical backdrop is not great. With the market back to 2-standard deviations above the 50-dma, conviction weak, and investors extremely bullish, the market remains set up for additional weakness.
However, we are in the first two weeks of July which tends to be bullishly biased. After increasing our equity exposure previously, we will give the market the benefit of seasonality for now.
With the “money flow buy signal” not yet back to a typical peak, such suggests another week or so of upside is likely. However, as noted, we suspect there is not much upside in the market for current levels.
Lastly, we discussed the high level of complacency in the markets previously. To wit:
“Currently, complacency has reached more extreme levels. As noted last week, the 15-day moving average of VIX, on an inverted scale, suggests a correction is likely. By this measure, the correction should begin somewhere around July 21st – August 10th.”
The same gets confirmed by the exceptionally high reading of the SKEW index.
“One such indicator is the CBOE SKEW index. The index measures the perceived tail risk of the distribution of S&P 500 investment returns over a 30-day horizon. It is similar to the VIX index, but instead of measuring implied volatility based on a normal distribution, it measures the implied risk of future returns realizing outlier behavior.
A SKEW value of 100 indicates the options market perceives a low risk of outlier returns. Conversely,values above 100 reflect an increased perception of risk for future outlier events.”
We are clearly above 100 currently.
The bulls are indeed in charge of the markets currently, but the clock is ticking.
As Good As It Gets
There is much at risk in the market as we head into the 3rd quarter and begin Q2-reporting for the S&P 500 index. For clarity, we need to review the “second-derivative” effect.
“In calculus, the second derivative, or the second-order derivative, of a function f is the derivative of the derivative of f.” – Wikipedia
In English, the “second derivative” measures how the rate of change of a quantity is itself changing.
I know, still confusing.
Here is a simplistic example.
Assume the economy is $1000 in value in Year 1. Then, in Year 2, there is a 50% recession. However, in Year 3, the economy grows back to $1000. And, in Year 4, the economy remains at $1000.
The “second derivative” effect is evident in years 3 and 4. In year 3, the economy recovers by $500, a 100% increase from Year 2’s level of $500. However, in Year 4, the growth rate falls to zero as the economy remains at $1000.
A Coming Change
Why am I telling you this? Because we are at that point in the recovery cycle. Over the next couple of months, we will see the most significant numbers of the recovery cycle as we compare Q2-2021 to Q2-2020, which was the depth of the economic shutdown. As shown in the chart below, we will see a robust GDP report, but such will be the cycle’s peak.
The manufacturing activity indices have already peaked, which has a high correlation to the annual change in the S&P 500 index.
We will also see a peak in the annual rate of change in earnings as the economy slows. (Note: Current earnings estimates are exceptionally optimistic. By the end of 2021, the peak in earnings growth will likely move forward.)
With valuations highly elevated on a two-year forward basis, when earnings are eventually revised lower with slower economic growth, valuations will rise. (You will often see media types compare forward P/E’s to current reported P/E’s, suggesting markets are cheap. However, that is not apples to apples as you are comparing forward to trailing P/E’s. As shown, two-year forward P/E’s are at the highest level since the “Dot.com” peak.)
The point here is that much of the growth in the economy is currently “priced in” to expectations. When things are as “good as they can get,” that is usually the point where things inevitably start to go wrong.
With no more stimulus coming from the Government and 9-million people coming off of unemployment benefits by September, a “fiscal cliff” is fast approaching. Such could well lead to a disappointment in expectations in a market currently priced for perfection.
In Case You Missed It
Fully Invested Bears
The problem in discussing “investment risk” is that such commentary is summarily dismissed as being “bearish,” By extension, such means I am either sitting in cash or short the market. In either event, I have “missed out” on the last advance. However, now, the discussion of “risk” is even more futile due to the Fed’s massive interventions.
Such reminds me of something famed Morgan Stanley strategist Gerard Minack said once:
“The funny thing is there is a disconnect between what investors are saying and what they are doing. No one thinks all the problems the global financial crisis revealed have been healed. But, when you have an equity rally as you’ve seen for the past four or five years, everybody has had to participate.
What you’ve had are fully invested bears.”
The idea of “fully invested bears” defines the reality of the markets we live with today. Despite the understanding that the markets are overly bullish, extended, and valued, portfolio managers must stay invested or suffer potential “career risk” for underperformance.
The reason I bring this up is because of this comment from the legendary Leon Cooperman.
"I have a strong feeling the cycle we're going through won't end well but I have no idea where it ends," hear the full details of what Lee Cooperman told @BeckyQuick at yesterday's @cnbcevents #FASummit at https://t.co/Rc4p9phRer. pic.twitter.com/NnjIezNOvN
— Squawk Box (@SquawkCNBC) June 30, 2021
The clip is fascinating because Becky Quick refers to Leon as a “fully-invested bear” as he states:
“You have to be in the market right now.”
The Two Big Risks
There are two inter-related risks to the market currently. The Fed and “inflation.”
As Leon correctly notes, companies should be able to pass on inflated materials costs to their consumers:
“Everybody is worried about inflation. Inflation is a positive for common stocks because inflation in companies’ costs works its way into selling prices, which lift the nominal level of revenues and earnings.”
In theory, that is true, but as noted above, with the “fiscal cliff” approaching, there is a risk that consumers can’t absorb as much “inflation” as he hopes. Moreover, as I showed previously, the gap between CPI and PPI already indicates that companies are retaining inflation.
The other problem is the Fed. The markets will not react kindly to the Fed moving to curb inflationary pressures.
In either case, the risk to markets remains elevated. While I certainly agree you “have to be invested in the markets currently,” we are also fully aware of the risks.
Yes, that makes us “fully invested bears.”
As noted above, the “buy signal” is back in play. With the markets bullishly biased, the seasonally strong first two weeks of July should lift asset prices. However, with the markets back to overbought, bullish, and deviated conditions, the upside is limited near term.
As noted above, with portfolios back to near full-allocations, we are “fully-invested bears.”
The biggest problem for investors is the “herding effect” and “loss aversion.”
As markets are rising, individuals believe that the current price trend will continue to last for an indefinite period. The longer the rising trend lasts, the more ingrained the belief becomes until the last of “holdouts” finally “buy-in” as the financial markets evolve into a “euphoric state.”
Once the market begins to decline, there is a slow realization it is more than a “buy the dip” opportunity. As losses mount, the anxiety of loss begins to climb until individuals seek to “avert further loss” by selling.
Such is the basis of the “Buy High / Sell Low” syndrome.
However, by understanding what drives market returns over the long term, you can mitigate the risk of making psychological errors.
It is likely, given there is “no fear” of a market correction, an overwhelming sense of “urgency” to get invested, and a continual drone of “bullish chatter,” the markets are poised for an unexpected, unanticipated, and inevitable event.
What will that be? No one knows until after the fact.
Such is why applying “risk management” before the event is critical to the eventual outcome. After all, you don’t carry an “umbrella” after it rains, do you?
I hope you have a terrific 4th of July weekend, and I will see you again next week.
By Lance Roberts, CIO
Market & Sector Analysis
Analysis & Stock Screens Exclusively For RIAPro Members
S&P 500 Tear Sheet
The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data. Readings above “80” are considered overbought, and below “20” are oversold. The current reading is 92.60 out of a possible 100.
Portfolio Positioning “Fear / Greed” Gauge
The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.
NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90. The current reading is 84.20 out of a possible 100.
Sector Model Analysis & Risk Ranges
How To Read This Table
- The table compares each sector and market to the S&P 500 index on relative performance.
- “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
- The risk range is a function of the month-end closing price and the “beta” of the sector or market.
- Table shows the price deviation above and below the weekly moving averages.
Weekly Stock Screens
Currently, there are four different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.
We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)
S&P 500 Growth Screen
Low P/B, High-Value Score, High Dividend Screen
Fundamental Growth Screen
Aggressive Growth Strategy
S&P 500, Portfolio, Technical, Market, Performance, 401k, Update, Risks, Analysis
Portfolio / Client Update
With our money flow signals switching back to a “buy,” we did increase exposures, as noted below. However, the rally has been feeble, and there is likely not a tremendous amount of upside currently. We expect that we will probably see a positive first two weeks of July, but August and September remain our targets for a bit of correction as we get through earnings season and all eyes to the Fed’s “Jackson Hole” confab.
The most significant risk to the markets remains a shift in the Fed’s monetary program. Given they have already started hinting about a potential taper and inflationary pressures are rising, the risk of a change remains elevated.
In the meantime, we continue to hold our positions and manage risk by adjusting holdings accordingly. As noted last week:
“There currently remain no ‘big red flags’ to make us significantly more active. But, should they appear, we assure you we will take action as needed.”
That remains the case this week.
Have a great 4th of July weekend.
During the past week, we made minor changes to portfolios. In addition, we post all trades in real-time at RIAPRO.NET.
*** Trading Update – Equity and Sector Models ***
We are reducing ADBE back to its original portfolio weight of 2% after a nice run lately that took the holding back to more extreme overbought conditions.
We are increasing AMLP to 2% of the portfolio in the ETF Sector model on the dip this morning to balance our Energy exposure and increase portfolio yield.” – 07/02/21
- Reduce ADBE to 2% of the portfolio.
- Increase AMLP to 2% of the portfolio.
“This morning we sold 1.5% of XOM and replaced it with 1.5% of AMLP in the equity model. We are picking up extra dividends and the technical backdrop looks better on AMLP than XOM.” – 06/30/21
- Sell 100% of XOM
- Add 1.5% in AMLP
“We added 7.5% of GSY to both portfolios this morning. The purpose is to sop up extra cash and improve our yield in the fixed income portfolio until we decide to increase our duration.” – 06/29/21
Equity & ETF Models
- Initiate a 7.5% position in GSY
“This morning we added a 5% trading position in DIA (Dow ETF) in all models. Our cash flow indicators signal an upward trend and historically the first two weeks of July are good for the markets. Beyond mid-July the market tends to consolidate or dip into the fall months, so we added a trading position now versus adding to individual holdings as it may likely be a short-term position.” – 06/28/21
Equity & ETF Models
- Initiate a 5% position in DIA
As always, our short-term concern remains the protection of your portfolio. Accordingly, we have shifted our focus from the election back to the economic recovery and where we go from here.
THE REAL 401k PLAN MANAGER
A Conservative Strategy For Long-Term Investors
If you need help after reading the alert, do not hesitate to contact me.
Model performance is a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. Such is strictly for informational and educational purposes only, and one should not rely on it for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril.
Have a great week!