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Technically Speaking: Risk Limits Hit, When Too Little Is Too Much

For the last several months, we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Importantly, we did not “sell everything” and go to cash.

Since then, we took profits and rebalanced risk again in late January and early February as well.

Our clients, their families, their financial and emotional “well being,” rest in our hands. We take that responsibility very seriously, and work closely with our clients to ensure that not only are they financially successful, but they are emotionally stable in the process.

This is, and has been, our biggest argument against “buy and hold,” and “passive investing.” While there are plenty of case studies showing why individuals will eventually get back to even, the vast majority of individuals have a “pain point,” where they will sell.

So, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threashold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened, which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern the Fed’s actions wouldn’t be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our Special Report for our RIAPro Subscribers (Risk-Free 30-Day Trial) last week:

“As you can see in the chart below, this is a massive surge of liquidity, hitting the market at a time the market is testing important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.” This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, with that important trendline broken, we took some action.

  • Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
  • Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private-sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.

This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008, which was a financial event alone).

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is the annual change in nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%; however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20 / share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

In other words, Wall Street estimates are still in “fantasy land.” 

If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

  • Current Earnings = 132.90
  • 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples, we can predict where “fair value” for the market is based on historical assumptions:

  • 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
  • 18x earnings: Still historically high.
  • 15x earnings: Long-Term Average
  • 13x earnings: Undervalued 
  • 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

  • 20x Earnings = -16% (Total decline from peak = – 40%)
  • 18x Earnings = 24.5% (Total decline from peak = – 46%)
  • 15x Earnings = -37.1% (Total decline from peak = – 55%)
  • 13x Earnings = 45.5% (Total decline from peak = – 61%)
  • 10x Earnings = 58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

  1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
  2. When you trap investors in markets, when they do open again, there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be an unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market.

Probably.

But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you, when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

RIA PRO: Risk Limits Hit

For the last several months we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Since then, as you know, we have taken profits, and rebalanced risk several times within the portfolios.

Importantly, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threshold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern we didn’t know if the Fed’s actions would be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions, but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our last week, in the Special Report Red Line In The Sand:

“As you can see in the chart below, this is a massive surge of liquidity hitting the market at a time the market is hitting important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure. However, given the extreme oversold condition, noted above, it is likely we are going to see a bounce, which we will use to reduce risk into.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.”

This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

This also explains why the market “failed to rally” when the Fed announced $500 billion today. There is another $500 billion coming tomorrow. We will see what happens.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, we took some action.

  • Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
  • Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.

This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008 which was a financial event alone).

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is annual nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%, however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20/share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

  • Current Earnings = 132.90
  • 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples we can predict where “fair value” for the market is based on historical assumptions:

  • 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
  • 18x earnings: Still historically high.
  • 15x earnings: Long-Term Average
  • 13x earnings: Undervalued 
  • 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

  • 20x Earnings = -16% (Total decline from peak = – 40%)
  • 18x Earnings = 24.5% (Total decline from peak = – 46%)
  • 15x Earnings = -37.1% (Total decline from peak = – 55%)
  • 13x Earnings = 45.5% (Total decline from peak = – 61%)
  • 10x Earnings = 58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

  1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
  2. When you trap investors in markets, when they do open again there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market?

Probably.

But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you that when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

Technically Speaking: On The Cusp Of A Bear Market

“Tops are a process, and bottoms are an event”

Over the last couple of years, we have discussed the ongoing litany of issues that plagued the underbelly of the financial markets.

  1. The “corporate credit” markets are at risk of a wave of defaults.
  2. Earnings estimates for 2019 fell sharply, and 2020 estimates are now on the decline.
  3. Stock market targets for 2020 are still too high, along with 2021.
  4. Rising geopolitical tensions between Russia, Saudi Arabia, China, Iran, etc. 
  5. The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
  6. Economic growth is slowing.
  7. Chinese economic data has weakened further.
  8. The impact of the “coronavirus,” and the shutdown of the global supply chain, will impact exports (which make up 40-50% of corporate profits) and economic growth.
  9. The collapse in oil prices is deflationary and can spark a wave of credit defaults in the energy complex.
  10. European growth, already weak, continues to weaken, and most of the EU will likely be in recession in the next 2-quarters.
  11. Valuations remain at expensive levels.
  12. Long-term technical signals have become negative. 
  13. The collapse in equity prices, and coronavirus fears, will weigh on consumer confidence.
  14. Rising loan delinquency rates.
  15. Auto sales are signaling economic stress.
  16. The yield curve is sending a clear message that something is wrong with the economy.
  17. Rising stress on the consumption side of the equation from retail sales and personal consumption.

I could go on, but you get the idea.

In that time, these issues have gone unaddressed, and worse dismissed, because of the ongoing interventions of Central Banks.

However, as we have stated many times in the past, there would eventually be an unexpected, exogenous event, or rather a “Black Swan,” which would “light the fuse” of a bear market reversion.

Over the last few weeks, the market was hit with not one, but two, “black swans” as the “coronavirus” shutdown the global supply chain, and Saudi Arabia pulled the plug on oil price support. Amazingly, we went from “no recession in sight”, to full-blown “recession fears,” in less than month.

“Given that U.S. exporters have already been under pressure from the impact of the “trade war,” the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S. With economic growth already struggling to maintain 2% growth currently, the virus could shave between 1-1.5% off that number. 

With our Economic Output Composite Indicator (EOCI) already at levels which has previously denoted recessions, the “timing” of the virus could have more serious consequences than currently expected by overzealous market investors.”

On The Cusp Of A Bear Market

Let me start by making a point.

“Bull and bear markets are NOT defined by a 20% move. They are defined by a change of direction in the trend of prices.” 

There was a point in history where a 20% move was significant enough to achieve that change in overall price trends. However, today that is no longer the case.

Bull and bear markets today are better defined as:

“During a bull market, prices trade above the long-term moving average. However, when the trend changes to a bear market prices trade below that moving average.”

This is shown in the chart below, which compares the market to the 75-week moving average. During “bullish trends,” the market tends to trade above the long-term moving average and below it during “bearish trends.”

In the last decade, there have been three previous occasions where the long-term moving average was violated but did not lead to a longer-term change in the trend.

  • The first was in 2011, as the U.S. was dealing with a potential debt-ceiling and threat of a downgrade of the U.S. debt rating. Then Fed Chairman Ben Bernanke came to the rescue with the second round of quantitative easing (QE), which flooded the financial markets with liquidity.
  • The second came in late-2015 and early-2016 as the market dealt with a Federal Reserve, which had started lifting interest rates combined with the threat of the economic fallout from Britain leaving the European Union (Brexit). Given the U.S. Federal Reserve had already committed to hiking interest rates, and a process to begin unwinding their $4-Trillion balance sheet, the ECB stepped in with their own version of QE to pick up the slack.
  • The latest event was in December 2018 as the markets fell due to the Fed’s hiking of interest rates and reduction of their balance sheet. Of course, the decline was cut short by the Fed reversal of policy and subsequently, a reduction in interest rates and a re-expansion of their balance sheet.

Had it not been for these artificial influences, it is highly likely the markets would have experienced deeper corrections than what occurred.

On Monday, we have once again violated that long-term moving average. However, Central Banks globally have been mostly quiet. Yes, there have been promises of support, but as of yet, there have not been any substantive actions.

However, the good news is that the bullish trend support of the 3-Year moving average (orange line) remains intact for now. That line is the “last line of defense” of the bull market. The only two periods where that moving average was breached was during the “Dot.com Crash” and the “Financial Crisis.”

(One important note is that the “monthly sell trigger,” (lower panel) was initiated at the end of February which suggested there was more downside risk at the time.)

None of this should have been surprising, as I have written previously, prices can only move so far in one direction before the laws of physics take over. To wit”

Like a rubber band that has been stretched too far – it must be relaxed before it can be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”

With the markets previously more than 20% of their long-term mean, the correction was inevitable, it just lacked the right catalyst.

The difference between a “bull market” and a “bear market” is when the deviations begin to occur BELOW the long-term moving average on a consistent basis. With the market already trading below the 75-week moving average, a failure to recover in a fairly short period, will most likely facilitate a break below the 3-year average.

If that occurs, the “bear market” will be official and will require substantially lower levels of equity risk exposure in portfolios until a reversal occurs.

Currently, it is still too early to know for sure whether this is just a “correction” or a “change in the trend” of the market. As I noted previously, there are substantial differences, which suggest a more cautious outlook. To wit:

  • Downside Risk Dwarfs Upside Reward. 
  • Global Growth Is Less Synchronized
  • Market Structure Is One-Sided and Worrisome. 
  • COVID-19 Impacts To The Global Supply Chain Are Intensifying
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
  • Peak Buybacks
  • China, Europe, and the Emerging Market Economic Data All Signal a Slowdown
  • The Democrats Control The House Which Effectively Nullifies Fiscal Policy Agenda.
  • The Leadership Of The Market (FAANG) Has Faltered.

Most importantly, the collapse in interest rates, as well as the annual rate of change in rates, is screaming that something “has broken,” economically speaking.

Here is the important point.

Understanding that a change is occurring, and reacting to it, is what is important. The reason so many investors “get trapped” in bear markets is that by the time they realize what is happening, it has been far too late to do anything about it.

Let me leave you with some important points from the legendary Marty Zweig: (h/t Doug Kass.)

  • Patience is one of the most valuable attributes in investing.
  • Big money is made in the stock market by being on the right side of the major moves. The idea is to get in harmony with the market. It’s suicidal to fight trends. They have a higher probability of continuing than not.
  • Success means making profits and avoiding losses.
  • Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major decision.
  • The trend is your friend.
  • The problem with most people who play the market is that they are not flexible.
  • Near the top of the market, investors are extraordinarily optimistic because they’ve seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and always rose to loftier levels. At the top, optimism is king; speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated. 
  • I measure what’s going on, and I adapt to it. I try to get my ego out of the way. The market is smarter than I am, so I bend.
  • To me, the “tape” is the final arbiter of any investment decision. I have a cardinal rule: Never fight the tape!
  • The idea is to buy when the probability is greatest that the market is going to advance.

Most importantly, and something that is most applicable to the current market:

“It’s okay to be wrong; it’s just unforgivable to stay wrong.” – Marty Zweig

There action this year is very reminiscent of previous market topping processes. Tops are hard to identify during the process as “change happens slowly.” The mainstream media, economists, and Wall Street will dismiss pickup in volatility as simply a corrective process. But when the topping process completes, it will seem as if the change occurred “all at once.”

The same media which told you “not to worry,” will now tell you, “no one could have seen it coming.”

The market may be telling you something important, if you will only listen.

Save

Technically Speaking: Sellable Rally, Or The Return Of The Bull?

Normally, “Technically Speaking,” is analysis based on Monday’s market action. However, this week, we are UPDATING the analysis posted in this past weekend’s newsletter, “Market Crash & Navigating What Happens Next.”

Specifically, we broke down the market into three specific time frames looking at the short, intermediate, and long-term technical backdrop of the markets. In that analysis, we laid out the premise for a “reflexive bounce” in the markets, and what to do during the process of that move. To wit:

“On a daily basis, the market is back to a level of oversold (top panel) rarely seen from a historical perspective. Furthermore, the rapid decline this week took the markets 5-standard deviations below the 50-dma.”

Chart updated through Monday

“To put this into some perspective, prices tend to exist within a 2-standard deviation range above and below the 50-dma. The top or bottom of that range constitutes 95.45% of ALL POSSIBLE price movements within a given period.

A 5-standard deviation event equates to 99.9999% of all potential price movement in a given direction. 

This is the equivalent of taking a rubber band and stretching it to its absolute maximum.”

Importantly, like a rubber band, this suggests the market “snap back” could be fairly substantial, and should be used to reduce equity risk, raise cash, and add hedges.”

Importantly, read that last sentence again.

The current belief is that the “virus” is limited in scope and once the spread is contained, the markets will immediately bounce back in a “V-shaped” recovery.  Much of this analysis is based on assumptions that “COVID-19” is like “SARS” in 2003 which had a very limited impact on the markets.

However, this is likely a mistake as there is one very important difference between COVID-19 and SARS, as I noted previously:

“Currently, the more prominent comparison is how the market performed following the ‘SARS’ outbreak in 2003, as it also was a member of the ‘corona virus’ family. Clearly, if you just remained invested, there was a quick recovery from the market impact, and the bull market resumed. At least it seems that way.”

“While the chart is not intentionally deceiving, it hides a very important fact about the market decline and the potential impact of the SARS virus. Let’s expand the time frame of the chart to get a better understanding.”

“Following a nearly 50% decline in asset prices, a mean-reversion in valuations, and an economic recession ending, the impact of the SARS virus was negligible given the bulk of the ‘risk’ was already removed from asset prices and economic growth. Today’s economic environment could not be more opposed.”

This was also a point noted by the WSJ on Monday:

Unlike today, the S&P 500 ETF (SPY) spent about a year below its 200-day moving average (dot-com crash) prior to the SARS 2003 outbreak. Price action is much different now. SPY was well above its 200-day moving average before the coronavirus outbreak, leaving plenty of room for profit-taking.”

Importantly, the concern we have in the intermediate-term is not “people getting sick.” We currently have the “flu” in the U.S. which, according to the CDC, has affected 32-45 MILLION people which has already resulted in 18-46,000 deaths.

Clearly, the “flu” is a much bigger problem than COVID-19 in terms of the number of people getting sick. The difference, however, is that during “flu season,” we don’t shut down airports, shipping, manufacturing, schools, etc. The negative impact to exports and imports, business investment, and potentially consumer spending, which are all direct inputs into the GDP calculation, is going to be reflected in corporate earnings and profits. 

The recent slide, not withstanding the “reflexive bounce” on Monday, was beginning the process of pricing in negative earnings growth through the end of 2020.

More importantly, the earnings estimates have not be ratcheted down yet to account for the impact of the “shutdown” to the global supply chain. Once we adjust (dotted blue line) for the a negative earnings environment in 2020, with a recovery in 2021, you can see just how far estimates will slide over the coming months. This will put downward pressure on stocks over the course of this year.

Given this backdrop of weaker earnings, which will be derived from weaker economic growth, in the months to come is why we suspect we could well see this year play out much like 2015-2016. In 2015, the Fed was beginning to discuss tapering their balance sheet which initially led to a decline. Given there was still plenty of liquidity, the market rallied back before “Brexit” risk entered the picture. The market plunged on expectations for a negative economic impact, but sprung back after Janet Yellen coordinated with the BOE, and ECB, to launch QE in the Eurozone.

Using that model for a reflexive rally, we will likely see a failed rally, and a retest of last weeks lows, or potentially even set new lows, as economic and earnings risks are factored in. 

Rally To Sell

As expected, the market rallied hard on Monday on hopes the Federal Reserve, and Central Banks globally, will intervene with a “shot of liquidity” to cure the market’s “COVID-19” infection.

The good news is the rally yesterday did clear initial resistance at the 200-dma which keeps that important break of support from being confirmed. This clears the way for the market to rally back into the initial “sell zone” we laid out this past weekend.

Importantly, while the volume of the rally on Monday was not as large as Friday’s sell-off, it was a very strong day nonetheless and confirmed the conviction of buyers. With the markets clearing the 200-dma, and still oversold on multiple levels, there is a high probability the market will rally into our “sell zone” before failing.

For now look for rallies to be “sold.”

The End Of The Bull

I want to reprint the last part of this weekend’s newsletter as the any rally that occurs over the next couple of weeks will NOT reverse the current market dynamics.

“The most important WARNING is the negative divergence in relative strength (top panel).  This negative divergence was seen at every important market correction event over the last 25-years.”

“As shown in the bottom two panels, both of the monthly ‘buy’ signals are very close to reversing. It will take a breakout to ‘all-time highs’ at this point to keep those signals from triggering.

For longer-term investors, people close to, or in, retirement, or for individuals who don’t pay close attention to the markets or their investments, this is NOT a buying opportunity.

Let me be clear.

There is currently EVERY indication given the speed and magnitude of the decline, that any short-term reflexive bounce will likely fail. Such a failure will lead to a retest of the recent lows, or worse, the beginning of a bear market brought on by a recession.

Please read that last sentence again. 

Bulls Still In Charge

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the weeks, and months, ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.) Currently, the good news for the bulls, is the bullish trend line from the 2015 lows held. However, weekly “sell signals” are close to triggering, which does increase short-term risks.

With the seasonally strong period of the market coming to its inevitable conclusion, economic and earnings data under pressure, and the virus yet to be contained, it is likely a good idea to use the current rally to rebalance portfolio risk and adjust allocations accordingly.

As I stated in mid-January, and again in early February, we reduced exposure in portfolios by raising cash and rebalancing portfolios back to target weightings. We had also added interest rate sensitive hedges to portfolios, and removed all of our international and emerging market exposures.

We will be using this rally to remove basic materials and industrials, which are susceptible to supply shocks, and financials which will be impacted by an economic slowdown/recession which will likely trigger rising defaults in the credit market.

Here are the guidelines we recommend for adjusting your portfolio risk:

Step 1) Clean Up Your Portfolio

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Take profits in positions that have been big winners
  3. Sell laggards and losers
  4. Raise cash and rebalance portfolios to target weightings.

Step 2) Compare Your Portfolio Allocation To Your Model Allocation.

  1. Determine areas requiring new or increased exposure.
  2. Determine how many shares need to be purchased to fill allocation requirements.
  3. Determine cash requirements to make purchases.
  4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.
  5. Determine entry price levels for each new position.
  6. Determine “stop loss” levels for each position.
  7. Determine “sell/profit taking” levels for each position.

(Note: the primary rule of investing that should NEVER be broken is: “Never invest money without knowing where you are going to sell if you are wrong, and if you are right.”)

Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are adjusting exposure to areas we like now, and using the rally to reduce/remove the sectors we do not want exposure too.

Stay alert, things are finally getting interesting.

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Technically Speaking: The Drums Of Trade War – Part Deux

In June of 2018, as the initial rounds of the “Trade War” were heating up, I wrote:

“Next week, the Trump Administration will announce $50 billion in ‘tariffs’ on Chinese products. The trade war remains a risk to the markets in the short-term.

Of course, 2018 turned out to be a volatile year for investors which ended in the sell-off into Christmas Eve.

As we have been writing for the last couple of weeks, the risks to the market have risen markedly as we head into the summer months.

“It is a rare occasion when the markets don’t have a significant intra-year correction. But it is a rarer event not to have a correction in a year where extreme deviations from long-term moving averages occur early in the year. Currently, the market is nearly 6% above its 200-dma. As noted, such deviations from the norm tend not to last long and “reversions to the mean” occur with regularity.”

“With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. Again, this is why we discussed taking profits and rebalancing risk in our portfolios last week.”

Well, that certainly didn’t take long. As of Monday’s close, the entirety of the potential 5-6% decline has already been tagged.

The concern currently, is that while the 200-dma is critical to warding off a deeper decline, the escalation of the “trade war” is going to advance the timing of a recession and bear market. 

Let me explain why.

The Drums Of “Trade War”

On Monday, we woke to the “sound of distant drums” beating out the warning of escalation as China retaliated to Trump’s tariffs last week. To wit:

“After vowing over the weekend to “never surrender to external pressure,” Beijing has defied President Trump’s demands that it not resort to retaliatory tariffs and announced plans to slap new levies on $60 billion in US goods.

  • CHINA SAYS TO RAISE TARIFFS ON SOME U.S. GOODS FROM JUNE 1
  • CHINA SAYS TO RAISE TARIFFS ON $60B OF U.S. GOODS
  • CHINA SAYS TO RAISE TARIFFS ON 2493 U.S. GOODS TO 25%
  • CHINA MAY STOP PURCHASING US AGRICULTURAL PRODUCTS:GLOBAL TIMES
  • CHINA MAY REDUCE BOEING ORDERS: GLOBAL TIMES
  • CHINA ADDITIONAL TARIFFS DO NOT INCLUDE U.S. CRUDE OIL
  • CHINA RAISES TARIFF ON U.S. LNG TO 25% EFFECTIVE JUNE 1

China’s announcement comes after the White House raised tariffs on some $200 billion in Chinese goods to 25% from 10% on Friday (however, the new rates will only apply to goods leaving Chinese ports on or after the date where the new tariffs took effect).

Here’s a breakdown of how China will impose tariffs on 2,493 US goods. The new rates will take effect at the beginning of next month.

  • 2,493 items to be subjected to 25% tariffs.
  • 1,078 items to be subject to 20% of tariffs
  • 974 items subject to 10% of tariffs
  • 595 items continue to be levied at 5% tariffs

In further bad news for American farmers, China might stop purchasing agricultural products from the US, reduce its orders for Boeing planes and restrict service trade. There has also been talk that the PBOC could start dumping Treasuries (which would, in addition to pushing US rates higher, also have the effect of strengthening the yuan).”

The last point is the most important, particularly for domestic investors, as it is a change in their stance from last year. As we noted when the “trade war” first started:

The only silver lining in all of this is that so far, China hasn’t invoked the nuclear options: dumping FX reserves (either bonds or equities), or devaluing the currency. If Trump keeps pushing, however, both are only a matter of time.”

Clearly, China has now put those options on the table, at least verbally.

It is essential to understand that foreign countries “sanitize” transactions with the U.S. by buying or selling Treasuries to keep currency exchange rates stable. As you can see, there is a high correlation between fluctuations in the Yuan and treasury activity.

One way for China to both penalize the U.S. for tariffs, and by “the U.S.” I mean the consumer, is to devalue the Yuan relative to the dollar. This can be done by either stopping the process of sanitizing transactions with the U.S. or by accelerating the issue through the selling of U.S. Treasury holdings.

The other potential ramification is the impact on interest rates in the U.S. which is a substantial secondary risk.

China understands that the U.S. consumer is heavily indebted and small changes to interest rates have an exponential impact on consumption in the U.S.. For example, in 2018 interest rates rose to 3.3% and mortgages and auto loans came to screeching halt. More importantly, debt delinquency rates showed a sharp uptick.

Consumers have very little “wiggle room” to adjust for higher borrowing costs, higher product costs, or a slowing economy that accelerates job losses.

However, it isn’t just the consumer that will take the hit. It is the stock market due to lower earnings.

Playing The Trade

Let me review what we said previously about the impact of a trade war on the markets.

“While many have believed a ‘trade war’ will be resolved without consequence, there are two very important points that most of mainstream analysis is overlooking. For investors, a trade war would likely negatively impact earnings and profitability while slowing economic growth through higher costs.”

While the markets have indeed been more bullishly biased since the beginning of the year, which was mostly based on “hopes” of a “trade resolution,” we have couched our short-term optimism with an ongoing view of the “risks” which remain. An escalation of a “trade war” is one of those risks, the other is a policy error by the Federal Reserve which could be caused by the acceleration a “trade war.” 

In June of 2018, I did the following analysis:

“Wall Street is ignoring the impact of tariffs on the companies which comprise the stock market. Between May 1st and June 1st of this year, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the “beat the estimate game”).  For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.”

The red dashed line denoted the expected 11% reduction to those estimates due to a “trade war.”

“As a result of escalating trade war concerns, the impact in the worst-case scenario of an all-out trade war for US companies across sectors and US trading partners will be greater than anticipated. In a nutshell, an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies by ~11% and, thus, completely offset the positive fiscal stimulus from tax reform.”

Fast forward to the end of Q1-2019 earnings and we find that we were actually a bit optimistic on where things turned out.

The problem is the 2020 estimates are currently still extremely elevated. As the impact of these new tariffs settle in, corporate earnings will be reduced. The chart below plots our initial expectations of earnings through 2020. Given that a 10% tariff took 11% off earnings expectations, it is quite likely with a 25% tariff we are once again too optimistic on our outlook.

Over the next couple of months, we will be able to refine our view further, but the important point is that since roughly 50% of corporate profits are a function of exports, Trump has just picked a fight he most likely can’t win.

Importantly, the reigniting of the trade war is coming at a time where economic data remains markedly weak, valuations are elevated, and credit risk is on the rise. The yield curve continues to signal that something has “broken,” but few are paying attention.

With the market weakness yesterday, we are holding off adding to our equity “long positions” until we see where the market finds support. We have also cut our holdings in basic materials and emerging markets as tariffs will have the greatest impact on those areas. Currently, there is a cluster of support coalescing at the 200-dma, but a failure at the level could see selling intensify as we head into summer.

The recent developments now shift our focus from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.

As a portfolio manager, I must manage short-term opportunities as well as long-term outcomes. If I don’t, I suffer career risk, plain and simple. However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the current market environment.

Assuming that you were astute enough to buy the 2009 low, and didn’t spend the bulk of the bull market rally simply getting back to even, you would have accumulated years of excess returns towards meeting your retirement goals. 

If you went to cash now, the odds are EXTREMELY high that you will outpace investors who remain invested in the years ahead. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,”  but when the next “mean reverting event” occurs, the decline will destroy most, if not all, of the returns accumulated over the last decade.

China understands that Trump’s biggest weakness is the economy and the stock market. So, by strategically taking actions which impact the consumer, and ultimately the stock market, it erodes the base of support that Trump has for the “trade war.”

This is particularly the case with the Presidential election just 18-months away.

Don’t mistake how committed China can be.

This fight will be to the last man standing, and while Trump may win the battle, it is quite likely that “investors will lose the war.” 

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Technically Speaking: “‘Trade War’ In May & Go Away.”

Over the weekend, President Trump decided to reignite the “trade war” with China with two incendiary tweets. Via WSJ:

“In a pair of Twitter messages Sunday, Mr. Trump wrote he planned to raise levies on $200 billion in Chinese imports to 25% starting Friday, from 10% currently. He also wrote he would impose 25% tariffs ‘shortly’ on $325 billion in Chinese goods that haven’t yet been taxed.

‘The Trade Deal with China continues, but too slowly, as they attempt to renegotiate,’ the president tweeted. ‘No!’”

This is an interesting turn of events and shows how President Trump has used the markets to his favor.

In January of 2018, the Fed was hiking rates and beginning to reduce their balance sheet but markets were ramping higher on the back of freshly passed tax reform. As Trump’s approval ratings were hitting highs, he launched the “trade war” with China. (Which we said at the time was likely to have unintended consequences and would kill the effect of tax reform.)

“While many have believed a ‘trade war’ will be resolved without consequence, there are two very important points that most of mainstream analysis is overlooking. For investors, a trade war would likely negatively impact earnings and profitability while slowing economic growth through higher costs.”

As I updated this past weekend:

But even more important is the impact to forward guidance by corporations.

Nonetheless, with markets and confidence at record highs, Trump had room to play “hard  ball” with China on trade.

However, by the end of 2018, with markets down 20% from their peak, Trump’s “running room” had been exhausted. He then applied pressure to the Federal Reserve to back off their policy tightening and the White House begin a regular media blitz that a “trade deal” would soon be completed.

These actions led to the sharp rebound over the last 4-months to regain highs, caused a surge in Trump’s approval ratings, and improved consumer confidence. In other words, we are now back to exactly the same point where we were the last time Trump started a “trade war.” More importantly, today, like then, market participants are at record long equity exposure and record net short on volatility.

With the table reset, President Trump now has “room to operate” heading into the 2020 election cycle.

The problem, is that China knows time is short for the President and subsequently there is “no rush” to conclude a “trade deal” for several reasons:

  1. China is playing a very long game. Short-term economic pain can be met with ever-increasing levels of government stimulus. The U.S. has no such mechanism currently, but explains why both Trump and Vice-President Pence have been suggesting the Fed restarts QE and cuts rates by 1%.
  2. The pressure is on the Trump Administration to conclude a “deal,” not on China. Trump needs a deal done before the 2020 election cycle AND he needs the markets and economy to be strong. If the markets and economy weaken because of tariffs, which are a tax on domestic consumers and corporate profits, as they did in 2018, the risk off electoral losses rise. China knows this and are willing to “wait it out” to get a better deal.
  3. As I have stated before, China is not going to jeopardize its 50 to 100-year economic growth plan on a current President who will be out of office within the next 5-years at most. It is unlikely, the next President will take the same hard line approach on China that President Trump has, so agreeing to something that is unlikely to be supported in the future is unlikely. It is also why many parts of the trade deal already negotiated don’t take effect until after Trump is out of office when those agreements are unlikely to be enforced. 

Even with that said, the markets rallied from the opening lows on Monday in “hopes” that this is actually just part of Trump’s “Art of the Deal” and China will quickly acquiesce to demands. I wouldn’t be so sure that is case.

The “good news” is that Monday’s “recovery rally” should embolden President Trump to take an even tougher stand with China, at least temporarily. The risk remains a failure to secure a trade agreement, even if it is more “show” than anything else.

Importantly, this is all coming at a time when the “Seasonal Sell Signal” has been triggered.

Sell In May

Let’s start with a basic assumption.

I am going to give you an opportunity to make an investment where 70% of the time you will win, but by the same token, 30% of the time you will lose. 

It’s a “no-brainer,” right? But,  you invest and immediately lose.

In fact, you lose the next two times, as well.

Unfortunately, you just happened to get all three instances, out of ten, where you lost money. Does it make the investment any less attractive? No. 

However, when in comes to the analysis of “Sell In May,” most often the analysis typically uses too short of a time-frame as the look back period to support the “bullish case.” For example, Mark DeCambre recently touched on this issue in an article on this topic.

“‘Sell in May and go away,’ — a widely followed axiom, based on the average historical underperformance of stock markets in the six months starting from May to the end of October, compared against returns in the November-to-April stretch — on average has held true, but it’s had a spotty record over the past several years.”

That is a true statement. But, does it make paying attention to seasonality any less valuable? Let’s take Dr. Robert Shiller’s monthly data back to 1900 to run some analysis. The table below, which provides the basis for the rest of this missive, is the monthly return data from 1900-present.

Using the data above, let’s take a look at what we might expect for the month of May

Historically, May is the 4th WORST performing month for stocks with an average return of just 0.29%. However, it is the 3rd worst performing month on a median return basis of just 0.52%.

(Interesting note:  As you will notice in the table above and chart below, average returns are heavily skewed by outlier events. For example, while October is the “worst month” because of major crashes like 1929 with an average return of -0.29%, the median return is actually a positive 0.39%. Such makes it just the 2nd worst performing month of the year beating out February [the worst].)

May and June tend to be some of weakest months of the year along with September. This is where the old adage of “Sell In May” is derived from. Of course, while not every summer period has been a dud, history does show that being invested during summer months is a “hit or miss” bet at best.

Like October, May’s monthly average is skewed higher by 32.5% jump in 1933. However, in more recent years returns have been primarily contained, with only a couple of exceptions, within a +/- 5% return band as shown below.

The chart below depicts the number of positive and negative returns for the market by month. With a ratio of 54 losing months to 66 positive ones, there is a 46% chance that May will yield a negative return.

The chart below puts this analysis into context by showing the gain of $10,000 invested since 1957 in the S&P 500 index during the seasonally strong period (November through April) as opposed to the seasonally weak period (May through October).

A Correction IS Coming

Based on the historical evidence it would certainly seem prudent to “bail” on the markets, right? No, at least not yet.

The problem with statistical analysis is that we are measuring the historical odds of an event occurring in the near future. Like playing a hand of poker, the odds of drawing to an inside straight are astronomically high. However, it doesn’t mean that it can’t happen.

Currently, the study of current price action suggests that the markets haven’t done anything drastically wrong as of yet. However, that doesn’t mean it won’t. As I discussed this past weekend:

“While the market did hold inside of its consolidation pattern, we are still lower than the previous peak suggesting we wait until next week for clarity. However, a bit of caution to overly aggressive equity exposure is certainly warranted.I say this for a couple of reasons.

  1. The market has had a stellar run since the beginning of the year and while earnings season is giving a “bid” to stocks currently, both current and forecast earnings continue to weaken.
  2. We are at the end of the seasonally strong period for stocks and given the outsized run since the beginning of the year a decent mid-year correction is not only normal, but should be anticipated.”

With the markets on “buy signals” deference should be given to the bulls currently. More importantly, the bullish trend, on both a daily and weekly basis, remains intact which keeps our portfolio allocations on the long side for now.

However, a correction is coming. This is why we took profits in some positions which have had outsized returns this year, rebalanced portfolio risk, and continue to carry a higher level of cash than normal.

As I noted last week:

“The important point to take away from this data is that “mean reverting” events are commonplace within the context of annual market movements. 

Currently, investors have become extremely complacent with the rally from the beginning of the year and are quick extrapolating current gains through the end of 2019.

As shown in the chart below this is a dangerous bet. In every given year there are drawdowns which have historically wiped out some, most, or all of the previous gains. While the market has ended the year, more often than not, the declines have often shaken out many an investor along the way.”

Let’s take a look at what happened the last time the market started out the year up 13% in 2012.

Here are some other years:

2007

2010

2011

Do you really think this market will continue its run higher unabated?

It is a rare occasion the markets don’t have a significant intra-year correction. But it is a rarer event not to have a correction in a year where extreme deviations from long-term moving averages occurs early in the year. Currently, the market is nearly 6% above its 200-dma. As noted, such deviations from the norm tend not to last long and “reversions to the mean” occur with regularity. 

With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. Again, this is why we discussed taking profits and rebalancing risk in our portfolios last week.

I am not suggesting you do anything, but it is just something to consider when the media tells you to ignore history and suggests “this time may be different.” 

That is usually just about the time when it isn’t.

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Why It’s Right To Warn About A Bubble For 10 Years

As a long-time anti-economic bubble activist (both in the mid-2000s bubble cycle and the post-2009 cycle), a very common charge that’s leveled against me is “you’ve been warning about bubbles for years, but the market keeps going up, up, and away!”, “you’re a permabear!,” and “you’ve been missing out on tons of profits!”

Because of the large scale that I’ve been warning on in the media, I’ve probably heard this criticism over a thousand times. The tweet below (from today) is a perfect example of this criticism:

 

Tweet

I find these criticisms to be extremely frustrating, factually incorrect, and completely ignorant of the message that I’ve been preaching over and over – here are the reasons why:

  • I’ve always said that the best bubble warnings are the earliest bubble warnings, because society needs as much lead time as possible to take action to prevent the bubble. Early bubble warnings also give individuals and families time to prepare for a coming bust and deep recession. Just think of how many people lost their homes, businesses, and jobs during the U.S. housing bust 10 years ago: don’t you think they could have benefited from an early warning?! Of course they would have! It’s common sense (which is not so common, unfortunately).
  • “You’re a permabear!,”You’ve missed the bull market!”, etc. This is flat-out wrong: I foresaw and warned of the coming debt and bubble-driven bull market in early-2012 in great detail. I said that we were likely headed for a huge bull market, but it wasn’t going to be a sustainable economic boom, but one that leads to a depression when it pops (which is still ahead).
  • “You’ve been calling for a bear market all along, but the market keeps going up!” – Yes, there will be a tremendous economic crash when this false economic recovery/bull market ends, but I’ve always said that you need to “trade with the trend, not against it” (if you must invest or trade). I have said this probably hundreds of times throughout the years, yet I keep receiving the same criticisms over and over. People simply do not listen. I’m at a complete loss as to how to communicate my ideas so that everyone clearly understands my positions. I think people just assume – without paying attention to the important nuances and caveats – that I’m a stereotypical “bear,” which means that I’m calling for a crash at all times.

Lately, I’ve been hearing the criticism “you’ve been warning about this bubble for 10 years now! When are you going to admit you were wrong?!” Yes, I know it’s been seven years (I started warning about the current bubble in June 2011), but even warning about a bubble for ten years isn’t crazy at all – for an example of this, we only need to look to the U.S. housing bubble, which inflated from roughly 1997 until 2007. I believe that someone would have been completely justified for warning about this disastrous bubble for a full decade. Just imagine the kind of criticisms that would be leveled in the latter stages of the bubble in 2005, 2006, and 2007 at someone who had been warning about the U.S. housing bubble since 1997! They’d probably want to hide under a rock, yet they would have been completely correct. I believe that the current bubble is no different.

The chart below shows the U.S. housing price bubble from 1997 to 2007. I believe that bubbles are a process rather than a specific point in time right before they burst. The U.S. housing bubble was actually a bubble even as early as 1998 and 1999, just like the current “Everything Bubble” was a bubble even back in 2011, 2012, and 2013. A bubble is differentiated from a sustainable economic boom and bull market because of what drives it: cheap credit (typically due to central banks holding interest rates low), rapid credit growth, asset overvaluation, rampant speculation, “fool’s gold” booms in various sectors and industries, and the “gold rush” mentality. Sustainable economic booms and bull markets, however, are driven by technological and scientific advances, rising productivity, improvements in governance and regulation, society or the world becoming more peaceful, individuals and corporations saving and investing for the long-term, debts being paid down and improving credit ratings, and so on.

Case-Shiller Chart #1

Similar to housing prices, the U.S. mortgage bubble inflated from approximately 1997 to 2007. While someone who warned about this credit expansion for ten years would have been written off as a total crackpot in the latter stages of the bubble, there was a method to their madness. If society had actually paid attention to those early bubble warnings, the ultimate crash would have been far less severe or may not have happened at all. Today’s bubble will prove to be no different: if society had listened to people like me back in 2011 and 2012, the coming crash would be far less severe. Instead, people like me are currently being labeled as crackpots, even though everything we’re saying will make complete sense in the next crisis.

U.S. Mortgage Bubble, Chart #1

Contrary to the two charts above, the two charts below illustrate how the mainstream economics and financial world thinks about bubbles: they think you are only correct if you warn about a bubble immediately before it pops. How does that make any sense? To me, it’s completely counterintuitive, but I’ve learned that the mainstream world really does think this way based on my interactions with them and the criticisms they keep hurling at me. Wouldn’t you want to try to prevent an economic crisis as early as possible? Of course, but they just don’t see it that way. The greed encouraged by the speculative bubble completely blinds them from seeing the truth. They can only think in terms of their Profit & Loss statement and tactical market timing signals – ie., if you warn about a bubble, that means that you’re calling “THE TOP,” right here and right now. Heaven forbid you’re slightly early, your financial career and reputation is basically ruined.

Case-Shiller Chart #2

The chart below shows the U.S. mortgage bubble and how the mainstream economics and financial world thinks of it.

U.S. Mortgage Bubble, Chart #2While I believe that the best bubble warnings are the earliest bubble warnings as an anti-economic bubble activist, I obviously don’t approach trading this way! As I explained earlier, I believe you need to trade with the trend, not against it (if you must trade). You should not short early on in a bubble, otherwise you will get destroyed. Again, this is common sense and I’ve said this all along, but people automatically assume that skeptics like me are short all the time. Anti-economic bubble activism is a completely different discipline from successful trading, and this is why people are often confused by my message and position.

"Trade with the trend"

The chart below shows total U.S. system leverage vs. the S&P 500. Rising leverage or debt is driving stock prices higher and has enabled the so-called “recovery” from the 2008 – 2009 crash. I have been warning about this bubble since 2011 and I am proud of it. If I could go back, I would warn about it even earlier – in 2009 or 2010. Every economist should have been warning about it. Each year that has passed since the 2009 bottom, leverage continues to increase, which means that the next crash is going to be even more extreme than 2008 was.

U.S. system leverage

Thanks to the current phase of the bubble that has inflated since 2009, the U.S. stock market is as overvalued as it was in 1929, which means that a painful mean reversion is inevitable. How did the market get to this point? It did so by inflating in 2010, 2011, 2012, and so on. Had society listened to people like me who warned about this inflating bubble back then, the market would not be this overvalued. Now, a massive bear market and financial crisis is “baked into the cake” or guaranteed.

Stock Market Valuation

Right now, with the market as inflated as it is, greed is the dominant emotion by far. Most economists, traders, and the general public only see Dollar signs right now, not the extreme risk that we’re facing as a society. In their minds, the greatest risk or “crisis” is to have missed out on the bull market. Anyone who plays the role of a naysayer and warns about these risks gets shunned. It is really “uncool” to be an economic skeptic right now, but I’m an unusual person – I don’t care about being popular or cool; I care about doing what’s right, which is warning society against dangerous inflating bubbles. I believe vindication is not far away.

Please follow or add me on TwitterFacebook, and LinkedIn to stay informed about the most important trading and bubble news as well as my related commentary.

Technically Speaking: The Evaporation Of Risk

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


On Monday, the markets broke out, again, to all-time highs. This is not surprising and something that I noted over the weekend. To wit: 

“Stepping back from the sector-specific action, if you only looked at the S&P 500 to judge what was happening in the markets, you wouldn’t suspect anything was wrong.”

“The market breakout remains intact currently with support at 2400 holding firm. The bullish trend line, which also intersects at 2400 remains critically important as the secondary buy/sell signal remains in positive territory. The only negative currently, despite improvement, is the ‘weekly sell signal-1’ remains triggered which keeps us on ‘alert.’ (It is also worth noting both signals remain at VERY high levels which suggest current upside remains somewhat limited.)

You can understand why more and more commentary is beginning to succumb to the ‘siren’s song’ of why ‘this time is different.’ Whether it is terrorist attacks, poor economic data, geopolitical tensions, or plunging oil prices, the market has continued its advance. It certainly seems to be ‘bulletproof.’” 

Last week, we added additional exposure for the second time since the “breakout” occurred.

Not surprisingly, I have gotten many emails questioning the addition given the current extension, over valuation and excess bullishness in the market. I can certainly understand the confusion.  Buying “breakouts” is a function of participating in a momentum driven market and clearly “momentum” is in full swing currently. As I discussed with one of the firm’s clients on Friday, while the long-term return outlook is not favorable, in the short-term we have to invest in order to create returns when opportunities exist. In this regard, we buy “breakouts” when they are confirmed, as the recent breakout has been, because “new highs tend to lead to further new highs.” 

Despite, one news headline to the next, the market has continued to push higher and last week’s test of “support,” set the market up for Monday’s move to “new highs.” While sustainability remains key, we remain invested currently with very tight stops, and some hedges, already in place.

But it is in that inherent breakout that we continue to see the rise of exuberance over the reality of fundamentals.

“There is very little concern about the risk being taken on by investors currently without any regard for the underlying risk as they chase ‘yield and return.’”

“The forgotten piece of this ‘fairytale’ is that RISK = How much you LOSE when you are wrong. 

Currently, the risk/reward ratio is currently heavily skewed against investors in both the short, intermediate and long-term outlook.”

The Evaporation Of Risk

As stated, the word “RISK” is not normally associated with positive outcomes.

I was visiting with a new client of the firm last week who had just transferred over from one of the “big box” financial firms. Of course, as usual, she began to regurgitate the media-driven myths of how she was a “long term” investor, how she was diversified and that she was willing to ride out the “wiggles” in the market.

It takes me only a couple of questions to quickly derail these myths.

  1. What did you do in 2001-2002 and/or 2008?
  2. How did you feel?
  3. Are you willing to do that again?

Since the “dot.com” bust, when I began asking those questions, I have NEVER had anyone tell me:

  1. I sold near the top and bought near the bottom. (Sell High/Buy Low)
  2. It was a truly terrific experience watching half of my money disappear. 
  3. Absolutely, just tell me when so I can get some popcorn.

In this particular case, she happened to be an avid “poker player” and enjoyed going to Las Vegas for a “few hands” at the tables.

Poker is an extremely easy comparison to investing as the general rules of risk management apply to both. The conversation was quick.

“Do you go ‘all in’ on every hand your are dealt?” 

“Of course, not” she responded.

“Why not?”

“Because I will lose all my money,” she said.

“You say that with a lot of certainty. Why?”

“Well, I am not going to win every hand, so if I bet everything, I will certainly lose everything” she stated.

“Correct. So why do you invest that way?”

“………….Silence………………….”

The issue of “risk,” as stated above, whether it is in the financial markets or a hand of poker is the same.  It is simply how much money you lose when the “bet” you made goes wrong.

In poker, most individuals can not calculate the odds of drawing a winning hand. However, while they may not know the odds of drawing a “full house” in a 7-card poker hand is just 2.6%, they do know the odds of “winning” with such a hand are fairly high. Therefore, they are comfortable betting heavier on that particular hand.

But when it comes to investing, they are comfortable betting the retirement savings on a market which, at current valuation levels, has a long history of delivering less than optimistic results. I have shown you the following chart before, and statistically speaking the odds simply aren’t in your favor.

Despite this simple reality, investors continue to chase stocks as if future returns over the next 10-years will be as profitable as the last 10-years. This most likely will not be the case.

Yet, the “evaporation of risk” continues to accelerate as the market seemingly becomes ever more immune to “bad news,” or should I just say “news.”

The S&P 500 P/E to VIX ratio is also elevated to levels that have normally warned that you are betting on a losing hand.

The issue of understanding risk/reward is the single most valuable aspect of managing a portfolio. Chasing performance in the short-term can seem to be a profitable venture, just as if hitting a “hot streak” playing poker can seem to be a “no lose” proposition.

But in the end, the “house always wins” unless you play by the rules.

8-Rules Of Poker:

1) You need an edge

As Peter Lynch once stated:

“Investing without research is like playing stud poker and never looking at the cards.”

There is a clear parallel between how successful poker players operate and those who are generally less sober, more emotional, and less expert. The financial markets are nothing more than a very large poker table where your job is to take advantage of those who allow emotions to drive their decisions and those who “bet recklessly” based on “hope” and “intuition.”

2) Develop an expertise in more than one area

The difference between winning occasionally and winning consistently in the financial markets is to be able to adapt to the changing market environments. There is no one investment style that is in favor every single year – which is why those that chase last years performing mutual funds are generally the least successful investors over a 10 and 20 year period.

As the great Wayne Gretzky once said:

“I skate where the puck is going to be, not where it has been.”

3) Figure out why people are betting against you.

“We know nothing for certain.” We know what a company’s business is today, maybe even what they are most likely to do in the coming months. We can determine whether the price of its stock is trending higher or lower. But in the grand scheme of things, we don’t know much. In fact, we are closer to knowing nothing than to knowing everything, so let’s just round down and be done with it.

Managing a portfolio for “what we don’t know” is the hardest part of investing. With stocks, we have to always remember that there is always someone on the other side of the trade. Every time some fund manager on television encourages you to “buy,”someone else has to be willing to sell those shares to you. Why are they selling? What do they know that you don’t?

3) Don’t assume you are the smartest person at the table. 

When an investment meets your objectives, be willing to take some profits. When it begins to break down, hedge the risk. When your reasons for buying have changed, be willing call it a day and walk away from the table.

4) It often pays to pass, and 5) Know when to quit and cash in your chips

Kenny Rogers summed this up best:

“If you’re gonna play the game, boy…You gotta learn to play it right – You’ve got to know when to hold ’em. Know when to fold ’em. Know when to walk away.  Know when to run. You never count your money when you’re sittin’ at the table.  There’ll be time enough for countin’ when the dealin’s done.”

This is the hardest thing for individuals to do. Your portfolio is your “hand” and there are times that you have to get rid of bad cards (losing positions) and replace them with hopefully better ones. However, even that may not be enough. There are times that things are just working against you in general and it is time to walk away from the table.

All great investors develop a risk management philosophy (a sell discipline) and combining that with a set of tools to implement that strategy. This increases the odds of success by removing the emotional biases that interfere with investment decisions. Just as a professional poker player is disciplined with his craft, a disciplined strategy allows for the successful navigation of a fluid investment landscape. A disciplined strategy no only tells you when you to “make a bet,” but also when to “walk away.”

6) Know your strengths AND your weaknesses & 7) When you can’t focus 100% on the task at hand – take a break.

Two-time World Series of Poker winner Doyle Brunson joked a bit about his book with which he had thrown around two alternative ideas for titles before going with “Super/System“. The first was How I made over $1,000,000 Playing Poker, and the second equally accurate idea was,How I lost over $1,000,000 playing Golf.

The larger point here is that invariably there will be things in life that you are good at, and there are things you are much better off paying someone else to do.

Many investors believe they can manage money effectively on their own – and they are likely right as long as they are in a cyclical bull market. Of course, this idea is equivalent to being the only person seated at a poker table and the dealer deals all the cards face up. You might still lose a hand every now and then, but most likely you are going to win.

8) Be patient

Patience is hard. Most investors want immediate gratification when they make an investment. However, real investments can take years to produce their real results, sometimes, even decades. More importantly, as with playing poker, you are not going to win every hand and there are going to be times that nothing seems to be “going your way”. But that is the nature of investing; no investment discipline works ALL of the time. However, it is sticking with your discipline and remaining patient, provided it is a sound discipline to start with, that will ultimately lead to long-term success.

Those are the rules. Play by them and you have a better chance of winning. Don’t and you will likely lose more than you can currently imagine. As the old saying goes:

“If you look around the poker table and can’t spot the pigeon, it’s probably you.” 

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Technically Speaking: A Shot Across The Bow For “Passive Indexers”

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


I wanted to pick up on a discussion I started in this past weekend’s missive, with respect to both Friday’s rout in technology stocks as well as Monday’s rather nasty open. While the issue seemed to be a simple short-term rotation in the markets from large capitalization Technology and Discretionary stocks into the lagging small and mid-capitalization stocks, the sharpness of the “Tech Break” on Friday revealed an issue worth re-addressing. To wit:

Both Discretionary and Technology plunged on Friday as a headline from Goldman Sachs questioning ‘tech valuations’ sent algo’s running wild. The plunge was extremely sharp but fortunately regained composure and shares rebounded. A ‘flash crash.’

One day, we will not be so lucky. But the point I want to highlight here is this is an example of the ‘price vacuum’ that can occur when computers lose control. I can not stress this enough. 

This is THE REASON why the next major crash will be worse than the last.”

I am not alone in this reasoning. Just recently John Dizard wrote for the Financial Times:

“The most serious risks arising from ETFs are the macro consequences of too much capital being committed in too few places at the same time. The vehicles for over-concentration change over time, such as the ‘Nifty Fifty’ stocks back in 1973, Mexican and Argentine bonds a few years after that, internet shares in 1999, and commercial property every other decade, but the outcome is the same. Investors’ cash goes to money heaven, and there is a pro-cyclical decline in productive investment.

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing. Since US growth stocks such as Avon, the cosmetics company, Polaroid, the photography group, and IBM, the computer company, outperformed the market, growth-orientated portfolio managers raised more money in the early 1970s, which then led to more cash going to buy the same stocks.”

Andrew Lapthorne from Societe Generale also weighed in:

“The sell-offs themselves are not particularly unusual, but the uniformity of the prices moves all on the same day indicates a market driven by price chasing momentum, with investors heading for the door all at the same time.

Indeed, those S&P 500 stocks which sold-off on Friday were almost all from the strongest performing decile over the previous 12 months (the r-squared on the S&P 500 line in the chart below is 85%). Within Nasdaq, the relationship is even stronger at 95%.

Such a uniform sell-off strikes us as systematic, especially as the relationship weakens once you look at the broader and less liquid Nasdaq composite. For price chasing investors, Friday’s plunge serves as a warning; when it’s time to head for the door, you better move fast.”

These points are absolutely correct, and as I addressed in the Passive Indexing Trap:

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the ‘herding’ into ETF’s begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments. Don’t believe me? It happened in 2008 as the ‘Lehman Moment’ left investors helpless watching the crash.”

“Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.

Currently, with complacency and optimism near record levels, no one sees a severe market retracement as a possibility. But maybe that should be warning enough.”

Warning Shot

As was seen on Friday, and again on Monday, the consequence of a “rush for the exits” can leave investors a bit flat-footed in the process. However, don’t mistake the importance of that statement.

One of the biggest problems facing investors is ultimately when “something goes wrong.” When this happens, the initial response is paralysis, followed by a bit of panic, before ultimately falling prey to the host of emotional mistakes that repeatedly plague investors time and again. 

This time is likely to be no different.

Currently, I do not believe that we have begun the next major corrective cycle. In fact, the current rout has all the earmarks of another “buy the dip” move to feed the ongoing bullish mantra.

While there is certainly damage being wrought in the Technology and Discretionary sectors, the rotation to Financials, Energy, Small and Mid-Capitalization areas are offsetting the correctionary process. As shown below, the markets remain confined to the bullish trend currently while the overbought condition is being reduced.

However, this should be a clear “warning shot” to investors who have piled into ETF’s in the hopes indexing will offset the penalties of not paying attention to the risk they have taken on. 

“While passive indexing works while all prices are rising, the reverse is also true.”

Importantly, it is only near peaks in extended bull markets that logic is dismissed for the seemingly easiest trend to make money. Today is no different as the chart below shows the odds are stacked against substantial market gains from current levels.

As my partner, Michael Lebowitz, noted in a recent posting:

“Nobody is going to ring a bell at the top of a market, but there are plenty of warped investment strategies and narratives from history that serve the same purpose — remember Internet companies with no earnings and sub-prime CDOs to name two.”

Once prices fall enough the previously “passive indexer” becomes an “active panic seller.” With the flood of money into “passive index” and “yield funds,” the tables are once again set for a dramatic and damaging ending.

In the near term, over the next several months or even a year, markets could very likely continue their bullish trend as long as nothing upsets the balance of investor confidence and market liquidity. However, of that, there is no guarantee.

As Ben Graham stated back in 1959:

“‘The more it changes, the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, ‘the more it changes.’

The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound,  then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.

In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one.”

He is right, of course, things are little different now than they were then.

What is important to remember is that for every “bull market” there MUST be a “bear market.” While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline. 

Oh…so you say you’re going to “sell” those “passive ETF’s” before that happens?

Ahh! Well, you are not so “passive” after all.

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Technically Speaking: The Formula Behind “Buy High/Sell Low”

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


With the markets closed on Monday, there really isn’t much to update you on “technically” from this past weekend’s missive. The important point, if you haven’t read it, was:

“The failure of the market to rotate to the “risk on” trade should not be lightly dismissed.  A healthy breakout of the market should have been accompanied by both an increase in trading volume and leadership from the “smaller and riskier” stocks in the market. The chart below is the Russell 2000 Index as compared to the S&P 500 Index.

You can see this exuberance in the deviation of the S&P 500 from its long-term moving averages as compared to the collapse in the volatility index. There is simply “NO FEAR” of a correction in the markets currently which has always been a precedent for a correction in the past. 

The chart below is a MONTHLY chart of the S&P 500 which removes the daily price volatility to reveal some longer-term market dynamics. With the markets currently trading 3-standard deviations above their intermediate-term moving average, and with longer-term sell signals still weighing on the market, some caution is advisable.

While this analysis does NOT suggest an imminent “crash,” it DOES SUGGEST a corrective action is more likely than not. The only question, as always, is timing.  

However, this brings me to something I have addressed in the past but thought would be a good reminder as we head into the summer months:

“The most dangerous element to our success as investors…is ourselves.”

The Formula To Buy High / Sell Low

This past week, Mark Yusko and I had the following exchange on Twitter.


The point here is quite simple. Individuals, especially in very late-stage cyclical bull markets, tend to get “sucked” into the markets primarily due to the Wall Street and media driven hype which feeds the “fear of missing out (FOMO).”  As I noted previously:

“The longer a bull market exists, the more it is believed that it will last indefinitely.”

The chart below shows the long-term view of the market with its inherent full-market (combined secular bull and bear) cycles exposed.

The idea of full market cycles is important to understand as this is precisely how the formula functions. In the latter stages of the bull market cycle, as “exuberance” eventually sucks the last of the holdouts back in, the “buy high” side of the equation is fulfilled. The second half of the full-market cycle will complete the process.

Every year Dalbar releases their annual “Quantitative Analysis of Investor Behavior” study which continues to show just how poorly investors perform relative to market benchmarks over time. More importantly, they discuss many of the reasons for that underperformance which are all directly attributable to your brain. 

George Dvorsky once wrote that:

“The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions.

Cognitive biases are an anathema to portfolio management as it impairs our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money. They “buy high” as the emotion of “greed” overtakes logic and “sell low” as “fear” impairs the decision-making process.

Here are the top-5 of the most insidious biases which keep you from achieving your long-term investment goals.

1) Confirmation Bias

As individuals, we tend to seek out information that conforms to our current beliefs. If one believes that the stock market is going to rise, they tend to only seek out news and information that supports that position. This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below. I discussed this just recently in why “5-Laws Of Human Stupidity” and in “Media Headlines Will Lead You To Ruin.”

As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are “right.”

This is why it is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.

The issue of “confirmation bias” also creates a problem for the media. Since the media requires “paid advertisers” to create revenue, viewer or readership is paramount to obtaining those clients.  As financial markets are rising, presenting non-confirming views of the financial markets lowers views and reads as investors seek sources to “confirm” their current beliefs.

As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are “right.”

This is why it is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.

2) Gambler’s Fallacy

The “Gambler’s Fallacy” is one of the biggest issues faced by individuals when investing. As emotionally driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same.

The bias is clearly addressed at the bottom of every piece of financial literature.

“Past performance is no guarantee of future results.”

However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future.

This is one of the key issues that affect investor’s long-term returns. Performance chasing has a high propensity to fail continually causing investors to jump from one late cycle strategy to the next. This is shown in the periodic table of returns below. “Hot hands” only tend to last on average 2-3 years before going “cold.”

I traced out the returns of the S&P 500 and the Barclay’s Aggregate Bond Index for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom of the list in subsequent years. “Performance chasing” is a major detraction from investor’s long-term investment returns.

Of course, it also suggests that analyzing last year’s losers, which would make you a contrarian, has often yielded higher returns in the near future. Just something to think about with “bonds” as one of the most hated asset classes currently.

3) Probability Neglect

When it comes to “risk taking” there are two ways to assess the potential outcome. There are “possibilities” and “probabilities.” As individuals, we tend to lean toward what is possible such as playing the “lottery.”  The statistical probabilities of winning the lottery are astronomical, in fact, you are more likely to die on the way to purchase the ticket than actually winning the lottery. It is the “possibility” of being fabulously wealthy that makes the lottery so successful as a “tax on poor people.”

As investors, we tend to neglect the “probabilities” of any given action which is specifically the statistical measure of “risk” undertaken with any given investment. As individuals, our bias is to “chase” stocks that have already shown the biggest increase in price as it is “possible” they could move even higher. However, the “probability” is that most of the gains are likely already built into the current move and that a corrective action will occur first.

Robert Rubin, former Secretary of the Treasury, once stated;

“As I think back over the years, I have been guided by four principles for decision making. First, the only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty we must decide and we must act. And lastly, we need to judge decisions not only on the results, but on how they were made.

Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”

Probability neglect is another major component to why investors consistently “buy high and sell low.”

4) Herd Bias

Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, they if I want to be accepted I need to do it too.

In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets, the “herding” behavior is what drives market excesses during advances and declines.

As Howard Marks once stated:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.

Moving against the “herd” is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is knowing when to “bet” against the stampede.

5) Anchoring Effect

This is also known as a “relativity trap” which is the tendency for us to compare our current situation within the scope of our own limited experiences. For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for.  However, can you tell me what exactly what you paid for your first bar of soap, your first hamburger or your first pair of shoes? Probably not.

The reason is that the purchase of the home was a major “life” event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event and, therefore, we assume that the next home purchase will have a similar result.  We are mentally “anchored” to that event and base our future decisions around a very limited data.

When it comes to investing we do very much the same thing. If we buy a stock and it goes up, we remember that event. Therefore, we become anchored to that stock as opposed to one that lost value. Individuals tend to “shun” stocks that lost value even if they were simply bought and sold at the wrong times due to investor error. After all, it is not “our” fault that the investment lost money; it was just a bad stock. Right?

This “anchoring” effect also contributes to performance chasing over time. If you made money with ABC stock but lost money on DEF, then you “anchor” on ABC and keep buying it as it rises. When the stock begins its inevitable “reversion,” investors remain “anchored” on past performance until the “pain of ownership” exceeds their emotional threshold. It is then that they panic “sell” and are now “anchored” to a negative experience and never buy shares of ABC again.

This is ultimately the “end-game” of the current rise of the “passive indexing” mantra. When the selling begins, there will be a point where the pain of “holding” becomes to great as losses mount. It is at that point where “passive indexing” becomes “active selling” as our inherent emotional biases overtake the seemingly simplistic logic of “buy and hold.”  

Conclusion

In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today. Does the current extension of the financial markets appear to be rational? Are individuals current assessing the “possibilities” or the “probabilities” in the markets?

As individuals, we are investing our hard earned “savings” into the Wall Street casino. Our job is to “bet” when the “odds” of winning are in our favor. Secondly, and arguably the most important, is to know when to “push away” from the table to keep our “winnings.”

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Technically Speaking: Bulls Struggle With Bearish Internals

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


In this past weekend’s newsletter, I discussed the fact that despite the bullish “exuberance” of market participants, the underlying internal deterioration has continued. To wit:

“Furthermore, the underlying internals have continued to weaken over the last week which has remained a concern over the last couple of months.

The 10-year chart below, while a bit cluttered, shows several very important things worth considering currently. First, the top part of the weekly chart is essentially a buy/sell indicator. Each sell signal previously, has been indicative of a correction. The middle of the chart is a combination of internal strength indicators from the number of stocks on bullish buy signals, advancing vs declining issues and volume, and the percent of stocks above their 200-day moving average.”

“With all the internal indicators currently on the decline, when combined with a stochastic ‘sell signal,’ there is a higher probability of a correction in the weeks ahead. While this time could certainly be different, it is probably worth noting that making such a bet with your retirement money has not often ended well.”

As I stated, the chart above is a bit cluttered so I wanted to use today’s technical update to take a closer look at the internals supporting the current bull run.

Number Of Stocks On Bullish Buy Signals 

The number of stocks on bullish “buy” signals continues to wane despite the markets pushing all-time highs. This continues to suggest the underlying participation remains weak as the “breadth” of the advance has narrowed.

Number Of Stocks Above Their 200-Day Moving Average

The same can be seen in the number of stocks trading above their 200-day moving average. Deterioration in advance of a decline has historically been a good warning sign to scale back portfolio risk.

Number Of Advancing Issues (50-Day Moving Average)

The number of issues advancing on the NYSE has likewise deteriorated and has now diverged from the advance in the market. Participation is coincident with a rising “bull market, “ and deterioration of participation has also been a warning sign of forthcoming weakness. 

Volume Of Advancing Issues (50-Day Moving Average)

The same is true for the volume of advancing issues on the NYSE.

Price Momentum

Multiple measures of price momentum of the S&P 500, as shown below, also suggests a market that is currently extremely advanced and vulnerable to a corrective action. The dashed red lines denote when the price momentum oscillator has triggered a “sell” signal previously.

Yields Need To “Buy It”

Lastly, despite stocks pushing near all-time highs, the bond market continues to flirt with levels close to 2%. The continued move to “risk off” holdings, despite a rising stock market, suggests that ultimately either stocks OR bonds will be wrong. Historically, bonds have tended to be right more often than not.

The Yin & Yang Of It

None of the above should be construed that I am saying a “bear market” is fast approaching. For now, market prices remain elevated on the “hope” the “mythical tax cuts/reforms” will soon appear. If they do, great, as asset prices should get a temporary lift higher. The risk is the “swamp devours Trump,” and Washington gridlock keeps progress frozen until the 2018 election cycle.  The question is how long will “hope” hold out over legislative advancement?

However, there is a bigger issue on the horizon for the bulls and it can be summed up as follows:

“The longer a bull market exists, the more it is believed that it will last indefinitely.”

Unfortunately, as it is with all things in life, to each there is a cycle. The chart below shows the long-term view of the market with its inherent full-market (combined bull and bear) cycles exposed.

The idea of full market cycles is important to understand. “Where” you are within the current long-term investing cycle has everything to do with your long-term outcomes. The charts below take the classic investing psychology cycle (below) and overlays it with the long-term full market cycles driven by valuation cycles in the chart above.

The first full-market cycle lasted 63-years from 1871 through 1934. This period ended with the crash of 1929 and the beginning of the “Great Depression.”  If you invested in the financial markets at any point prior to 1920, you likely died much worse off than when you started.

The second full-market cycle lasted 45-years from 1935-1980. This cycle ended with the demise of the “Nifty-Fifty” stocks and the “Black Bear Market” of 1974. While not as economically devastating to the overall economy as the 1929-crash, it did greatly impair the investment psychology of those in the market. But even in this cycles, many individuals ran out of time long before achieving the financial goals they were promised.

The current full-market cycle is only 37-years in the making. Given the 2nd highest valuation levels in history, corporate, consumer and margin debt near historical highs, and average economic growth rates running at historical lows, it is worth questioning whether the current full-market cycle has been completed or not.

Importantly, considering most individuals didn’t start investing until near the turn of the century, much of the damage from the last two bear markets still remain. If the next down cycle completes the pattern, it is quite likely most investors won’t live long enough to be repaired by the first-half of the next cycle. 

The idea the “bull market” which begin in 1980 is still intact is not a new one. As shown below a chart of the market from 1980 to present, suggests the same.

The long-term bullish trend line remains and the cycle oscillator is only half-way through a long-term cycle. Furthermore, on a Fibonacci-retracement basis, a 61.8% retracement would current intersect with the long-term bullish trendline around 1000 suggesting the next downturn could indeed be a nasty one. But again, this is only based on the assumption the long-term full market cycle has not been completed as of yet.

I am NOT suggesting this is the case. This is just a thought-experiment about the potential outcome from the collision of weak economics, high levels of debt, and valuations and “irrational exuberance.”

Yes, this time could entirely be different.

It just never has been before. As I noted this past weekend, Rich Breslow summed the current environment up well, and is worth repeating in case you missed it.

“Markets can trend, range trade, and correct. But one thing they can’t do under the current scenario is time-correct. The minute they stop moving, a powerful, even if short-lived, impulse takes over to reevaluate, cherry-pick and average down. Even if you’re sure the story hasn’t run its course, it takes real moxie to remain exposed to the other side of trades you were very comfortably holding for the previous weeks and months.

We’re all leery of getting caught in over-crowded trades. Nothing feels more teeming than new trades predicated on emotion. Even if you feel very strongly about the subject. This is a be nimble, very nimble, environment when we’ve been rewarded time and again for buying and holding. Traders will need skills that have atrophied over years. Another reason we are years away from ‘normal.’”

I suspect he is right.

In the short-term, the market’s internals need to improve to support the ongoing bullish thesis. Our portfolios remain long-biased currently, but we have rebalanced by harvesting some profits and raising a little higher than normal cash levels.

However, in the longer-term as shown above, fundamental underpinnings continue to suggest the risk/reward ratio is heavily tilted against investors trying to “passively” index their portfolios. Such “armchair” approaches to investing are generally only seen in late stage bull market advances as “exuberance exceeds grasp.” The reason is it takes a very long period of a bullish advance to wipe-out the painful memories of the losses incurred by those same approaches previously.

The reminder will be just as painful.

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Technically Speaking: Market In Confusion

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


In this past weekend’s newsletter, I discussed the fact this market has been “nothing short of boring” as of late, but remains on a “bullish buy signal” currently. To wit:

“Importantly, the ‘buy’ signal that was registered in late April is very close to tripping a short-term sell signal. These signals have usually been indicative of short-term correction actions which can provide for better entry points for trading positions and rebalancing.

However, as shown below, on a longer-term basis the backdrop is more indicative of a potential correction rather than a further advance. With an intermediate-term (weekly) ‘sell’ signal triggered at historically high levels, the downside risk currently outweighs the potential for reward.”

Of course, as has become a usual outcome, on Monday, the markets clung to an announcement that both Saudi Arabia and Russia had hinted at extended production cuts for a while longer. The announcement created a rush to close out oil shorts and lifted prices back above resistance at $48/bbl. The fundamental problem which remains is a world in which global demand is weakening and supplies are still rising as shale production continues to expand. Not surprisingly, this will end badly in the not so distant future as the realization of the supply glut comes to fruition against the backdrop of weaker economic demand.

The push higher in energy prices did energize the markets enough to push back up to the top of the current trading range and temporarily staving off an approaching “sell signal.” 

It is critically important the market rallies this week enough to push the markets out of the current trading range and move asset prices higher on a broader base of participation.

Portfolios should remain weighted to the long-side currently, but some caution should be exercised as we move into the historically more volatile summer months which tends to sport weaker performance. 

One Confused Market

As I stated above, the internal measures of the market have weakened substantially in recent months. As I showed previously, the problem is while the stock market has pushed higher, both the number of stocks on bullish buy signals and the number trading above their respective 200-day moving averages have continued to weaken.

This divergence will likely not last much longer, the only question is whether the internals will “catch up,” as the “bulls” currently hope.

Interestingly, the overall market seems more “confused” as ever as to its general investment thesis. Let me walk you back in history for a moment prior to the election last year. As shown in the chart below, the market was fairly concentrated moving into the election as fears of a “Trump Victory,” would elicit a major market route. 

Following the election, the attitude changed quickly as the “Trumpflation” trade set in pushing Financials, Industrials and Materials to extremes at the end of the year. It was at this point that we began recommending adding to the deeply out of favor sectors for a “risk off” rotation trade moving into the New Year. 

Of course, that was exactly what happened as the current Administration became quickly acquainted with Washington bureaucracy and political infighting. As hopes of a quick resolution to the health care debacle and tax reforms began to fade, the “Trumpflation” trade faded with it. 

Now, a new problem has emerged, “confusion.” With time wearing on, the hopes of a swift reform of the tax code, which would be the primary boost to the resurgence in profitability, has faded. Furthermore, the early surge in consumer confidence has yet to transform into stronger economic activity. As noted over the weekend Morgan Stanley’s Chief Economist Ellen Zentner wrote: 

“ARIA appears to have fallen off a cliff in April, with a 0.72% decline, the largest since December 2008.”

(Note: ARIA, is a monthly US macro indicator based on data collected through primary research on key US sectors such as consumer, autos, housing, employment, and business investment.)

This has shown up in a bit of a “cluster ****” as money is quickly jumping from once sector to the next trying to figure out what the next “trade” is going to be.

In the lead right now are sectors that are both “risk on” (ie Technology, Emerging Market and Discretionary) as well as the “risk off” sectors. (Utilities, Health Care and Staples).

Talk about confused.

The problem, of course, that both trades are unlikely to be right. Either the market is going to breakout to the upside with a clear participation in the “risk on” stocks, or money will begin a rotation into the “risk off” trade of bonds and defensive equities. 

Net Positioning Suggests Caution

I currently suspect, although the market has defied logic in recent weeks, the outcome will lean towards the latter as we move further into the summer months. I base that assumption on the net positioning of traders in the recent Commitment of Traders reports.

Currently, the net-short positioning on the Volatility Index suggests there is a substantial amount of “fuel” to sustain a market “sell off” if one gets started for any reason. 

The net-short positioning in the Euro-Dollar also suggests much the same. The reversals of such large net-short positions have been associated with a liquidation run in the markets. With a record net-short position currently, combined with the VIX, the amount of “fuel” for an unwinding/reversion event could be much larger than most currently anticipate. 

Of course, such an event would lead ultimately to inflows into the “risk off” trade which would primarily be U.S. Treasuries. The current net long positioning suggests “smart money” has already taken that bet and will use the rush of “panicked buyers” to “sell into” as gains are made. This would be the same as has been witnessed previously as rates have tended to fall (pushing bond prices higher) as the net positioning is reversed. (vertical dashed lines)

Let me repeat from this past weekend’s missive, the current advance has been driven by several artificial factors:

  • Central Bank policies are succeeding in encouraging risk takers to take more risks in long-duration financial assets.
  • Many U.S. corporations that face lackluster top-line growth are repurchasing stock in record amounts at record prices rather than doing capital spending to bolster their physical plant. 
  • Volatility-trending strategies, risk-parity trading systems, and other quant-programs, keep pushing stock prices to new all-time highs.

All this feeds on itself, but what’s surprising is that few question how the above factors contribute to higher asset prices. They fail to recognize that if there were no adverse consequences to low or negative interest rates, massive liquidity injections, and central banks buying stocks, these would have become permanent and continuous monetary-policy strategies decades ago.

However, in the short-term, we must recognize the potential for the markets to remain “irrational” longer than logic would currently dictate. This is why I am cautiously managing portfolio risk and allowing the markets to “tell me” what to do rather than guessing at it.

“What happens over the next few days to weeks is really anyone’s guess. But, over the longer-term time horizon, I am unashamedly bearish as the current detachment between prices and fundamental reality can not last forever.”

Eventually, something’s gotta give, but until then we must remember:

“A bull market lasts until it is over.” – Jim Dines

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Technically Speaking: Breakout Or Fakeout

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


In this past weekend’s newsletter, I discussed the relatively “weak” breakout of the market to new record highs. To wit:

“Over the last few weeks, I have been discussing the ongoing consolidation process for the S&P 500 from the March highs. (For a review read: “Oversold Bounce Or Return Of The Bull,” and “Return Of The Bull…For Now.”) As the expected rally in stocks, and reversal in bonds, took shape as the S&P 500 was finally able to ratchet a record close at 2399.29. (Read: 10/2016 – “2400 Or Bust”)

“With the market on a short-term ‘buy signal,’ deference should be given to the probability of a further market advance heading into May. With earnings season in full swing, there is a very likely probability that stocks can sustain their bullish bias for now.

The market did do exactly that this past week, and while hitting a new high, as noted above, it was a ‘weak’ breakout as volume contracted.”

The question for the bulls, of course, is whether the current “breakout” is sustainable, or, is it a “fakeout” that reverses back into the previous trading range? As Steve Reitmeister from Zack’s Research suggested on Monday:

“I would say it all depends on investor confidence that tax breaks are on the way.”

It all hangs on just one issue.

As I have discussed previously, there is a huge risk with respect to the timing and extent of tax reform there will be.

“Given the current problems in Washington D.C. in getting legislative agenda agreed to by Congressional Republicans, delays should be expected.”

“The question, of course, is just how much time the markets will give Washington to make progress on legislative agenda? As noted above, the estimates currently driving stocks were based on tax cuts being brought through to boost bottom line profitability. If those cuts don’t happen soon, earnings disappointments may bite investors.”

It is that potential for disappointment given the overly bullish earnings estimates which poses the greatest risk to investors given the currently elevated levels of valuations.

There is no arguing corporate profitability improved during 2016 as oil prices recovered. The recovery in oil prices specifically helped sectors tied to the commodity such as Energy, Basic Materials, and Industrials.

Currently, while earnings have ticked up modestly with the recovery in oil prices, the price of the S&P 500 has moved substantially more than the earnings recovery would justify.

Furthermore, the recovery in earnings, without the direct bottom line impact from tax cuts, may be fleeting as the dollar remains persistently strong. 

Of course, we already know much of the rise in “profitability,” since the recessionary lows, has come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top line revenue. As shown in the chart below, there has been a stunning surge in corporate profitability despite a lack of revenue growth.

Since 2009, the reported earnings per share of corporations has increased by a total of 221%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 28% during the same period.

In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons: wage reduction, productivity increases, labor suppression and stock buybacks.  The problem is that each of these tools creates a mirage of corporate profitability which masks the real underlying weakness of the overall economic environment. Furthermore, each of the tools used to boost EPS suffer from both being finite in nature and having diminishing rates of return over time.

Of course, given the weakness in revenue growth, it is not surprising the markets are anxiously awaiting “tax cuts” which are a direct injection into bottom line earnings per share.

Importantly, it should be remembered that “tax cuts” will impact “earnings growth” rates for JUST ONE YEAR.

Let me explain:

  • Year-1 earnings = $1.00 per share.
  • Tax cuts add $0.30 per share in bottom lines earnings.
  • Year-2 earnings = $1.30 per share or 30% growth.
  • Year-3 earnings growth (assuming no organic growth) = $1.30 per share or 0% growth.

While tax cuts are certainly welcome as a boost to bottom line earnings, it should be remembered earnings growth must be sustained indefinitely to justify valuations at current levels.

Such is unlikely to happen.

With the Senate getting ready to scrap Congresses “AHCA” bill, and write their own plan which will then have to go back to Congress where the debates will begin again, it will likely take MUCH longer to get to tax reform than currently expected.

The problem, technically is that while the stock market is continuing to push higher, the internal strength continues to diminish as shown by both the number of stocks on bullish buy signals and the number trading above their respective 200 day moving averages.

Furthermore, with the volatility level now pressed to its lowest levels since 2007, combined with an extreme overbought condition, a sell signal at a high level, and a large deviation from the 200-dma, the risk of a short to intermediate-term correction has risen markedly.

S&P 3000…Or 1500

It would not surprise me to see the markets break out and attempt to push higher in the current environment. This is particularly the case as the confluence of Central Banks continue to buy assets, $1 Trillion since the beginning of the year, increased leverage and the embedded belief “There Is No Alternative (TINA).”  

It would be quite naive to suggest otherwise.

The chart below is a Fibonacci retracement/extension chart of the S&P 500. I have projected both a 123.6% advance from the 2009 lows as well at a standard 50% retracement using historical weekly price movements.

From the bullish perspective, a run to 3000, after a brief consolidation following an initial surge to 2500, is a distinct possibility. Such an advance is predicated on earnings and economic growth rates accelerating with tax cuts/reform being passed.

However, given the length of the economic and market cycle, there is a significant bear case being built which entails a pullback to 1543. Such a decline, while well within historical norms, would wipe out all gains going back to 2014. 

Just for the mathematically challenged, this is NOT a good risk/reward ratio.

  • 3000 – 2399 (as of Monday’s close) =  601 Points Of Potential Reward 
  • 2399 – 1543 = -856 Points Of Potential Loss

With a 1.3 to 1 risk/reward ratio, the potential for losses is far more damaging to your long-term investment goals than the gains available from here.

Moreover, the bearish case is also well supported by the technical dynamics of the market going back to the 1920’s, it would be equally naive to suggest that “This Time Is Different (TTID)” and this bull market has entered a new “bull phase.” (The red lines denote levels that have marked previous bull market peaks.)

Of course, as has always been the case, in the short-term it may seem like the current advance will never end.

It will.

And when it does the media will ask first “why no saw it coming.” Then they will ask “why YOU didn’t see it coming when it so obvious.” 

In the end, being right or wrong has no effect on the media as they are not managing money nor or they held responsible for consistently poor advice. But, being right or wrong has a very big effect on you.

Yes, a breakout and a move higher is certainly viable in the current “riskless” environment that is believed to exist currently.

However, without a sharp improvement in the underlying fundamental and economic back drop the risk of failure is rising sharply. Unfortunately, there is little evidence of such a rapid improvement in the making. Either that, or a return to QE by the Fed which would be a likely accommodation to offset a recessionary onset.

In either case, it will likely be a one-way trip higher and it should be realized that such a move would be consistent with the final stages of a market melt-up.

Just as a reminder…“gravity is a bitch.”

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Technically Speaking: Sell In May – Myth Or Reality?

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


With April now behind us, investors now enter into the seasonally weak 6-month period of the year. It is also the annual “right of passage” as the debate over the old Wall Street axiom “Sell In May And Go Away,” rages. As I noted in last week’s Technical Update:

“As we wrap up the month of April, we now begin the march into the seasonally weaker period of the year. As noted by Nautilus Research, the markets tend to get choppy over the next couple of months.”

Just recently at the 2017 Economic & Investment Summit, Greg Morris made an interesting statement worth considering in today’s discussion:

“If you believe something that you learned from your parents, or teachers, when you were young and have never questioned; how many things about investing and finance do you believe today but have never questioned?”

It is from this point that I want to discuss the issue of “Sell In May.”

Let’s start with a basic assumption.

I am going to give you an opportunity to make an investment where 70% of the time you will win, but by the same token, 30% of the time you will lose. 

It’s a “no-brainer,” right?

So, you invest and immediately lose. In fact, you lose the next two times, as well. Unfortunately, you just happened to get all three instances, out of ten, where you lost money. Does it make the investment any less attractive? No. 

But this is exactly what happens to investors all the time. They read about some investment strategy, or discipline, that historically has had a very high success rate, so, they jump in. Of course, as luck would have it, the next year market dynamics change somewhat and the strategy doesn’t work. Since, whatever strategy is obviously flawed, they jump to the next “hot” trend from last year.

This “rotation” can be seen in the Callan Periodic Table Of Returns. Most investors tend to “buy” whatever was “hot” last year, but as you can see, it rarely stays that way for long.

Wash. Rinse. Repeat.

In most instances, the analysis of “Sell In May” typically uses too short of a timeframe looking back only to the beginning of the last secular “bull market” that begin in the early 1980’s. Even Nautilus’ analysis above, while excellent, only looks back at the last 20-years. In order to properly analyze the historical tendencies of the markets, particularly given the impact of Central Bank interventions in recent years, we need a more extensive data set.

Therefore, using the monthly data provided by Dr. Robert Shiller, let’s take a look at the seasonally strong versus weak periods of the year going back to 1900. The table below, which provides the basis for the rest of this missive, is the monthly return data from 1900-present.

Using the data above, let’s take a look at what we might expect for the month of May

Historically, May is the 4th WORST performing month for stocks with an average return of just 0.26%. However, it is the 3rd worst performing month on a median return basis of just 0.49%.

(Interesting note:  As you will notice in the table above and chart below, average returns are heavily skewed by outlier events. For example, while October is considered the “worst month” with an average return of -0.32%, the median return is actually a positive 0.39% which makes it just the 2nd  worst performing month of the year beating out February [the worst].)

As noted, May represents the beginning of the “seasonally weak” period for stocks. As the markets roll into the early summer months, May and June tend to be some of weakest months of the year along with September. This is where the old adage of “Sell In May” is derived from. Of course, while not every summer period has been a dud, history does show that being invested during summer months is a “hit or miss” bet at best.

Like October, May’s monthly average is skewed higher by 32.5% jump in 1933. However, in more recent years returns have been primarily contained, with only a couple of exceptions, within a +/- 5% return band as shown below.

The chart below depicts the number of positive and negative returns for the market by month. With a ratio of 54 losing months to 62 positive ones, there is a 46% chance that May will yield a negative return.

No Reason To Sell Just Yet

Based on the historical evidence it would certainly seem prudent to “bail” on the markets, right? Maybe not. The problem with statistical analysis is that we are measuring the historical odds of an event occurring in the near future. Like playing a hand of poker, the odds of drawing to an inside straight are astronomically high against success. However, it doesn’t mean that it can’t happen.

Currently, the study of current price action suggests that the markets will likely break out to new highs in the days ahead. Such action, should it occur, will continue to support the “bullish case” for equities for now. This is why, as I have reiterated in our weekly missive, that portfolio allocations should remain biased toward equities.  To wit:

With the market on a short-term “buy signal,” deference should be given to the probability of a further market advance heading into May. With earnings season in full swing, there is a very likely probability that stocks can sustain their bullish bias for now.”

And again in Return Of The Bull…For Now

Clearly, the bullish trend on both a daily and weekly basis remains intact. This keeps portfolio allocations on the long side for now.”

However, the “risk” to investors is not a continued rise in the markets, but the risk of a sharp decline. As discussed in “The Math Of Loss:”

The reason that portfolio risk management is so crucial is that it is not “missing the 10-best days” that is important, it is “missing the 10-worst days.” The chart below, from Greg Morris’ recent presentation, shows the comparison of $100 invested in the S&P 500 Index (log scale) and the return when adjusted for missing the 10 best and worst days.

Clearly, avoiding major drawdowns in the market is key to long-term investment success. If I am not spending the bulk of my time making up previous losses in my portfolio, I spend more time compounding my invested dollars towards my long term goals. As Greg notes in his presentation, the markets are only making new highs roughly 4% of the time. Spending a bulk of bull market cycle making up previous losses is hardly a successful investment strategy one can utilize.

Since our job, as investors, is to compound our investment over time, the REAL RISK is NOT MISSING UPSIDE in the markets, but CAPTURING DECLINES. The destruction of investment capital is far more damaging to long-term investment goals than simply missing a potential for rather limited gains at this very late juncture of the investment market cycle.

The chart below shows the gain of $10,000 invested since 1957 in the S&P 500 index during the seasonally strong period (November through April) as opposed to the seasonally weak period (May through October).

It is quite clear that there is little advantage to be gained by being aggressively allocated during the summer months. However, in reality, there are few individuals that can maintain a strict discipline of only investing during seasonally strong periods consistently. Also, time frames of when you start and when you need your capital for retirement make HUGE differences in actual performance.

That is why, for investors, while the data is certainly interesting, it yields little. For investors, market returns cannot be anticipated with any given degree of certainty from one day to the next. No one has that ability. What we do know, is that eventually, prices will take a turn for the worse and history shows that there will be little warning, fanfare or acknowledgment that something has changed.

As the trend reverses, it will initially be met with denial, followed by hope, and ultimately acknowledgment, but only well after the fact.

As shown in the chart below, we are currently on intermediate-term sell signal and overbought with a secondary sell signal approaching. Both are occurring from very high levels which suggests the current rally should likely be used for portfolio repositioning and rebalancing. However, such a statement does NOT mean “cashing out” of the market as the bull market trend remains intact. Maintain, appropriate portfolio “risk” exposure for now, but cash raised from rebalancing should remain on the sidelines until a better risk/reward opportunity presents itself.

With our portfolios invested at the current time, it makes little sense to focus on what could go right. You can readily find that case in the mainstream media which is biased by its needs for advertisers and ratings. However, by understanding the impact to portfolios when something goes “wrong” is inherently more important. If the market rises, terrific. It is when markets decline that we truly understand the “risk” that we take. A missed opportunity is easily replaced.  However, a willful disregard of “risk” will inherently lead to the destruction of the two most precious and finite assets that all investors possess – capital and time.

Just something to consider when the media tells you to ignore history and suggests “this time may be different.” 

That is usually just about the time when it isn’t.

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Technically Speaking: Return Of The Bull…For Now

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


Last week, I asked a simple question:

“Was Monday’s rally an oversold bounce or the return of the “bull market?”

As I stated then, the short-term oversold condition of the market set the stage for a rally. I updated the analysis on Saturday discussing the two possible paths of the market this week.

“As expected the market did rally last week. As I noted it would be the success or failure of the rally attempt which would dictate what happens next. 

  1. “If the market can reverse course next week, and move back above the 50-dma AND break the declining price trend from the March highs, then an attempt at all time highs is quite likely. (Probability Guess = 30%)
  2. However, a rally back to the 50-dma that fails will likely result in a continuation of the correction to the 200-dma as seen previously. From current levels that would suggest a roughly -5% drawdown. However, as shown below, those drawdowns under similar conditions could approach -15%. (Probability Guess = 70%)”

As of Friday, the market failed at resistance closing below the 50-dma for the week. As denoted by the red dashed lines, the current price action of the market being compressed within a downtrend.

A “breakout” will likely occur next week which will fulfill one of the two potential outcomes noted above. “

Chart updated through Tuesday’s open.

As noted the “breakout” did occur which sent the markets pushing back above both the 50-dma and the previous downtrend resistance from the March highs. The “short covering” surge following the French elections now puts a retest of old highs within reach. As noted last week, the oversold condition is the “fuel supply” for the rally.

“The chart below is the ratio between the 3-Month Volatility Index and the Volatility Index (VIX). As shown, when this ratio declines to 1.00, or less, it has generally coincided with short-term bottoms in the market.”

Importantly, for the roughly one-percent rally on Monday, there was a significant reduction in the “fear” of the market suggesting that while we may indeed get an attempt at old highs, it may well not be much more than that. Also, the 14-period Wm%R indicator has already swung from extreme oversold to extreme overbought with Monday’s move as well. Again, the “fuel” for the rally is being quickly absorbed which suggests a rather limited advance heading into the seasonally “weak” period of the year.

On an intermediate term basis, the market cleared the overall downtrend currently as shown below. The good news is the rally on Monday has kept the secondary “sell” signal, bottom of chart, from being registered. If the secondary signal is registered it would suggest a more cautionary approach to portfolio allocations, however, for now that is not the case. As shown below, during previous periods where both signals were in play, vertical dashed red lines, it coincided with deeper corrections, if not immediately, in the near future.  

Clearly, the bullish trend on both a daily and weekly basis remains intact. This keeps portfolio allocations on the long side for now.

Sector By Sector

With that bit of analysis in place, let’s review the market environment for risks and opportunities.

ENERGY

The OPEC oil cut has likely run the majority of its course and with Permian Basin production on the rise, the pressure on oil prices from supply/demand imbalances remains an issue.

However, the recent test of $48/bbl support provides a support level currently, but a break of that level will likely see oil sliding back to the low 40’s. While energy-related earnings have helped the overall S&P 500 earnings rebound over the last quarter, it is likely transient and forward earnings estimates will likely have to be ratcheted down rather sharply for the rest of the year. 

Currently, the energy sector remains in a negative trend and suggests a further decline in oil prices will likely lead the sector substantially lower. Importantly, while the sector is oversold enough for a bounce in the short-term, it is not unprecedented for the sector to remain oversold during a continued decline as the highlighted green area shows. 

HEALTH CARE

The outperformance of the Health Care sector has slowed in recent weeks particularly as the risks related to the Affordable Care Act replacement continues to rise.

Current holdings should be reduced to market-weight for now with a stop-loss at $73. A correction to $71-72 would provide an entry point while maintaining a stop at $69.

FINANCIALS

As the “Trump Trade” has faltered in recent weeks, Financials have weakened. However, the recent test of support at$23 provides a tradeable entry point with a stop at that level. The sector is currently oversold on a short-term basis, and the upside is limited to $25/share at the moment.

Risk is rising in the sector as loan delinquencies are increasing and loan demand is falling. Caution is advised.

INDUSTRIALS

Industrials, like Financials, has seen relative performance lagging as of late as concerns over the viability of the “Make America Great Again” infrastructure plan has come into question. Importantly, this sector is directly affected by the broader economic cycle which continues to remain weak so the risk of disappointment is very high if “hope” doesn’t become reality soon.

The sector is currently overbought with little upside currently. Stops on existing holdings should be placed at $64 and reduced back to portfolio weight for now.

MATERIALS

As with Industrials, the same message holds for Basic Materials, which are also a beneficiary of the dividend / “Make America Great Again” chase. This sector should also be reduced back to portfolio weight for now with stops set at the lower support lines $51.00.

UTILITIES

Back in January, I discussed the “rotation” trade into Utilities and Staples. That performance shift has played out nicely and the sector is now extremely overbought.

Currently, on a risk/reward basis, stops should be placed at $50 on existing positions. Look for a correction to $48.50-$49.50 for potentially adding new positions.

STAPLES

Staples, have recovered as of late and are now back to extreme overbought, along with every other sector of the market. As with Utilities, set stops on existing positions at $54.50 while rebalancing current holdings back to portfolio weights.

Look for a correction to $52 to $53 before adding exposure to the sector.

DISCRETIONARY

Discretionary has been running up in hopes the pick-up in consumer confidence will translate into more sales. There is little evidence of that occurring currently as retail stores are rapidly losing sales and fighting the “retail apocalypse.”. However, with discretionary stocks at highs, profits should be harvested.

Trim portfolio weightings should back to portfolio weight with stops set at $86. With many signs the consumer is weakening, caution is advised and stops should be closely monitored and honored.

TECHNOLOGY

The Technology sector has been the “obfuscatory” sector over the past couple of months. Due to the large weightings of Apple, Google, Facebook, and Amazon, the sector kept the S&P index from turning in a worse performance than should have been expected prior to the election and are now elevating it post election.

The so-called FANG stocks (FB, AMZN/AAPL, NFLX, GOOG) continue to push higher, and due to their large weightings in the index, push the index up as well. 

The sector is extremely overbought and stops should be moved up to $52 where the bullish trendline currently intersects with the previous corrective bottom. Weighting should be revised back to portfolio weight.

EMERGING MARKETS

Emerging markets have had a very strong performance and have now run into the top of a long-term downtrend live. The strengthening of the US Dollar will weigh on the sector and will only get worse the longer it lasts. With the sector overbought, the majority of the gains in the sector have likely been achieved. Profits should be harvested and the sector under-weighted in portfolios. Long-term underperformance of the sector relative to domestic stocks continues to keep emerging markets unfavored in allocation models for now.

INTERNATIONAL MARKETS

As with Emerging Markets, International sectors also remain extremely overbought and unfavored in models due to the long-term underperformance. With the international sector now trading 3-standard deviations above the long-term mean, take profits and rebalance to portfolio weightings for now. 

DOMESTIC MARKETS

As stated above, the S&P 500 is extremely overbought, extended and exuberant. However, with a “sell signal” currently in place, there is a reason for some near-term caution. The French Election sparked a massive short-covering rally, the big question now will be the ability for follow through. The market will need to break out to new highs to end the current consolidation process. 

Caution is advised for now.

SMALL CAP

Small cap stocks went from underperforming the broader market to exploding following the Trump election. However, as of late, that performance has stalled and the sector has lagged the broader S&P 500 index. 

Importantly, small capitalization stocks are THE most susceptible to weakening economic underpinnings which are being reflected in the indices rapidly declining earnings outlook. This deterioration should not be dismissed as it tends to be a “canary in the coal mine.” 

Currently, small caps are back to an overbought condition which suggests the current advance may be somewhat limited. Stops should be placed at $820, a break of which would suggest a much deeper reversion is in process. Reduce exposure back to portfolio weight for now.

MID-CAP

As with small cap stocks above, mid-capitalization companies had a rush of exuberance following the election as well. However, Mid-caps are currently overbought and remain below resistance. With the risk/reward setup currently unfavorable, reduce exposure back to portfolio weight for now and carry a stop at $1675.

REIT’s

REIT’s have performed well despite the Fed’s ongoing rate hiking campaign. With rates now very overbought, as discussed below, take profits in REIT’s short-term and look for a pullback to trend-line support around $81 to add new positions. A stop should be placed at $80.

TLT – BONDS

As expected a couple of months ago, rates fell as the economic underpinnings failed to come to fruition. However, with rates now oversold, bonds are now overbought. Look for a pullback to support on the index to $120 to add bond holdings back into portfolios. There is no reasonable stop currently for bond trading positions so caution is advised. 

 

As we wrap up the month of April, we now begin the march into the seasonally weaker period of the year. Therefore, there is a higher probability the current rally could fail given the ongoing debates in Washington over the debt ceiling, tax cut and infrastructure spending plans.

As noted by Nautilus Research, the markets tend to get choppy over the next couple of months.

With the understanding, we are currently on intermediate term sell-signal and overbought, the current short-term rally should likely be used for portfolio repositioning and rebalancing. However, such a statement does NOT mean “cashing out” of the market as the bull market trend remains intact. Maintain, appropriate portfolio “risk” exposure for now, but cash raised from rebalancing should remain on the sidelines until a better risk/reward opportunity presents itself.

Caution remains advised.

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Technically Speaking: Oversold Bounce Or Return Of The Bull?

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.


In this past weekend’s missive, “Markets Go On Alert,” I stated that due to the oversold condition of the market on a very short-term basis, a rally was due this week. To wit:

IMPORTANT: By the time weekly signals are issued on an intermediate-term basis, the market is generally oversold, with ‘bearish’ sentiment increasing, on a short-term (daily) basis. Given those short-term conditions, it is quite likely the markets will rally next week.”

Chart updated through Monday’s close.

“IMPORTANT: It is the success or failure of that rally attempt that will dictate what happens next.

  1. If the market can reverse course next week, and move back above the 50-dma AND break the declining price trend from the March highs, then an attempt at all time highs is quite likely. (Probability Guess = 30%)

  2. However, a rally back to the 50-dma that fails will likely result in a continuation of the correction to the 200-dma as seen previously. From current levels that would suggest a roughly -5% drawdown. However, as shown below, those drawdowns under similar conditions could approach -15%. (Probability Guess = 70%)”

I have denoted both setups in the chart above. The downtrend resistance from the March highs is quite evident as well as the 50-dma resistance at 2353 currently. Furthermore, as noted, the oversold condition has provided the “fuel” for a reflexive, “oversold,” bounce.

The chart below is the ratio between the 3-Month Volatility Index and the Volatility Index (VIX). As shown, when this ratio declines to 1.00, or less, it has generally coincided with short-term bottoms in the market.

It is worth noting that in several cases, these “oversold” conditions were generally precursors to a future decline.

But how can we tell the difference?

This is where we have to step away from a very short-term view and move to an intermediate-term perspective. The chart below is essentially the same as above but the data is weekly, versus daily, which reduces some of the “noise.”

As shown, when the volatility ratio has hit low levels previously, the determination of whether the subsequent rally failed or succeeded was dependent upon how “overbought or oversold” the market was at the time of the volatility ratio low. If the volatility low was hit with the market still primarily overbought, a subsequent decline in the markets tended to follow. The best buying opportunity came when the volatility low coincided with an oversold condition in the market on a weekly basis. Such is not the case today. 

Does this mean the market is about to crash? No.

However, it does suggest that as we wrap up the “seasonally strong” period of the year, the markets may run into some trouble this summer given the recent rise in uncertainty in both the geopolitical and fiscal policy backdrop.

As I noted in my recent presentation at the 2017 Economic and Investment Summit, the main support for stocks has been the hopes of tax reform, tax cuts, and infrastructure spending. Given the current problems in Washington D.C. in getting legislative agenda agreed to by Congressional Republicans, delays should be expected. 

 

The question, of course, is just how much time the markets will give Washington to make progress on legislative agenda? As noted above, the estimates currently driving stocks were based on tax cuts being brought through to boost bottom line profitability. If those cuts don’t happen soon, earnings disappointments may bite investors. 

A look at the weekly internals of the market shows some notable deterioration in both the advancing-declining issues and volume. With a weekly “sell” signal in place for the NYSE Advance-Decline line, it suggests more weakness ahead.

Importantly, given these are weekly signals, it does NOT MEAN stocks can’t rally in the short-term. It simply suggests there is selling pressure on stocks the path of least resistance currently is lower.

If we apply a Fibonacci retracement to a weekly chart, shown below, a correction to the first retracement level would take the market back to 2208. While the Williams %R at the top, and the Full Stochastics at the bottom, are effectively the same measure, they tell us two things.

  1. The market, on a weekly basis, is very overbought.
  2. The weekly “sell” signal combined with the overbought condition suggests a move to the first retracement level is possible over the course of the next few weeks.

Again, while a short-term bounce in likely given the recent sell-off, it will require a move to new highs to reverse the currently more “bearish” dynamics at work in the market. 

Bulls Still In Charge

The good news for the bulls is that on a long-term, monthly basis, the ongoing bull market remains intact for now. As noted below by the vertical blue dashed line, the monthly “buy signal” that was registered at the end of 2010, as the market moved above the long-term supportive trend line going back to 1965, remains for now. However, given the current extension of the market, and the deviation between the current price and long-term average, a reversion to the mean could be quite painful while the market remains within the “confines” of a bullish trend. 

More importantly, as denoted by the red circles, the market is currently trading 3-standard deviations above the long-term average. This has only happened a few times in history and has generally preceded a rather sharp correction in the not too distant future.

Conclusion & Suggestions

With the seasonally strong period of the market coming to its inevitable conclusion, geopolitical tensions rising, economic data trending weak and fiscal policy in a bit of a disarray – it may be time for investors to rethink levels of risk exposure in their portfolios currently.

As I stated at the beginning of March, we reduced exposure in portfolios by raising cash and rebalancing portfolios back to target weightings. We had also added interest rate sensitive hedges to portfolios back in January as well. (I update our portfolio strategy in the weekly newsletter.)

Given the weekly “sell” signals currently in place, the recommendation to rebalance portfolio risks remains. Here are the guidelines I recommended previously:

Step 1) Clean Up Your Portfolio

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Take profits in positions that have been big winners
  3. Sell laggards and losers
  4. Raise cash and rebalance portfolios to target weightings.

Step 2) Compare Your Portfolio Allocation To Your Model Allocation.

  1. Determine areas requiring new or increased exposure.
  2. Determine how many shares need to be purchased to fill allocation requirements.
  3. Determine cash requirements to make purchases.
  4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.
  5. Determine entry price levels for each new position.
  6. Determine “stop loss” levels for each position.
  7. Determine “sell/profit taking” levels for each position.

(Note: the primary rule of investing that should NEVER be broken is: “Never invest money without knowing where you are going to sell if you are wrong, and if you are right.”)

Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are looking for a rally to reduce the oversold condition of the market and allow for a better opportunity to rebalance equity risk.

As noted in yesterday’s missive on 10-Investment Wisdoms:

“The absolute best buying opportunities come when asset holders are forced to sell.” – Howard Marks

But you can’t buy low, if you didn’t sell high to raise the cash, first.

Stay alert…things are finally getting a lot more interesting.

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