Tag Archives: moving average

Don’t Be Euphoric Over Two Months Of Gains

Stocks are up big this year, and that means it’s time to be skeptical.

Warren Buffett says you should be greedy when others are fearful and fearful when others are greedy. That doesn’t mean stocks are ready to give up all their January and February gains immediately or even eventually. But it means the right psychological disposition to have is one of doubt and skepticism. If we get the decline, you’ll be ready for it. And being ready for declines, so that they don’t surprise you and cause you to sell, is the most important thing in investing.

Here are the numbers. Domestic and foreign stock are all up between 9% and 12% for the opening two months of the year. Mid-caps and small-caps are up even more, with the Russell 2000 up an eye-watering 17%. Junk bonds are up more than 6% and REITs are up more than 12%. Balanced indices are up between 7% and 8%, depending on whether they have foreign stocks or not.

It’s okay to be happy about this, but it’s also good to temper that happiness with some skepticism. Stocks don’t usually go up this much in two months. In fact, they don’t usually go up this much in a year. If you’re thinking that the current move is justified because of how much stocks declined in the last quarter of 2018, you still may be fooling yourself with too much optimism. Stocks have been up like gangbusters for the past decade. (Incidentally, if you panicked at the end of last year, and sold, you know how prone  you are to make moves at the exact wrong moment.)

None of this means you should run for the hills and sell all your stocks in a fit of contrarianism. But it means you should temper your expectations. (And trimming some gains might not be a bad idea. Rebalancing, especially in a tax-advantaged account is reasonable after a run like this.) It’s just as likely that stocks could drop from here as it is that they could tread water or keep going up. Nobody knows.

The end of last year is instructive about trying to time short-term moves. At the end of last year, longer term moving averages indicated that there was more downside, while shorter term moving averages indicated that the markets were “oversold,” and that a least a few days of upside were in the cards. It turned out that when things looked bleakest, on Christmas Eve or quickly thereafter, the market bottomed, and stocks have been off to the races ever since.

In other words, both the long term indicators and the short term indicators from the end of last year look foolish right now. We didn’t get a few days’ worth of gains in response to being “oversold;” instead we’ve gotten eight solid weeks of boffo returns. That’s what the market does — it makes everything look foolish sometimes. Sure, stocks might decline from here, proving the longer term indicators from late last year correct. But these two months show how hard short term timing is. It’s possible to argue that U.S. Federal Reserve Chairman Powell indicating that the rate-hiking regime would end was a wild card at the end of last year. That’s true, but it doesn’t damage the thesis that short term trading is difficult.

Being successful in the stock market isn’t so much a function of what system you follow as much as it is a function of whether you can follow a system and whether you can keep your emotions in check. Every system – buy-and-hold, buy-and-rebalance, moving average – will look foolish at times. It will deliver losses or look lackluster when others are making gains. Take Bill Bernstein’s advice in this weekend’s Wall Street Journal, and consider your financial assets (stocks and bonds) as future assets and not present assets. In other words, “mentally vaporize 75% of your assets; imagine you don’t even have them.” That can help you get through market declines. You don’t own stocks to buy groceries tomorrow, after all. Remembering that, and having the right psychological disposition can make a big difference in helping you let financial assets work for you — instead of letting them work you over.

The Ghosts Of 2007 Are Calling

Borrowing from Mark Twain, a headline in the Chicago Tribune in 1941 said: “History May Not Repeat, But It Looks Alike.” Real or imagined that is often the case in financial markets especially when perusing historical price charts of stocks, bonds, commodities or any financial instrument for that matter. Comparing charts of some financial index or security from different time frames in search of resemblance is known as an analogue. Although one may occasionally find an uncanny similarity, it does not usually offer much in the way of influence over decision-making. Then again, there are some circumstances where charts align and we would be well-served to pay attention if not for purposes of immediate action, then as a means of allowing for better preparation.

One famous example involved hedge fund manager Paul Tudor Jones who in 1987 picked up on similarities in the price action and chart pattern of the Dow Jones Industrial Average that year and what transpired in 1929. Watching the progression of the stock market in 1987, he was convinced a market crash was coming. And come it did.

While analogues may seem contrived, the concept makes sense. Technical charts in all their forms are simply a reflection of human beings and their decisions about buying and selling. They are a visual representation of human emotion, and although difficult to predict, there is a pattern to how human beings behave in markets.

2006-2007

With that said, the developing price action of the S&P 500 has held our attention for several weeks. Below is a chart of the S&P 500 from two different time frames. The top frame is a chart from October 2006 to November 2007. The bottom frame is from October 2017 to the current day.

Data Courtesy Bloomberg

In early 2007 when everyone felt invincible due to home price appreciation and stock market gains, the first reports of subprime losses began to roil earnings reports for banks. Although initially disruptive, the market shrugged off those concerns and moved higher throughout spring and summer. The S&P 500 hit all-time highs in October, two months before the beginning of the recession and three months before a speech on January 10, 2008, in which Fed Chairman Bernanke stated: “The Federal Reserve is not currently forecasting a recession.”

The equity market contours have definitively changed in 2018 versus preceding years. An initial surge in equities in the opening weeks of 2018 was followed by a 10% decline and a long-absent spike in volatility. However, after the initial disruption in late January, the bull market managed to find its legs. By summer, the market was steadily rising and established new all-time highs in late September.

While the patterns do not line up perfectly, the symmetry of time, record highs, and the confluence of many potentially unstable events is certainly comparable.

2018

If 2006-2007 represents a proper analogue, the all-time high recently set on September 21st was the end of the great post-crisis, stimulus-fueled bull-run. It is early yet, and many prior calls for market tops lie in a graveyard full of bear bones. However, the analogue, when coupled with valuation analysis, liquidity concerns and economic data suggest that there is a likelihood that what we are observing is a topping process to the ten-year bull market.

Unlike 2007 where early disbelief around housing market excess and subprime lending finally offered easily identifiable culprits, today, like terrorism, the villains are not so easily identified. We live so deeply embedded in a world of debt and spending, a world so far away from fiscal discipline and prudence, that the tactics of ultra-low interest rates and quantitative easing now seem natural and healthy. Simply they have blinded our perspective.

Isaac Newton’s third law of physics states that “for every action, there is an equal and opposite reaction.” Years of monetary excess and the rampant speculation that resulted might be finally reversing. Regardless of whether the market is topping as the analogue warns or avoids significant declines for another year or two, investors would be well-served to be aware. The risk/reward framework is not in our favor.

Dissecting This Selloff

Comparing the 10% market dip that occurred in the first quarter of 2018 to the current decline can provide us clues as to whether 2018 is a period of consolidation or the makings of a bearish topping process. As the charts reflect, there are some similarities and differences between the two periods.

We start with the weekly chart of the S&P 500 shown below.

Candle Structure

The first two weeks of each sell-off were nearly identical when viewed using candles, as highlighted in the graph below.

Note the similarity of the long second candle in each shaded area which occurred during the second week of each sell-off period. In the January-April timeframe, the second candle was the longest candle of the period, and its bottom proved to be the low for the entire time frame. That low was tested in April and it held. In the current period, the market has so far failed to bounce higher following the early October lows. Further, as of writing this, the S&P 500 has broken below that candle’s low point.

Trend Line Support

During the January – April period, all of the weekly closes stayed above the dotted black trend line, which has reliably supported the market since early 2016. In the current period, the second weekly close finished well below the trend line and the market has continued to trade further below it since.

34-Week Moving Average

While not perfect, the 34 -week moving average (orange) has demonstrated reasonable support for the market since 2016. Currently, the S&P 500 is 80 points below that moving average, and it is not, at least yet, proving supportive. Another weekly close below that level will offer more conclusive evidence of a meaningful breach.

The slope of the 34 -week moving average continued upward throughout the January – April period without any degradation in trajectory. Currently, the slope, while still upward, has flattened considerably.

The 20 -week moving average (green) turned lower in the sixth week of the January – April decline. It turned lower in the second week of the current decline.

The 34 -week moving average and the trend line are important markers to follow. When the market bounces, the next test will be to see if it can rise above these lines or if they become resistance.

Volatility

In the first week of February, the S&P 500 Volatility Index (VIX) went from 12.5 to over 50. This was a signal of distress in the market and likely a signal of illiquid conditions driven by impetuous selling. That spike was also fueled by concentrated selling due to the failure of poorly constructed short VIX ETFs. Currently, the VIX has risen from the same 12.5 to 25. Our concern is that this move is not as driven by fear which might lead to a more measured and durable sell-off.

Traditional Safe Havens

On January 26, 2018, when the S&P 500 peaked, gold closed at 1352. Over the next three months, as the S&P fell over 10%, gold was never able to close above that level.

On October 3, 2018, when the current decline started gold closed at 1202. As of October 23, it stands above 1230. This time around, unlike the prior decline, gold is reacting positively as a safe haven.

During the first three weeks of the January – April decline, U.S. Treasury yields rose, and prices fell. Typically during periods of market stress, yields decline as investors seek safety. In the current move, yields have declined since early October. While that decline in yields has been moderate, U.S. Treasuries are acting more like a safe haven than earlier in the year.

Summary

This second decline of the year is showing signs that are a little more concerning than those offered at the beginning of the year. While the moves may appear somewhat similar thus far in regards to points lost, the differences should be watched closely. The question we must consider is, are we simply in a period of consolidation before the bull market resumes or is this a bearish topping process?

One other comparison bears mentioning. In 2007, the market peaked at record highs in February, recovered and set new record highs over the next eight months before setting a final top in October 2007.

In addition to following the signals detailed above, the low set on February 9, 2018, of 2532 is an important line in the sand. As long as the S&P stays above that line, we must assume the bullish trend since 2009 is intact and the ups and downs of 2018 are merely a period of consolidation. A break below that line leads us to believe further that we may be in the midst of a topping process. Given extreme valuations and the poor risk/reward dynamics offered by stocks, we urge caution and responsiveness as the market further presents itself.

For more on our most current technical thoughts, please read our latest Technically Speaking.

Technical Alert – 30 Year Treasury Bonds

One of the biggest economic and market concerns that we harbor is the enormous burden of debt residing on public and private balance sheets. There are two facets to the debt issue that are worth keeping in mind. First, debt plays a large role in funding current economic activity. Second, significant debts from public and private consumption of years past are still outstanding and must be serviced and ultimately paid off.

The technical alert and trade idea discussed in this article is not just for bond investors and traders.  The gravity and ubiquity of this problem is of utmost importance for those forecasting economic growth as well as investors of equities and every other asset class whose returns are predicated on economic activity.

The Lower Forever Scheme

Through inflation targeting and abnormally low interest rates, the Federal Reserve has been complicit in pushing the growth of debt beyond the aggregated ability to pay for it. One look at total debt or the ratio of government debt to GDP graphs makes this clear. Despite a few disruptions, this deliberate policy has driven economic growth but at a very high cost.

The problem for us to consider is that a large amount of economic activity is predicated on ever declining interest rates. Further, the performance of most asset classes has clearly benefited from abnormally low interest rates. Most notably, stocks have once again soared to extremely high valuations in large part for the following reasons:

  • Low interest rates make equities attractive versus low yielding bonds
  • A lower discounting factor makes the present value of future corporate earnings higher
  • Corporations have been able to drastically lower their interest expense while at the same time raising increasing aggregate debt levels
  • Corporations have been able to borrow at will to buy back their stock
  • Individuals and institutions have used excessive margin debt to leverage up their investments
  • Private and public consumption as a result of debt has greatly benefited earnings

There are a variety of questions vital to investors. Among these are the following:

  • Can rates continually keep going lower?
  • Can low interest rates be sustained indefinitely?
  • Can individuals, corporations and the government continue to endlessly accumulate debt with no consequence?

We firmly believe the answer to all of these questions is no. Even with lower rates the burden of debt will become too overwhelming and force various forms of default. That said we are fairly certain the Federal Reserve will do everything in their power to keep rates as low as they can and try to avoid the inevitable.

Chart of the Decade

While this long game plays out we must carefully watch the amount of debt outstanding and more importantly the level of interest rates. Of particular current interest is the long term charts below.

The first graph is the monthly closing price of the 30 year U.S. Treasury bond and its 100 month moving average. The six labeled data points show the times when yields came close to breaching the 100 month moving average but were rebuffed. The second graph compares the monthly closing yield on the bond with the 100 month moving average.

Since October of 1985 the yield on the bond has never been above the moving average on a monthly closing basis. That is until Friday, September 29th, when the closing 30 -year yield on the U.S. Treasury bond was 3.197% and the 100 month moving average was 3.160%. As shown on the second graph, this is the first time the moving average has failed as a point of resistance in over 30 years.

A few basis points is cause for concern but not yet a technical break in our opinion. Despite breaching it by only 3.70 basis points we think it is quite possible that yields turn lower and prove the moving average as valid resistance.  We emphasize caution however with this view, if yields are truly breaking out to the upside, investors of bonds and most other asset classes should be on alert.

Trade Idea

From a trading perspective, the current set-up in the 30-year bond offers a favorable risk/return construct. Taking a long position in the bond with a tight stop loss level, limits risk and allows for upside if yields bounce off of the resistance line.

The table below provides three and six month total return figures for the six instances labeled in the graph above. As shown all six instances provided investors substantive three and six month total returns. Further, at any point during the six periods any temporary losses were more than offset by coupon payments.

The trade can be executed using the 30-year U.S. Treasury bond, 30-year U.S. Treasury bond futures or iShares Barclays 20+ Year U.S. Treasury Bond ETF (TLT). We recommend a stop loss of ten basis points of yield which would result in a possible loss of approximately 1.95% less any coupon earned during the holding period.

If you are using TLT to execute this trade, 10 basis points is equal to approximately 2 points based on the current price of 117.38 and a duration of 17 years for the ETF.

 

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.