“If the U.S. economy entered a recession soon and interest rates fell in line with levels seen during the moderate recessions of 1990 and 2001, yields on even longer-dated Treasury securities could fall to or below zero.” – Senior Fed Economist, Michael Kiley – January 20, 2020

I was emailed this article no less than twenty times within a few hours of it hitting the press. Of course, this was not a surprise to us. To wit:

“Outside of other events such as the S&L Crisis, Asian Contagion, Long-Term Capital Management, etc. which all drove money out of stocks and into bonds pushing rates lower, recessionary environments are especially prone at suppressing rates further. Given the current low level of interest rates, the next recessionary bout in the economy will very likely see rates near zero.” 

That article was written more than 3-years ago in August 2016. 

Of course, three-years ago, as the “Bond Gurus,” like Jeff Gundlach and Bill Gross, were flooding the media with talk about how the “bond bull market was dead,” and “interest rates were going to rise to 4%, or more,” I repeatedly penned why this could not, and would not, be the case.

While it seemed a laughable concept at the time, particularly as the Fed was preparing to hike rates and reduce their balance sheet, the critical aspect of leverage was overlooked.

“There is an assumption that because interest rates are low, that the bond bull market has come to its inevitable conclusion. The problem with this assumption is three-fold:

1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields, which pushes rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largesse in the future, the budget deficit is set to swell above $1 Trillion in coming years. This will require more government bond issuance to fund future expenditures, which will be magnified during the next recessionary spat as tax revenue falls.
3. Central Banks will continue to be a buyer of bonds to maintain the current status quo, but will become more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion which will push the 10-year yield towards zero.”

Of course, since the penning of that article, let’s take a look at where we currently stand:

1. Negative yielding debt surged past $17 trillion pushing more dollars into positive yielding U.S. Treasuries which led to rates hitting decade lows in 2019.
2. The budget deficit has indeed swelled to $1 Trillion and will exceed that mark in 2020 as unbridled Government largesse continues to run amok in Washington.
3. The Federal Reserve, following a very short period of trying to hike rates and reduce the bloated balance sheet, completely reversed the policy stance by cutting rates and flooding the system with liquidity by ramping up bond purchases.

The biggest challenge the Fed faces currently is how to deal with a recession. Given the current expansion is the longest on record; a downturn at some point is inevitable. Over the last decade, as shown in the chart below, the Federal Reserve has kept rates at extremely low levels, and flooded the system with liquidity, which did NOT have the effect of fostering either economic growth or inflation to any significant degree. (As noted the composite index is of inflation, GDP, wages, and savings which has closely tracked the long-term trend of interest rates.)

Naturally, at any point monetary accommodation is removed, an economic, and market downturn is almost immediate. This is why it is feared central banks do not have enough tools to fight the next recession. During and after the financial crisis, they responded with a mixture of conventional interest-rate cuts and, when these reached their limit, with experimental measures, such as bond-buying (“quantitative easing”, or QE) and making promises about future policy (“forward guidance”).

The trouble currently is that global short-term interest rates are still close to, or below zero, and cannot be cut much more, which has deprived central banks of their main lever if a recession strikes.

The Fed Is Trapped

While the Fed talks about wanting higher rates of inflation, as shown above, they can’t run the risk that rates will rise. Simply, in an economy that requires $5 of debt to create $1 of economic growth, the leverage ratio requires rates to remain low or “bad things” happen economically.

1) The Federal Reserve has been buying bonds for the last 10- years in an attempt to keep interest rates suppressed to support the economy. The recovery in economic growth is still dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.

2) Rising interest rates immediately slows the housing market, taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.

3) An increase in interest rates means higher borrowing costs, which leads to lower profit margins for corporations. This will negatively impact the stock market given that a bulk of the “share buybacks” have been completed through the issuance of debt.

4) One of the main arguments of stock bulls over the last 10-years has been the stocks are cheap based on low interest rates. When rates rise, the market becomes overvalued very quickly.

5) The massive derivatives market will be negatively impacted, leading to another potential credit crisis as interest rate spread derivatives go bust.

6) As rates increase, so does the variable rate interest payments on credit cards. With the consumer being impacted by stagnant wages, higher credit card payments will lead to a rapid contraction in disposable income and rising defaults. 

7) Rising defaults on debt service will negatively impact banks, which are still not adequately capitalized and still burdened by large levels of risky debt.

8) Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in. (Such may already be underway.)

9) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits have already crumbled as the deficits have already surged to $1 Trillion and will continue to climb.

10) Rising interest rates will negatively impact already massively underfunded pension plans leading to insecurity about the ability to meet future obligations. With a $7 Trillion funding gap, a “run” on the pension system becomes a high probability.

I could go on but you get the idea.

The issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. This is because the vast majority of Americans are living paycheck-to-paycheck.

However, since average American’s requires roughly $3000 in debt annually to maintain their standard of living, interest rates are an entirely different matter.

As I noted last week, this is a problem too large for the Fed to bail out, which is why they are terrified of an economic downturn.

The Fed’s End Game

The ability of the Fed to use monetary policy to combat recessions is at an end. A recent article by the WSJ agrees with our assessment above.

“In many countries, interest rates are so low, even negative, that central banks can’t lower them further. Tepid economic growth and low inflation mean they can’t raise rates, either.

Since World War II, every recovery was ushered in with lower rates as the Fed moved to stimulate growth. Every recession was preceded by higher interest rates as the Fed sought to contain inflation.

But with interest rates now stuck around zero, central banks are left without their principal lever over the business cycle. The eurozone economy is stalling, but the European Central Bank, having cut rates below zero, can’t or won’t do more. Since 2008, Japan has had three recessions with the Bank of Japan, having set rates around zero, largely confined to the sidelines.

The U.S. might not be far behind. ‘We are one recession away from joining Europe and Japan in the monetary black hole of zero rates and no prospect of escape,’ said Harvard University economist Larry Summers. The Fed typically cuts short-term interest rates by 5 percentage points in a recession, he said, yet that is impossible now with rates below 2%.”

This too sounds familiar as it is something we wrote in 2017 prior to the passage of the tax reform bill:

“The reality is that the U.S. is now caught in the same liquidity trap as Japan. With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.

This is the same problem that Japan has wrestled with for the last 20 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

• A decline in savings rates to extremely low levels which depletes productive investments
• An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
• A heavily indebted economy with debt/GDP ratios above 100%.
• A decline in exports due to a weak global economic environment.
• Slowing domestic economic growth rates.
• An underemployed younger demographic.
• An inelastic supply-demand curve
• Weak industrial production
• Dependence on productivity increases to offset reduced employment

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.“

It’s good news the WSJ, and mainstream economists, are finally catching up to analysis we have been producing over the last several years.

The only problem is that it is likely too little, too late.Save

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In this past weekend’s newsletter, I discussed the rather severe extensions of the market above both the longer-term bullish trend and the 200-dma. To wit:

“Currently, it will likely pay to remain patient as we head into the end of the year. With a big chunk of earnings season now behind us, and economic data looking weak heading into Q4, the market has gotten a bit ahead of itself over the last few weeks.

On a short-term basis, the market is now more than 6% above its 200-dma. These more extreme price extensions tend to denote short-term tops to the market, and waiting for a pull-back to add exposures has been prudent..”

But it isn’t just the more extreme advance of the market over the past 5-weeks which has us a bit concerned in the short-term, but a series of other indications which typically suggest short- to intermediate-terms corrections in the market. 

Not surprisingly, whenever I discuss the potential of a market correction, it is almost always perceived as being “bearish.” Therefore, by extension, such must mean I am either all in cash or shorting the market. In either case, it is assumed I “missed out” on the previous advance.

If you have been reading our work for long, you already know we have remained primarily invested in the markets, but hedge our risk with fixed income and cash, despite our “bearish” views. I am reminded of something famed Morgan Stanley strategist Gerard Minack said once:

“The funny thing is there is a disconnect between what investors are saying and what they are doing. No one thinks all the problems the global financial crisis revealed have been healed. But when you have an equity rally like you’ve seen for the past four or five years, then everybody has had to participate to some extent.

What you’ve had are fully invested bears.”

While the mainstream media continues to misalign individual’s expectations by chastising them for “not beating the market,” which is actually impossible to do, the job of a portfolio manager is to participate in the markets with a preference toward capital preservation. This is an important point:

“It is the destruction of capital during market declines that have the greatest impact on long-term portfolio performance.”

It is from that view, as a portfolio manager, the idea of “fully invested bears” defines the reality of the markets that we live with today. Despite this understanding, the markets are overly bullish, extended, and overvalued and portfolio managers must stay invested or suffer potential “career risk” for underperformance. What the Federal Reserve’s ongoing interventions have done is push portfolio managers to chase performance despite concerns of potential capital loss.

Managing portfolios for both risk adjusted returns while protecting capital is a delicate balance. Each week in the Real Investment Report (click here for free weekly e-delivery) we discuss the risks and challenges of the current market environment and report on how we are adjusting our exposures to the market over time.

In this past weekend’s missive, we discussed how to “play” the latest round of the Fed’s QE program, along with what sectors and markets tend to perform the best.

However, I wanted to share a few charts which suggests that being patient currently, will likely yield a much better entry point for investors in the not-so-distant future.

Overbought And Extended

By the majority of measures that we track from momentum, to price, and deviation, the market’s sharp advance has pushed the totality of those indicators back to overbought.

Historically, when all of the indicators are suggesting the market has likely encompassed the majority of its price advance, a correction to reverse those conditions is often not far away. Regardless of the timing of that correction, it is unlikely there is much upside remaining in the current advance, and taking on additional equity exposure at these levels will likely yield a poor result.

Overly Complacent

The post-Fed rate cut and QE driven advance in the market has also pushed investors back to levels of extreme complacency.

Such extremely low levels of volatility, combined with investors piling into record “short positions” on the VIX, provides all the “fuel” necessary for a fairly sharp 3-5% correction given the proper catalyst.

Given that investors are “all in,” as discussed last week, there is plenty of room for investors to get forced out of holdings and push markets lower over the next few weeks. However, it isn’t just individual investors that are “all in,” but professionals as well.

Eurodollar Sends A Warning

Eurodollar positioning is also sending a major warning. (“Eurodollar” refers to U.S. dollar-denominated deposits at foreign banks, or at the overseas branches of American banks.)

When the ECB launched QE following the 2016 selloff, foreign banks liquidated Eurodollar deposits as it was deemed less risky to hold foreign denominated deposits. Currently, that view has reversed sharply as the global economy slows, and foreign banks are “hedging” their risk by flooding money into U.S. dollar denominated deposits. Historically, when you have an extremely sharp reversal in Eurodollars, it has preceded more troubling market events.

With Eurodollar deposits at record levels, do foreign banks know something we don’t?

Earnings Vs. Profits

The deviation between corporate GAAP earnings and corporate profits is currently at record levels. It is also entirely unsustainable. Either corporate profits will catch up with earnings, or vice-versa. Historically, profits have never caught up with earnings, it is always the other way around.

Expectations for corporate earnings going forward are still way to elevated, and with corporate share buybacks slowing, this leaves lots of room for disappointment.

Deviation

I have written many times in the past that the financial markets are not immune to the laws of physics.

There is a simple rule for markets:

“What goes up, must, and will, eventually comes down.”

The example I use most often is the resemblance to “stretching a rubber-band.” Stock prices are tied to their long-term trend which acts as a gravitational pull. When prices deviate too far from the long-term trend they will eventually, and inevitably, “revert to the mean.”

See Bob Farrell’s Rule #1

Currently, the market is not only more than 6% above its 200-dma, as shown in the opening of this missive, but is currently more than 15% above its 3-year moving average.

More importantly, the market is currently extremely deviated above it long-term bullish trend. During this entire decade-long bull market advance, the trendline is retested with some regularity from such extreme extensions.

Sentiment

Lastly, is sentiment. When sentiment is heavily skewed toward those willing to “buy,” prices can rise rapidly and seemingly “climb a wall of worry.” However, the problem comes when that sentiment begins to change and those willing to “buy” disappear.

This “vacuum” of buyers leads to rapid reductions in prices as sellers are forced to lower their price to complete a transaction. The problem is magnified when prices decline rapidly. When sellers panic, and are willing to sell “at any price,” the buyers that remain gain almost absolute control over the price they will pay. This “lack of liquidity” for sellers leads to rapid and sharp declines in price, which further exacerbates the problem and escalates until “sellers” are exhausted.

Currently, there is a scarcity of “bears.”

See Bob Farrell’s Rule #6

As we discussed just recently, consumer and investor confidence are both closely tied and are extremely elevated. However, CEO confidence is pushing record lows. A quick look at history shows this level of disparity is not unusual around market peaks and recessionary onsets.

Another way to analyze confidence data is to look at the consumer expectations index minus the current situation index in the consumer confidence report.

This measure also is signaling a correction/recession is coming. The differential between expectations and the current situation, as you can see below, is worse than the last cycle, and only slightly higher than prior to the “dot.com” crash. Recessions start after this indicator bottoms, which has already started happening.

Currently, the bottoming process, and potential turn higher, which signals a recession and bear market, appears to be in process.

None of this should be surprising as we head into 2020. With near-record low levels of unemployment and jobless claims, combined with record high levels of sentiment, job openings, and record asset prices, it seems to be just about as “good as it can get.”

Does this mean the current bull market is over?

No.

However, it does suggest the “risk” to investors is currently to the downside, and some caution with respect to equity-based exposure should be considered.

What Are We Doing About It?

Given the fact that the short, intermediate, and long-term indicators have all aligned, the risk of running portfolios without a hedge is no longer optimal. As such, we added an “inverse” S&P 500 position to all of our portfolios late yesterday afternoon. 

While none of the charts above necessarily mean the next “great bear market” is coming, they do suggest a modest correction is likely. The reason we hedge against declines is that one day, and we never know when, a modest correction will turn into a more significant decline.

Remaining fully invested in the financial markets without a thorough understanding of your “risk exposure” will likely not have the desirable end result you have been promised. All of the charts above have linkages to each other, and when one breaks, they all break.

So pay attention to the details.

As I stated above, my job, like every portfolio manager, is to participate when markets are rising. However, it is also my job to keep a measured approach to capital preservation.

SO, why shouldn’t you show these charts to the bulls?

Because you need someone to “sell to” first.

It’s Bullish…Always

Last Wednesday, the Federal Reserve announced the latest decision concerning monetary policy which contained three primary components:

1. A cut of 25bps
2. Stopping balance sheet reductions (or Quantitative Tightening or Q.T.)
3. An outlook suggestive this may be the only rate cut for a while.

While stocks dropped on disappointment they Fed may not cut further; it didn’t take long for bullish commentators to start suggesting why the cuts were supportive of higher asset prices. To wit:

“Given today’s Fed decision and guidance, we remain comfortable with our view that the Fed will provide two more 25bp cuts this year (September and October),” – Bank of America.

Simply, cutting rates, and stopping Q.T., is the return of “accommodative policy” for the markets and the “ringing of Pavlov’s bell.”  Via CNBC:

“The old investing mantra ‘don’t fight the Fed’ stands the test of time for a reason. Going back to 1982, the average annualized return for the S&P 500 between the first rate cut and the next hike has been 20%, while the median increase has been 13%, according to Strategas. The data show investors would do well if they invest in a way that aligns with the Federal Reserve’s policy direction, rather than against it, hence ‘don’t fight the Fed.’”

This is an interesting premise because when the Fed started hiking rates at the end of 2015, it also was bullish. Via Forbes:

“Early in a rate increase cycle, however, higher rates are actually good for the stock market. This is because rising rates, early on, signal an improving economy, and the faster growth more than compensates for higher rates.”

So, exactly “when” are Fed actions are “not bullish?” 

I would suggest now.

As I noted in this past weekend’s missive:

“Lower rates have less impact on the ‘economy,’when the monetary transmission system is weak. This is evident from the fact that surging asset prices have left 80% of the population behind in terms of higher levels of prosperity. This also is why tax cuts failed to work as intended. After a decade of low rates, and excess liquidity, the ability to ‘pull-forward’ demand has become limited.”

While, in the short-term, it may seem that whatever the Fed does is “bullish,” as the performance of the stock market since 2009 would seem to support, it has been a function unbridled fiscal largesse. As shown in the chart below, the Fed’s actions have been supported by a massive amount of Government spending as noted last week:

“As shown in the chart below, since 2010 it has taken continually increases in Federal expenditures just to maintain economic growth at the same level it was nearly a decade ago.”

But let’s modify that chart to compare the Fed’s actions plus government expenditures to the S&P 500.

With that much liquidity sloshing around, it had to go somewhere. Not surprisingly, as the Fed suppressed interest rates, it forced investors to chase yield.

The problem with the table from CNBC above, as it only tells you what happens immediately after the Fed cut rates the first time. By the time the Fed is starts cutting rates, the markets are well entrenched into a bullish trend. Stocks aren’t beginning a bull run, but rather are being carried higher by existing momentum which has typically been a hallmark of a late-stage bullish cycle. In every case, there was an eventual negative outcome following Fed rate cut cycles. (The table below uses the 3-month average of the effective Fed Funds rate.)

The chart of the effective Fed funds rate and the S&P 500 tells the story. (The vertical dashed lines marked the initial cuts, and you can see where subsequent crisis and declines occurred.)

The one exception was the initial rate cut in 1995 following the Orange County Bankruptcy, an “insurance cut,” despite both a strong market and economy at the time. As recently noted by J.P. Morgan:

“The late 1990’s rate cuts were used as insurance against Mexican and Russian default and collapse of hedge fund Long-Term Capital Management at the time, bolstered the equity market. The only other time the S&P 500 saw stronger performance following a rate cut was in 1980.”

The early 1980s are NOT comparative to the current cycle.

• The U.S. economy was just coming out of back-to-back recessions
• Valuations were extremely low
• Dividends were high; and,
• Inflation and interest rates were in double-digits.
• President Reagan had just passed tax reform
• The banks were deregulated; and,
• Inflation and interest rates were beginning a 40-year secular decline.
• Household debt was only about 60% of net worth and just starting a 40-year “leveraging cycle” .

In other words, there was nowhere for the market to go but up.

Clearly, such is not the case today, as deflation, debt, and demographic shifts loom large.

But What About 1995?

The mid-late 1990’s rate cuts was also another anomalous market environment. The Fed began a rate hiking campaign in 1993 as the economy began to stretch its legs post the 1991 recession. However, the Fed cut rates slightly in 1995, and again in 1998, to offset the risk imposed from three major market-related events. Ironically, it was the Fed’s tightening of monetary policy which contributed to those events.

Another critical point is that rates were relatively stable post the 1991 recession rather than the rather sharp increase we have seen over the last couple of years. Also, economic growth, as I showed last week, was running at an average of 3.5% on an inflation-adjusted basis, versus 2%-ish today.

Importantly, the markets sharp advance in the late-1990’s was due to a period of “market nirvana” as the internet became mainstream changing the way information was accessed, utilized, and institutionalized.

• Mutual funds were a virtual “Hoover vacuum” sucking up retail assets and lofting asset prices higher.
• Pension funds were finally allowed to invest in stocks, rather than just Treasuries, which brought massive buying power to the markets.
• Foreign flows also poured into Wall Street to chase the raging bull market higher.
• Lastly, “internet trading” hit the internet, which further opened the doors of the “WallStreet Casino” to the masses.

Yes, for a brief moment, the markets raged as “irrational exuberance” prevailed. Of course, while the rate cuts in 1995 didn’t slow the growth of the “bubble” immediately, it wasn’t long before all the gains were wiped out by the “Dot.com” crash.

Timing, as they say, is everything.

This Isn’t 1995

A quick comparison between 1995, and today, also elicits many other concerns about the markets ability to dramatically extend its current cycle.

From 1991-2000 (10-Years)

• Personal Incomes averaged 4% and were rising to 5% on an annual rate
• Employment averaged a 2.5% annual growth rate and was solid heading into 2000.
• Industrial Production averaged about 5% annual growth and was rising at the end of 1999.
• Real Consumer Spending averaged a nearly 12% annual growth rate heading into 2000.
• Real Wages were climbing steadily from 1991 to 1999 and hit a peak of almost 14% in 1999.
• Real GDP was running at more than 4% annually in December of 1999.

NOTE: There was NO SIGN of RECESSION in late 1999.

Compare the chart above with the one below.

There is a vast difference between the strength of the economy today versus 1999; particularly we are already in a longer economic expansion than we were then.

• Personal Incomes currently average about 2% versus 4% in 1995
• Employment is averaging about a 1.5% annualized growth rate versus 2.5% in 1995.
• Industrial Production has averaged about 2% annual growth vs 5% previously.
• Real Consumer Spending has averaged about 4% annual growth versus 8-10% in 1995.
• Real Wages have averaged about a 3.5 annual growth rate versus 8-10% in 1995.
• Real GDP has averaged about 2% annual growth over the last decade versus 3% previously.

There is also one other significant difference.

In 1995, Consumer Confidence was at about 100 on its way to 140.

Today, it is likely not possible to get more optimistic than consumers are currently.

It’s All Bullish

“We could get more volatility in the coming days, but as we settle into August you’ll see equities start to perk again. My assumption is that we could start to see a buy-the-dip mentality, created by the easy money move and the need to chase returns.” – Yousef Abbasi, INTL FCStone

“Low rates will continue to support a higher-than-average valuations for the S&P 500. At the same time that corporations are growing revenue at a healthy clip and appear set to avoid the earnings recession that many investors had been fearing this year.” – Brad McMillan, CommonWealth

Not surprisingly, since the Fed’s announcement, the financial media and Wall Street have been pushing the bullish narrative. Just as they did in 1999 and 2007, as there was “no recession in sight,” then either.

The problem is financial media, or Wall Street, is they never tell you when to sell. (They don’t make money when you are in cash.)

Currently, the risk to the market is elevated.

• Confidence is at highs, not lows.
• Economic growth is at a cycle peak
• Earnings growth is beginning to weaken, and corporate profits are on the decline.
• Valuations are elevated
• Leverage is at records
• Stock buyback activity is slowing  (As we noted previously, since 2014, buyback activity has accounted for nearly 100% of net equity purchases in the market and is now slowing).

While it is certainly possible for equities to push higher over the short-term, seemingly to confirm the “bullish calls,” don’t forget your time horizon is substantially longer than 6-12 months. 

No one will ring a bell at the eventual top, the media won’t tell you to “sell,” and the mainstream financial advice will tell you that if your only option is to “buy and hold.” 

If history is any guide, the next mean reverting event will likely wipe out of the bulk of the gains made over the last 5-7 years at a minimum.

If you are close to retirement, it should be clear that risk outweighs the reward currently. 

Not everything the Fed does can be bullish.

In this past weekend’s newsletter, I discussed the rather severe extensions of the market above both the longer-term bullish trend and the 200-dma. To wit:

There is also just the simple issue that markets are very extended above their long-term trends, as shown in the chart below. A geopolitical event, a shift in expectations, or an acceleration in economic weakness in the U.S. could spark a mean-reverting event which would be quite the norm of what we have seen in recent years.”

“As shown below, while the market is on a near-term “buy signal”(lower panel) the overbought condition, and near 9% extension above the 200-dma, suggests a pullback is in order.”

Of course, discussing the potential of a market correction is almost always perceived as being “bearish.” Therefore, by extension that must mean that I am either all in cash or shorting the market. In either case, it is assumed I “missed out” on previous advances.

If you have been reading our work for long, you already know we have remained primarily invested in the markets, but hedge our risk with fixed income and cash, despite our “bearish” views. I am reminded of something famed Morgan Stanley strategist Gerard Minack said once:

“The funny thing is there is a disconnect between what investors are saying and what they are doing. No one thinks all the problems the global financial crisis revealed have been healed. But when you have an equity rally like you’ve seen for the past four or five years, then everybody has had to participate to some extent.

What you’ve had are fully invested bears.”

While the mainstream media continues to misalign individuals expectations by chastising them for “not beating the market,” which is actually impossible to do, the job of a portfolio manager is to participate in the markets with a predilection toward capital preservation. This is an important point:

“It is the destruction of capital during market declines that have the greatest impact on long-term portfolio performance.”

It is from that view, as a portfolio manager, the idea of “fully invested bears” defines the reality of the markets that we live with today. Despite the understanding the markets are overly bullish, extended and overvalued, portfolio managers must stay invested or suffer potential “career risk” for underperformance. What the Federal Reserve’s ongoing interventions have done is push portfolio managers to chase performance despite concerns of potential capital loss.

Managing portfolios for both risk adjusted returns while protecting capital is a delicate balance. Each week in the Real Investment Report (click here for free weekly e-delivery) we discuss the risks and challenges of the current market environment and report on how we are adjusting our exposures to the market over time. I wanted to share these charts from our friends at Crescat Capital which are all sending an important message. Currently, these are “risks” the market is ignoring, but eventually they will matter, and they will matter a lot.

Valuations

One of the consistent drivers behind the bull market over the last few years has been the idea of the “Fed Put.” As long as the Federal Reserve was there to “bailout” the markets if something went wrong, there was no reason NOT to be invested in equities. In turn, this has pushed investors to not only “chase yield,” due to artificially suppressed interest rates but to push valuations on stocks back to levels only seen prior to the turn of the century. As Crescat notes:

“ The reality is that stocks have never been this expensive for how low the 10-year Treasury yield is today. It’s true that all else equal, low interest rates justify higher valuations. However, the lowest interest rates historically haven’t corresponded to the highest P/E markets because extremely depressed yields also signal fundamental problems in the economy. Ultra-low rate environments are often marked by highly leveraged economies where future growth is likely to be weak.”

Given that valuations are all in the 90th percentile of historical values, it suggests that a reversion to the mean is increasingly likely.

Given these valuations are occurring against a backdrop of deteriorating economic growth and corporate profits, the risk to investor capital is high.

Divergences

I have previously addressed the narrowing of participation in the markets. Much of the advance in the markets this year alone can be solely accounted for by a handful of mega-capitalization stocks. Since those mega-cap reside in both the Nasdaq and the S&P 500 index, the lack of breadth is worth noting. As Crescat points out:

“While many US equity indices have marginally broken out to new highs recently, they have done so in the face of weakening market internals. Equity indices are being propped up by a narrowing group of leaders. The deteriorating breadth is most evident in the NASDAQ Composite, home to today’s leading growth stocks. While the overall index has reached record levels, the number of declining stocks has significantly outpaced the number of advancing stocks since last September. The collapsing internals point to an exhausted bull market.”

Volume & Participation

Another warning sign is that volume and participation have have also weakened markedly. These are all signs of a market advance nearing “exhaustion.”  Back to Crescat:

“Stocks are also rising in defiance of extremely low volume. On July 16th, the SPDR S&P 500 ETF (SPY) had its lowest daily volume in almost 2 years. In a 15-daily average terms, volume is now as low as it was at the peak of the housing bubble and prior to the last two selloffs in 2018. Unusual calmness and breadth deterioration are not a good set up for record overvalued stocks.”

“The following chart is yet another illustration of how this recent rally in equities is running on empty, and again lacking substance. On July 15th, S&P 500 reached record levels, but only three sectors were at all-time highs. Market breadth today is faltering just as much as it did ahead of the last two recessions. In 2015, this was also the case, but back then only 20% of the yield curve was inverted. Now it’s close to 60%!”

Deviation

I have written many times in the past that the financial markets are not immune to the laws of physics. As I started out this missive, the deviation between the current market and long-term means is at some of the highest levels in market history.

There is a simple rule for markets:

“What goes up, must, and will, eventually come down.”

The example I use most often is the resemblance to “stretching a rubber-band.” Stock prices are tied to their long-term trend which acts as a gravitational pull. When prices deviate too far from the long-term trend they will eventually, and inevitably, “revert to the mean.”

See Bob Farrell’s Rule #1

As Crescat laid out, a “mean reverting” event would currently encompass a 53% decline from recent peaks.

Does this mean the current bull market is over?

No.

However, it does suggest the “risk” to investors is currently to the downside and some caution with respect to equity-based exposure should be considered.

Sentiment

Lastly, is investor sentiment. When sentiment is heavily skewed toward those willing to “buy,” prices can rise rapidly and seemingly “climb a wall of worry.” However, the problem comes when that sentiment begins to change and those willing to “buy” disappear.

This “vacuum” of buyers leads to rapid reductions in prices as sellers are forced to lower their price to complete a transaction. The problem is magnified when prices decline rapidly. When sellers panic, and are willing to sell “at any price,” the buyers that remain gain almost absolute control over the price they will pay. This “lack of liquidity” for sellers leads to rapid and sharp declines in price, which further exacerbates the problem and escalates until “sellers” are exhausted.

Currently, there is a scarcity of “bears.”

See Bob Farrell’s Rule #6

With sentiment currently at very high levels, combined with low volatility and excess margin debt, all the ingredients necessary for a sharp market reversion are present. Am I sounding an “alarm bell” and calling for the end of the known world?

Of course, not.

However, I am suggesting that remaining fully invested in the financial markets without a thorough understanding of your “risk exposure” will likely not have the desirable end result you have been promised. All of the charts above have linkages to each other, and when one goes, they will all go.

So pay attention to the details.

The markets currently believe that when the Fed cuts rates this week, the bull market will continue higher. Crescat, and history, suggest a different outcome.

As I stated above, my job, like every portfolio manager, is to participate when markets are rising. However, it is also my job to keep a measured approach to capital preservation.

Yes, I am bearish on the longer-term outlook of the markets for the reasons, and many more, stated above.

Just make sure you understand that I am an “almost fully invested bear.”

At least for now.

But that can, and will, rapidly change as the indicators I follow dictate.

What’s your strategy?

On Tuesday, Federal Reserve Chairman Jerome Powell, in his opening remarks at a monetary policy conference in Chicago, raised concerns about the rising trade tensions in the U.S.,

“We do not know how or when these issues will be resolved. As always, we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective.”

However, while there was nothing “new” in that comment it was his following statement that sent “shorts” scrambling to cover.

“In short, the proximity of interest rates to the ELB has become the preeminent monetary policy challenge of our time, tainting all manner of issues with ELB risk and imbuing many old challenges with greater significance.  

“Perhaps it is time to retire the term ‘unconventional’ when referring to tools that were used in the crisis. We know that tools like these are likely to be needed in some form in future ELB spells, which we hope will be rare.”

As Zerohedge noted:

“To translate that statement, not only is the Fed ready to cut rates, but it may take ‘unconventional’ tools during the next recession, i.e., NIRP and even more QE.”

This is a very interesting statement considering that these tools, which were indeed unconventional “emergency” measures at the time, have now become standard operating procedure for the Fed.

Yet, these “policy tools” are still untested.

Clearly, QE worked well in lifting asset prices, but not so much for the economy. In other words, QE was ultimately a massive “wealth transfer” from the middle class to the rich which has created one of the greatest wealth gaps in the history of the U.S., not to mention an asset bubble of historic proportions.

However, they have yet to operate within the confines of an economic recession or a mean-reverting event in the financial markets. In simpler terms, no one knows for certain whether the bubbles created by monetary policies are infinitely sustainable? Or, what the consequences will be if they aren’t.

The other concern with restarting monetary policy at this stage of the financial cycle is the backdrop is not conducive for “emergency measures” to be effective. As we wrote in “QE, Then, Now, & Why It May Not Work:”

“If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.

But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.

“The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the ‘norm’ are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.”

The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more diametrically opposed.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

While Powell is hinting at QE4, it likely will only be employed when rate reductions aren’t enough. Such was noted in 2016 by David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

In effect, Powell has become aware he has become caught in a liquidity trap. Without continued “emergency measures” the markets, and subsequently economic growth, can not be sustained. This is where David compared three policy approaches to offset the next recession:

1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

This is exactly the prescription that Jerome Powell laid out on Tuesday suggesting the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

This is also why 10-year Treasury rates are going to ZERO.

Why Rates Are Going To Zero

I have been discussing over the last couple of years why the death of the bond bull market has been greatly exaggerated. To wit: (Also read: The Bond Bull Market)

“There is an assumption that because interest rates are low, that the bond bull market has come to its inevitable conclusion. The problem with this assumption is three-fold:

1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields which push rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largesse in the future, the budget deficit is set to swell back to $1 Trillion or more in the coming years. This will require more government bond issuance to fund future expenditures which will be magnified during the next recessionary spat as tax revenue falls.
3. Central Banks will continue to be a buyer of bonds to maintain the current status quo, but will become more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion which will push the 10-year yield towards zero.”

It’s item #3 that is most important.

In “Debt & Deficits: A Slow Motion Train Wreck” I laid out the data constructs behind the points above.

However, it was in April 2016, when I stated that with more government spending, a budget deficit heading towards $1 Trillion, and real economic growth running well below expectations, the demand for bonds would continue to grow. Even from a purely technical perspective, the trend of interest rates suggested at that time a rate below one-percent was likely during the next economic recession.

Outside of other events such as the S&L Crisis, Asian Contagion, Long-Term Capital Management, etc. which all drove money out of stocks and into bonds pushing rates lower, recessionary environments are especially prone at suppressing rates further. But, given the inflation of multiple asset bubbles, a credit-driven event that impacts the corporate bond market will drive rates to zero.

Furthermore, given rates are already negative in many parts of the world, which will likely be even more negative during a global recessionary environment, zero yields will still remain more attractive to foreign investors. This will be from both a potential capital appreciation perspective (expectations of negative rates in the U.S.) and the perceived safety and liquidity of the U.S. Treasury market. 

Rates are ultimately directly impacted by the strength of economic growth and the demand for credit. While short-term dynamics may move rates, ultimately the fundamentals combined with the demand for safety and liquidity will be the ultimate arbiter.

With the majority of yield curves that we track now inverted, many economic indicators flashing red, and financial markets dependent on “Fed action” rather than strong fundamentals, it is likely the bond market already knows a problem in brewing.

However, while I am fairly certain the “facts” will play out as they have historically, rest assured that if the “facts” do indeed change, I will gladly change my view.

Currently, there is NO evidence that a change of facts has occurred.

Of course, we aren’t the only ones expecting rates to go to zero. As Bloomberg noted:

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade and there is rising evidence that growth is beginning to decelerate.

While another $2-4 Trillion in QE might indeed be successful in further inflating the third bubble in asset prices since the turn of the century, there is a finite ability to continue to pull forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. 

There is evidence the cycle peak has been reached.

If I am correct, and the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be far larger than currently imagined. There is a limit to just how many bonds the Federal Reserve can buy and a deep recession will likely find the Fed powerless to offset much of the negative effects. 

If more “QE” works, great.

But as investors, with our retirement savings at risk, what if it doesn’t?Save

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“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, I went dove into the current backdrop of the markets, bullish exuberance, interest rates and oil prices. Of particular note was the current bifurcation of the market as shown in the sector rotation chart below.

“The problem with the breadth of the advance is significant. As shown in the sector rotation chart, the current rally has been extremely bifurcated. Such extreme deviations in performance tend not to last long and tend to have rather nasty reversions.”

The importance of understanding the nature of reversions is critical for investors. Markets rarely move in one direction for very long, notwithstanding overall trends, without a correction process along the way. While the chart below shows this clearly for the overall market, it applies to individual sectors of the market as well.

Importantly, notice the bottom two part of the chart above. When there is a simultaneous culmination of overbought conditions combined with a more extreme deviation, corrections usually occur back to the underlying trend.

This can also be seen in the next chart as well. While the “Trump Rally” has pushed asset prices higher and triggered a corresponding “buy signal,” that signal has been triggered at very high levels combined with a very overbought condition. Historically, rallies following such a combination have not been extremely fruitful.

Stepping back for just a moment, while the markets continue to ignore the risks of “Brexit”, “Trumponomics,” “Italexit,” rising interest rates, a stronger dollar and valuations in the short-term, history suggests the consequences of excessive risk-taking have not been resolved.

As shown in the very long-term chart below (back to 1925), the markets are pushing long-term overbought conditions, combined with high valuation levels, that have historically yielded low-return outcomes.

Of course, the timing and the catalysts of a long-term reversion to the mean are unknowable. However, throughout history, they have been repeated with regularity, and ignoring fundamental realities will likely prove to be a bad decision for most.

One other interesting tidbit in this regard came from a dear friend of mine over the weekend as we discussed market outlooks and consequences. The chart below is the ratio of the price of stocks relative to the price of bonds. When there is extreme bullishness in the equity markets, the ratio rises to high levels as investors pile into “risk” based assets over “safety.” Outcomes, again, have tended not to be good.

The point here is that while asset prices have certainly surged since the election, there is little room for errors in the future. But that is a story for another day.

In the meantime, it’s “Santa Claus” hats for everyone.

It’s Now Or Never For Santa

With the market now back to overbought conditions, it is now or never for the traditional “Santa Rally.”

If we go back to 1990, the month of December has had average returns of 2.02% with positive returns 81% of the time. Over the past 100 years, those numbers fall slightly to a 1.39% average return with positive returns 73% of the time. Statistically speaking, the odds are high that the market will muster a rally over the few weeks headed into the end of the year.

As discussed over the last couple of weeks, this is not to be unexpected as portfolio managers and hedge funds “Stuff Their Stockings” of highly visible positions to have them reflected in year-end statements. 

Come January, it is potentially a different story as we saw last year as the Federal Reserve hiked rates at their December meeting. The chart below shows the December rally over the last 3-years followed by a January sell-off.

However, given the spike of the recent advance and rally into the end of the year may be more subdued from this point forward. As I discussed in detail recently, the underlying technical underpinnings are pushing extremes on many levels and are more akin to market peaks than the beginning of new bull market advances.

Buybacks At A Limit?

One of the biggest drivers to earnings growth has not been revenue growth but share buybacks. As I discussed previously:

“One of the primary tools used by businesses to increase profitability has been through the heavy use of stock buybacks. The chart below shows outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buybacks.”

“The problem with this, of course, is that stock buybacks create an illusion of profitability. If a company earns $0.90 per share and has one million shares outstanding – reducing those shares to 900,000 will increase earnings per share to $1.00. No additional revenue was created, no more product was sold, it is simply accounting magic. Such activities do not spur economic growth or generate real wealth for shareholders.”

The problem with the use of share buybacks to boost earnings is that there is a finite limit to the number of shares you can buy back until you become a privately owned company again. Furthermore, there is a limit to share buybacks from the availability of either “free cash” OR availability of cheap debt with which to repurchase shares. Both of those may become a problem in the next year.

As David Bianco recently stated:

“20% of the S&P 500’s earnings per share will come from buybacks. By shrinking the amount of stock outstanding, earnings are boosted on a per share basis.

Strains on maintaining buybacks (even dividends) will be at Energy, Industrials, and Materials. But Healthcare and most of big cap Tech should be in a very good position to maintain buybacks or even boost them a bit as [free cash flow] at these sectors is healthy and these companies still very much have access to bank lines of credit and debt capital markets and low interest rates.”

As noted buybacks are back to levels last seen at the peak of the last major bull market. More importantly, with interest rates rising pushing borrowing costs higher, the net benefit of share buybacks will become less attractive. Combined with tighter bank lending standards, and the availability of free capital to buy back shares is more limited. 

This can be seen in the following two charts which show the deterioration in the financial health of corporate balance sheets since the “purge” of the financial crisis. Leverage is back.

While this time could certainly be different, there are many similarities that suggest it won’t be.

My feeling is that if Santa does come to Wall Street, it is probably a good opportunity to get a little more defensive heading into a year that has historically lower odds of being a winner.

As an investor, you should remember that making money in the market is only one-half of the job. Keeping it is the other.

“We can not direct the wind, but we can adjust the sail.” – Anonymous

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“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.

Due to the holiday, I did not write my normal weekend missive, so I have a few things to catch up on from last weeks “Technically Speaking” which discussed the entrance into a market melt-up. To wit:

“As I have noted, there are many similarities in market action between the “post-Trexit” bounce, “Brexit” and last December’s Fed rate hike. I have highlighted there specific areas of note in the chart.”

“As with ‘Brexit’ this past June, the markets sold off heading into the vote assuming a vote to leave the Eurozone would be a catastrophe. However, as the vote became clear that Britain was voting to leave, global Central Banks leaped into action to push liquidity into the markets to remove the risk of a market meltdown. The same setup was seen as markets plunged on election night and once again liquidity was pushed into the markets to support asset prices forcing a short squeeze higher.”

And, as I noted then:

“So, with that breakout, I am increasing equity risk exposure to portfolios. “

However, as I also noted, I tempered that increase in equity increase with interest-rate sensitive exposure. This exposure will act as a hedge against a sudden reversal in rates, and the dollar, as economic realities eventually collide with the “Trump rally” fantasy.

Despite the rally from the election lows, which has been ebullient, to say the least, we need to remain cognizant of the underlying risks currently developing in the market. That is the focus of today’s analysis which takes a look at the different between what we “see” versus what “really is.”

Market Strength Not What It Seems

First, despite all of the media chatter of the markets hitting “all-time highs,” such lofty attainment has not been uniform across markets and sectors. As shown in the charts below, relative performance has been bifurcated between domestic and international exposure. As such, any portfolio which has been “diversified” in recent weeks has lost ground to the broad market domestic indices.

So, despite all of the rhetoric about the benefits of “indexing,” such has not worked given the recent state of the markets.

More importantly, since individuals are consistently told to only “buy and hold” within their portfolios, there has been little gained in recent months as the index is only slightly higher (0.75%) than it was prior to the election

However, in the short-term, there are bullish arguments to certainly be made for the market.

1. We are entering into the “seasonally strong” period of the year which typically generates the bulk of returns for stocks.
2. The “hope” for a massive infrastructure spending package, combined with tax cuts, from the “Trump” administration has not only bolstered hopes for a stronger domestic economy, but a global recovery as well. Such was noted by the OECD recently:

“GDP is projected to return to a moderate growth trajectory in 2017 and strengthen in 2018, mainly due to the projected fiscal stimulus, which takes effect particularly in 2018. Indeed, projected fiscal support will boost GDP growth by just under ½ and 1 percentage point in 2017 and 2018 respectively.”

Such an outlook is certainly encouraging, but there is a long way to go between President-elect taking office, drafting bills and getting them passed. There is even a further period of time before any actions actually passed by the Trump administration actually create perceivable effects within the broader economy. In the meantime, there are many concerns, from a technical perspective, that must be recognized within the current market environment.

First, the market has moved from extremely oversold conditions to extremely overbought in a very short period. This is the first time, within the last three years, the markets have pushed a 3-standard deviation move from the 50-day moving average. Such a move is not sustainable and a correction to resolve this extreme deviation will occur before a further advance can be mounted. Currently, a pullback to the 50-day moving average, if not the 200-dma, would be most likely.

Secondly, as discussed above, the advance to “all-time highs” has been narrowly defined to only a few sectors. As shown the number of stocks participating, while improved from the pre-election lows, remains relatively weak and does not suggest a healthy advance.

As with the discussion of the 3-standard deviation of the market above, the current deviation from the long-term average is also consistently with a late stage move that will need to be corrected. As discussed many times previously, a moving average only exists at a point where previous prices have traded both above, and below, certain levels. Therefore, moving averages exert a “gravitational force” on prices which grows in strength as prices deviate further away from the average. As shown below, despite beliefs that prices can only move higher, there is an extreme regularity of “reversions back to the mean” over time.

Currently, with prices pushing a 5% deviation from the longer-term average, it is only a function of time until a reversion occurs back to, if not beyond, the 200-dma which currently resides around 2105.

Furthermore, the rally from the pre-election lows has been a massive short-covering squeeze as markets were hedging a “Trump” win as bad for the markets. The ramp up in the market caused shorts to be frantically covered as Wall Street quickly reversed their message from “Trump The Horrible” to “Trump The Great.”

As shown below the current put/call ratio has quickly reverted to levels that have historically been associated with at least short-term market peaks as well as major market corrections. 

Lastly, as I addressed last Tuesday, the combined rise in the US dollar and 10-year interest rates is a combination that has historically not worked out great for investors but is currently being ignored. To wit:

“The chart below is the 60-day moving average of total 60-day change of both interest rates and the dollar.  In other words, I have used a 60-day moving average to smooth out the volatility of the 60-day net change in the dollar and rates so a clearer trend could be revealed. I have then overlaid that moving average with the S&P 500 index.”

“Not surprisingly, since stronger rates negatively impacts economic growth due to increased borrowing costs, and a stronger dollar reduces exports and ultimately corporate earnings, markets tend not to like the combination of two very much.”

As shown in the last chart below, whenever LIBOR, and the 10-year rate has increased, it has led to an economic, currency or market-related shock. These shocks have tended to negatively impact investors on both a short and intermediate-term basis.

While such an event has not occurred as of yet, it does not mean the impact of a strong dollar and higher rates should be summarily dismissed. The negative impacts to both corporate earnings, as well as economic forecasts, can quickly spoil the “bull market party” particularly given the level of valuations that currently exist. 

As I stated last week:

“Importantly, with next week (Thanksgiving) being a light trading week, it would not be surprising to see markets drift higher. 

However, expect a decline during the first couple of weeks of December as mutual funds and hedge funds deal with distributions and redemptions. That draw down, as seen in early last December, ran right into the Fed rate hike that set up the sharp January decline.”

I still expect such could very well be the case with a “Santa Claus” rally into the end of the year as fund managers scramble to add performance before the year-end reporting period comes to an end. This would certainly coincide with the “hope” that investors have currently built into the market during the recent advance.

“The greatest streak of stock market gains in almost 28 years may have some wondering if it is sustainable, but, according to AAII, this objective spike in valuations following Donald Trump’s victory has sparked overwhelming bullishness among investors.

15 straight days of gains in Small Caps (only bettered by 1988’s streak) has sent AAII bullishness soaring to its highest since January 2015 (following the end of QE3) with the biggest 3-week spike since September 2010.”

You don’t have to look back very far to begin to get an idea of what happens when investors have come to grips with reality versus “hope.”

This analysis does not necessarily suggest a major market crash is imminent. However, it also does not suggest a major advance directly to 2400 is in the offing either. The point to be made is the risk of a corrective action, which could provide a buying opportunity provided important support levels hold, is likely in the short term.

Given that most individuals have not even gotten “back to even,” given the drag from interest rate sensitive investments, this may be a good opportunity to rethink allocations and make some decisions about the inherent level of risk in portfolios.

In other words, if you are supposed to “sell high,” and “buy low,” there are certainly many short-term indications which suggest this may be an apropos opportunity to take some profits and rebalance risks accordingly.

Or, you can just “hope” it will all turn out okay.

“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 potential for a breakout by the markets to “all time” highs during a holiday shortened, and light trading, week. On Monday, not to be disappointed, that expectation was met.

“The good news, as shown in the next chart, is the market was able to clear that downtrend resistance this week and turn the previous “sell signal” back up.  As suggested previously, it is not surprising the markets are pushing all-time highs as we saw on Friday.”

But what about after that?

“Importantly, with next week being a light trading week, it would not be surprising to see markets drift higher. 

However, expect a decline during the first couple of weeks of December as mutual funds and hedge funds deal with distributions and redemptions. That draw down, as seen in early last December, ran right into the Fed rate hike that set up the sharp January decline.”

As I have noted above, there are many similarities in market action between the “post-Trexit” bounce, “Brexit” and last December’s Fed rate hike. I have highlighted there specific areas of note in the chart above.

“As with ‘Brexit’ this past June, the markets sold off heading into the vote assuming a vote to leave the Eurozone would be a catastrophe. However, as the vote became clear that Britain was voting to leave, global Central Banks leaped into action to push liquidity into the markets to remove the risk of a market meltdown. The same setup was seen as markets plunged on election night and once again liquidity was pushed into the markets to support asset prices forcing a short-squeeze higher.”

So, with that breakout, I am increasing equity risk exposure to portfolios. 

However, I am doing so with an offsetting hedge by adding exposure to interest rate sensitive sectors and beaten down opportunities. The reason for those hedges is due to the combined current backdrop of a sharply higher dollar and interest rates which have historically been the ingredients for rather nasty corrections.

The chart below is the 60-day moving average of total 60-day change of both interest rates and the dollar.  In other words, I have used a 60-day moving average to smooth out the volatility of the 60-day net change in the dollar and rates so a clearer trend could be revealed. I have then overlaid that moving average with the S&P 500 index.

Not surprisingly, since stronger rates negatively impacts economic growth due to increased borrowing costs, and a stronger dollar reduces exports and ultimately corporate earnings, markets tend not to like the combination of two very much.

My analysis agrees with Dr. Lacy Hunt via Hoisington Investment Management who recently stated:

“The recent rise in market interest rates will place downward pressure on the velocity of money (V) and also the rate of growth in the money supply (M). This is not a powerful effect, but it is a negative one. Some additional saving or less spending will occur, thus giving V a push downward. So, in effect, the markets have tightened monetary conditions without the Fed acting. If the Fed raises rates in December, this will place some additional downward pressure on both M and V, and hence on nominal GDP. Thus, the markets have reduced the timeliness and potential success of the coming tax reductions.

Another negative initial condition is that the dollar has risen this year, currently trading close to the 13-year high. The highly relevant Chinese yuan has slumped to a seven-year low. These events will force disinflationary, if not deflationary forces into the US economy. Corporate profits, which had already fallen back to 2011 levels, will be reduced due to several considerations. Pricing power will be reduced, domestic and international market share will be lost and profits of overseas subs will be reduced by currency conversion. Corporate profits on overseas operations will be reduced, but with demand weak and current profits under downward pressure, the repatriated earnings are likely to go into financial rather than physical investment.

Markets have a pronounced tendency to rush to judgment when policy changes occur. When the Obama stimulus of 2009 was announced, the presumption was that it would lead to an inflationary boom. Similarly, the unveiling of QE1 raised expectations of a runaway inflation. Yet, neither happened. The economics are not different now.Under present conditions, it is our judgment that the declining secular trend in Treasury bond yields remains intact.”

While not all combined increases led to major market events/crisis as noted above, more often than not equity participants tended not to fare exceptionally well.

That’s just reality.

Welcome To The “Melt-Up”

However, while economic and fundamental realities HAVE NOT changed since the election, markets are pricing in expected impacts of changes to fiscal policy expecting a massive boost to earnings from tax rate reductions and repatriated offshore cash to be used directly for stock buybacks.

To wit:

“We expect tax reform legislation under the Trump administration will encourage firms to repatriate $200 billion of overseas cash next year. A significant portion of returning funds will be directed to buybacks based on the pattern of the tax holiday in 2004.” – Goldman Sachs

But it is not just the repatriation but lower tax rates that will miraculously boost bottom line earnings. This time from Deutsche Bank:

“Every 5pt cut in the US corporate tax rate from 35% boosts S&P EPS by $5. Assuming that the US adopts a new corporate tax rate between 20-30%, we expect S&P EPS of $130-140 in 2017 and $140-150 in 2018. We raise our 2017E S&P EPS to $130.”

See…buy stocks. Right?

Maybe not so fast. Here is the problem.

While you may boost bottom line earnings from tax cuts, the top line revenue cuts caused by higher interest rates, inflationary pressures, and a stronger dollar will exceed the benefits companies receive at the bottom line.

I am not discounting the rush by companies to buy back shares at the greatest clip in the last 20-years to offset the impact to earnings by the reduction in revenues. However, none of the actions above go to solving the two things currently plaguing the economy – real jobs and real wages. 

The rush by Wall Street to price in fiscal policy, which may or may not arrive in a timely manner, will likely push the markets higher in the short-term completing the final leg of the current bull market cycle. This was a point I addressed back in October on the potential for a rise to 2400 in the markets. With the breakout of the market to new highs, the bullish spirits have emboldened investors to rush into the most speculative areas of the market.

For now, it is all about the “Trump” trade. Which is interesting considering that just before the election we were all told how horrible a Trump election would be for the world economy.

However, it should be noted that despite the “hope” of fiscal support for the markets, longer-term “sell signals” only witnessed during major market topping processes currently remain as shown below.

The problem for the new Administration is the economy is already pushing in excess of 100% of debt-to-GDP which by its very nature reduces the impact of stimulative programs such as infrastructure spending. But the debt itself is also a problem and a point made today by Fed vice chair Fischer issued a clear warning as to the “enormous uncertainty around new US fiscal policies.”

• FISCHER: NOT A LOT OF ROOM TO INCREASE U.S. DEFICIT WITHOUT ADVERSE CONSEQUENCES DOWN THE ROAD

But that is a story for another day.

For now, the market is ignoring such realities in the “hope” this time is different. The market has regained its running bullish trend line for now which keeps the “bulls” in charge.

As shown below, the breakout to new highs does clear the markets for a further advance. However, while the technicals suggest a move to 2400, it is quite possible it could be much less. Notice in the bottom section of the chart below. Turning the current “sell signal” back into a “buy signal” at such a high level does not give the markets a tremendous amount of runway.

Furthermore, the market is also pushing into resistance of the previously supportive bullish trend lines. This may limit the upside advance temporarily as the markets work off the currently extreme overbought conditions following the advance from the election lows. 

There is also the issue of deviations above the long-term trend line. Trend lines and moving averages are like “gravity.”  Prices can only deviate so far from their underlying trends before eventually “reverting to the mean.” However, as we saw in 2013-14, given enough liquidity prices can remain deviated far longer than would normally be expected.  (I have extrapolated move to 2400 using weekly price data from the S&P 500.)

A move to 2400 would once again stretch the limits of deviation from the long-term trend line likely leading to a rather nasty reversion shortly thereafter.

We can see the deviation a little more clearly in the analysis below. Once again, the data in the orange box is an extrapolated price advance using historical market data. The dashed black line is the 6-month moving average (because #BlackLinesMatter) and the bar chart is the deviation of the markets from price average.

Historically speaking deviations of such an extreme rarely last long. As discussed above, while it is conceivable that a breakout of the current consolidation pattern could lead to a sharp price advance, it would likely be the last stage of the bull market advance before the next sizable correction. 

This Won’t End Well

As shown in the first chart above, the rising in the dollar and interest rates will lead to an explosion somewhere in the economy and the markets that will negate a good chunk, if not all, of any fiscal policy measures implemented by the next administration.

Where, and when, are the two questions that can not be answered.

How big of a correction could be witnessed? The chart below, once again extrapolated to 2400, shows the mathematical retracement levels based on the Fibonacci sequence. The most likely correction would be back to 2000-ish which would officially enter “bear market” territory of 23.6%. However, most corrections, historically speaking, generally approach the 38.2% correction level. Such a correction would be consistent with a normal recessionary decline and bear market. 

Of course, given the length and duration of the current bull-market with extremely weak fundamental underpinnings, leverage, and over-valuations, a 50% correction back towards the 1300 level is certainly NOT out of the question.  Let’s not even discuss what would happen if go beyond that, but suffice it to say it wouldn’t be good.

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. However, being right or wrong has a very big effect on you.

Yes, a move to 2400 is viable, but there must be a sharp improvement in the underlying fundamental and economic backdrop. Right now, there is little evidence of that in the making, and with the rise of the dollar and rates, the Fed tightening monetary policy and real consumption weak there are many headwinds to conquer. Regardless, it will likely be a one-way trip and it should be realized that such a move would be consistent with the final stages of a market melt-up.

As Wile E. Coyote always discovers as he careens off the edge of the cliff, “gravity is a bitch.”

“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 in detail the “Post-Trexit” market action as the pre-election certainty, a “Trump Catastrophe,” turned into a “Make America Great Again” rally. To wit:

“Last week, I detailed the various levels of overhead resistance to any rally that must be defeated to reinstate a more bullish market.

• The downtrend resistance from the previous highs is colliding with the previous support level which now acts as important resistance.
• The 50-dma is also trending downward adding further resistance to price advances in the near-term. 
• An important ‘sell signal’ has been registered at fairly high levels and current remains intact.

The post “Trexit” rally that started on Wednesday took out the first two levels of resistance with some ease. However, the ‘sell signal’ remains intact with the market now back to extreme overbought levels.

The good news is the market is holding above the downtrend resistance line currently which puts all-time highs as the next logical point of attack if this bull market is to continue.

However, as we step back to a longer-term (weekly) picture we get a little clear picture about the overall directional trend of the market.”

“I like weekly charts because the “noise” of daily volatility in price action is removed. As shown in the chart above, the “sell signal” remains intact but the reflexive move has only taken stocks back to retest the underside of the longer-term bearish “downtrend” line.

This suggests, the current move may be near its limits and the short-covering frenzy seen on Wednesday and Thursday of this past week is near completion.”

Importantly, while the Dow hit new “all-time” highs this past week, other major indices did not.

Furthermore, when we dig down into the S&P index itself, we find the very limited nature of the advance, the “great divide”, as shown below

Interestingly, the same sectors which “ran like a scalded ape” following the election were also rising prior to election day which suggests the markets were already placing bets on a ‘Trump” win. However, the limited breadth of the move was evident from the large number of both new-highs and lows simultaneously registered in the market. This was noted by Dana Lyons last week:

“The first is the fact that both the number of New Highs and New Lows set 3-month highs yesterday. If that sounds odd, it is. In fact, it was only the 2nd day ever in which each set a 3-month high. And since 1970, only 18 prior days saw New Highs and New Lows set as much as a 1-month high.

As the next data point shows, the level of New Highs and Lows is elevated on an absolute basis as well. To wit: Yesterday saw both the number of NYSE New Highs and New Lows account for more than 5% of all issues traded. That is another rare occurrence, with just 11 precedents since 1970.”

“As one can see on the chart, all of the prior instances occurred in fairly close proximity to cyclical market tops (the jury is still out on the late 2014 occurrences). Thus, unlike the prior table, in a way, S&P 500 returns following these occurrences have been unanimously poor – at least over a 2-month time frame.”

“As the table shows, the return in the S&P 500 has been negative 2 months after all 11 occurrences. And it wasn’t just the 2-month period that was poor. Median returns are negative across nearly all time frames from 1 week to 2 years. The 2-year result is perhaps the most eye-opening after the 2-month. The market is not typically down over a 2-year period so to see 7 of the 8 instances lower is a rare result.”

The Dollar / Rate Headwind

Adding to the weak underpinnings of market breadth is also the strong rise in the US Dollar and benchmark interest rates in recent months.

As stated many times previously in this blog, roughly 40% of corporate profits are impacted by the rise and fall of the US dollar. While there are many hoping the 18-month earnings recession is finally over, the strong rise in the dollar negatively impacts corporate profitability.

Of course, it is not JUST the rise in the dollar impacting corporate earnings, but also the end game profit manipulation as the effectiveness of cost cutting, layoffs, share buybacks and other accounting gimmicks used to boost earnings at the bottom line found its limits.

Furthermore, the negative impact of the strong dollar is being coupled with a surge in labor costs from the onset of the Affordable Care Act as I have warned about many times in the past.

As shown in the US dollar chart above, continued pressure on earnings is leading to a rise in the price/earnings ratio. At some point, valuations WILL matter. (Read This)

Adding to the headwinds of a continued bull market is the strong rise in US interest rates back to their long-term downtrend line. As I discussed this past weekend:

“As Jeff Gundlach stated last week:

‘I do think this rate rise is about 80% through. If yields rise beyond ‘critical resistance’ levels, including 2.35% on the 10-year note, then things are in really big trouble.’

He is right, higher rates negatively impact economic growth. But in BOTH CASES, the outcome for bonds is EXCELLENT.

The chart below shows the long-term trend of the 10-year Treasury going back to 1978 as compared to its RSI index.”

Whenever the RSI on rates has exceeded 80%, red dashed lines, it has preceded a subsequent decline in rates. In other words, strong rises in rates negatively impact economic growth and earnings. Rates then fall as the economy slides towards weaker or recessionary environments.

As with the dollar, rising rates, due to the impact on economic growth and consumption, also impacts corporate earnings and stock prices. To wit:

“While the punditry continues to push a narrative that ‘stocks are the only game in town,’ this will likely turn out to be poor advice. But such is the nature of a media driven analysis with a lack of historical experience or perspective.

From many perspectives, the real risk of the heavy equity exposure in portfolios is outweighed by the potential for further reward. The realization of ‘risk,’ when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower.”

“This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.

In other words, I get paid to hedge risk, lower portfolio volatility and protect capital. Bonds aren’t dead, in fact, they are likely going to be your best investment in the not too distant future.”

In the short-term, the markets can act completely contradictory to logic as the rebalancing of portfolio exposures (both long and short) lead to sector and market dislocations.

Over the longer-term time frame, the markets will come back to focus on economic and fundamental realities which remain fragile currently. As noted by Lawrence McDonald just recently:

“Granted, the economic impact of policies introduced by Donald Trump will not be seen for many months or years. Nevertheless, we can look to other market events to get an idea of what we might expect in equity and currency markets over the near term, while the markets are still absorbing the news.”

“Admittedly, two examples of vote-related surprises (2000 uncertainty post-election, and Brexit) and associated market movements and volatilities, along with the example of how the market may view one of Trump’s signature issues (NAFTA agreement in Jan 1994), are hardly comprehensive indicators of what we might see in markets over the next few months; and of course, the economic impact of trade and other policies may not be known for months or years.

But we believe the uncertainty and associated market volatility we have seen in the past may well come to pass again, and market volatility may become the order of the day, as the US transitions to a substantially different style of administration from the past eight years and new policies are put into place.”

Could the policies eventually turn out to be a benefit to economic growth? Sure. However, as Dr. Lacy Hunt recently stated:

“Markets have a pronounced tendency to rush to judgment when policy changes occur. When the Obama stimulus of 2009 was announced the presumption was that it would lead to an inflationary boom. Similarly, the unveiling of QE1 raised expectations of a runaway inflation.

Yet, neither happened. The economics are not different. Under present conditions, it is our judgment that the declining secular trend in Treasury bond yields remains intact.”

This is the most important point. Over the intermediate to longer-term time frame, when considering economic and fundamental underpinnings, the consequences of aggressive equity exposure are entirely negative.

“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 laid out a case for a bounce this week due to the continuous string of declines previously that had reached an extreme. To wit:

“This past week that support gave way leading to the first 9-day straight decline in the index since 1980. 

However, as I explained during the ‘Real Investment Hour‘ on Thursday, it is never advisable to “panic sell” when a break of support occurs. This is because that by the time you have an extended period of selling, the markets tend to be oversold enough for a short-term reflexive bounce to rebalance portfolio risk at better levels. 

The chart below is a daily chart showing the market currently bouncing off support at the 200-dma combined with a 3-standard deviation move from that short-term moving average. This all suggests a reflexive bounce from oversold conditions is extremely likely.”

That bounce came on Monday traders frantically covered bearish bets launching asset prices higher. However, while the bounce was certainly a welcome relief after a long stretch of selling, we are now struggling with multiple levels of previous resistance.

As noted on the chart above, there is a confluence of events currently occurring that suggests further downside risk following the reflexive bounce illustrated by the blue dashed line.

• The downtrend resistance from the previous highs is colliding with the previous support level which now acts as important resistance.
• The 50-dma is also trending downward adding further resistance to price advances in the near-term. 
• An important “sell signal” has been registered at fairly high levels and current remains intact.

However, if we step back to a longer-term (weekly) picture we get further evidence of the potential for more corrective action to come.”

Even on a weekly basis, sell signals are currently being registered which have typically suggested further deterioration in the markets to come. This supports the idea that any reflexive bounces, particularly following the election this week, should be used to rebalance portfolio risk accordingly.

If we zoom in on a daily chart we can get a better view of the “traffic” that lies ahead. This confluence of resistance will require a substantial push in the markets to clear. However, a move above the current downtrend resistance should allow for a push back to 2175.

“It is important, as an investor, is not to ‘panic’ and make emotionally driven decisions in the short-term. All that has happened currently is a ‘warning’ you should start paying attention to your investments.

Just be cautious for the moment.”

As I recommended this past weekend, use this rally to take some actions in portfolios to reduce risk and clean up allocation models.

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

As voters go to the polls today to finally put one of the most contentious presidential elections out of its misery, the question is now what happens next?

Markets & Seasonal Tendencies

The technical deterioration of the markets, combined with weakening economic and earnings data, suggest the markets are likely to struggle in the months ahead. However, there is a reasonable expectation that following a weak summer performance, that there could be better performance as we enter the historically stronger period of the investment year.

As StockTraders Almanac penned:

“The ‘Best Six Months’ switching strategy found in our annual Stock Trader’s Almanac which is basically the flip side of the old “sell in May and Go Away” adage. After decades of historical research, we discovered that most market gains occur during the months November through April. Investing in the Dow Jones Industrial Average between November 1st and April 30th each year and then switching into fixed income for the other six months has produced reliable returns with reduced risk since 1950.

The “Best Months” Switching Strategy will not make you an instant millionaire as other strategies claim they can do. What it will do is steadily build wealth over time with half the risk (or less) of a “buy and hold” approach.”

As noted above, there is a statistical probability that the markets will potentially try and trade higher over the next couple of months particularly as portfolio managers try and make up lost ground from the summer.

However, it is important to note that not ALL seasonally strong periods have been positive. Therefore, while it is more probable that markets could trade higher in the few months ahead, there is also a not-so-insignificant possibility of a continued correction phase.

Furthermore, the probability of a continued correction is increased by factors not normally found in more “bullishly biased” markets:

1. Weakness in revenue and profit margins
2. Deteriorating economic data
3. Deflationary pressures
4. Increased bearish sentiment
5. Declining levels of margin debt
6. Contraction in P/E’s (5-year CAPE)

How To Play It

With the markets currently in extreme short-term oversold territory and encountering a significant amount of overhead resistance, it is likely the current reflexive rally that began on Monday could have further to go. However, with overhead resistance fairly strong, and given the ongoing number of weekly “sell signals,” it is currently advised to remain more cautious until a more bullish “trend” reasserts itself.

For individuals with a short-term investment focus, pullbacks in the market can be used to selectively add exposure for trading opportunities. However, such opportunities should be done with a very strict buy/sell discipline just in case things go wrong.

For longer-term investors, and particularly those with a relatively short window to retirement, the downside risk far outweighs the potential upside in the market currently. Therefore, using the seasonally strong period to reduce portfolio risk and adjust underlying allocations makes more sense currently. When a more constructive backdrop emerges, portfolio risk can be increased to garner actual returns rather than using the ensuing rally to make up previous losses. 

I know, the “buy and hold” crowd just had a cardiac arrest.

However, it is important to note that you can indeed “opt” to reduce risk in portfolios during times of uncertainty. As my colleague Jesse Felder pointed noted:

“It was nearly a year ago that I looked back at times when stocks became ‘extremely overvalued’ and then the trend turned down. In every case, it paid very handsomely for investors to implement a system that either shifted to cash (and avoided major drawdowns) or actually got short the major indexes (to profit from major drawdowns).”

The point is that an extremely overvalued and over-bullish stock market that shifts from uptrend to downtrend is the sort of rare environment that has led to the largest declines in history. For this reason, it presents investors with the most dangerous of all possible environments.”

For More Read: “You Can’t Time The Market?”

This is not a market that should be trifled with or ignored. With the current market and economic cycles already very long by historical norms, the deteriorating backdrop is no longer as supportive as it has been.

“Benchmarking” your portfolio remains a bad choice for most investors with a visible time frame to retirement. While it is true that over VERY long periods of time, “benchmarking” your portfolio will indeed lead to gains. The problem is that most individuals do not have 116 years to garner 8% annualized rates of return.

The index is a mythical creature, like the Unicorn, and chasing it takes your focus off of what is most important – your money and your specific goals. Investing is not a competition and, as history shows, there are horrid consequences for treating it as such.

Incorporating some method of managing the inherent risk of investing over the full-market cycle is crucially important to conserving principal and creating longer-term risk-adjusted returns. While you will probably not beat the index from one year to the next, you are likely to arrive at your financial destination on time and intact. But isn’t that really why you invested in the first place?

“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 laid out a case for being a bit more “cautious” as the technical action has deteriorated as recession risks have risen.

“More importantly, despite the ongoing defense of support at current levels, the deterioration in momentum and price action has now triggered intermediate and longer-term “sell signals” as shown below.”

“Importantly, notice that both of the previous bullish trend lines (depending on how you measure them) have now been violated. Previously, when both “sell signals” have been triggered, particularly with the market overbought as it is now, the subsequent decline has been rather sharp.”

“Lastly, as stated above, the 50-dma moving average has begun to trend lower, the downtrend resistance from the previous market highs remains present and the “sell signal” occurring at high levels suggests the risk of a further correction has not currently been eliminated.

It is important, as an investor, is not to ‘panic’ and make emotionally driven decisions in the short-term. All that has happened currently is a ‘warning’ you should start paying attention to your investments.

Just be cautious for the moment.”

With earnings season now in full swing, and coming in a bit weaker than expected, volatility at extremely low levels, and the final push to one of the most contentious elections in the history of the country, the question to now ask is “what happens next?”

NOVEMBER STATS & POST-ELECTION HISTORY

As the U.S. Presidential election draws near, it is worth considering how the market has historically performed during the month of November and specifically during election years.

First, if we look at the month of November going back to 1960, we find that there is a bias for the month to end positively 61% of the time. In other words, 3 out of every 5 months finished in positive territory which is why it is included in the seasonally strong period of the entire year. Furthermore, the average and median returns for the month top 1% over the course of that time.

However, when we look at just the November months which coincided with people going to the polls to cast their vote, we find an even split of wins and losses. Even though the number of months are evenly split between gains and losses, the average and median returns were still positive over the given time frame.

Unfortunately, average and median returns aren’t representative of the capital destruction that have taken place historically such as the massive draw drown during the 2008 election. The chart below shows the history of actual market returns by day for every month of November going back to 1960. Importantly, in order for the market to have an average return of 1.01%, it means there has been a variability of returns both above and below that average.

A look at daily price movements during the month, on average, reveal the 5th through the 8^th trading days of the month are the weakest followed by mid-month.

However, during election years, we see the same periods remaining weak, but more dramatically so as the volatility of election years skews the average of all years. In other words, regardless of who is elected on the 8th, look for a relief rally on the 9th, followed by a sell-off over the next few days. The traditional post-Thanksgiving rally tends to be stronger performance wise as the “inmates run the asylum” during exceptionally light volume trading days.

Jason Goepfert via Sentimentrader.com did some similar analysis as well recently but took it down to the sector specific level which is helpful in determining what sectors to over/underweight heading into the end of the year.

“We show the same data for each of the 10 major S&P 500 sectors on the next page (REITs aren’t yet included). Again, it’s hard to discern any actionable pattern among the sectors. There was some general weakness in tech ahead of the election, but the group had strong returns in the weeks following, excepting a few large outliers. Financials also did well after the elections, and the returns were more tightly grouped on the upside. Consumer discretionary stocks were the most consistent laggards.”

What If I Am Wrong?

I have repeatedly discussed over the last month the danger of the market correcting to the downside in the near term. With risk/reward dynamics still out of favor, there is little reason to currently be aggressively long equities until the investment environment improves.

I understand the risk of advocating a more conservative posture heading into the “seasonally strong” period of the investment calendar, however, there are many signs suggesting caution.  the levels of funds invested “bearishly” is at levels associated with reversals volatility coinciding with market declines.

While the seasonal tendencies suggest an increase in equity exposure, the underlying technical dynamics warn of an increased risk to investment capital. The protection of which is paramount to long-term investment success.

In yesterday’s post on the problem with “Buy and Hold” investing. The crux of the article is that spending a bulk of your time making up lost gains is hardly a way to build wealth longer-term. More importantly, is the consideration of “time” in that equation. Unless you discovered the secret of immortality, “long-term” is simply the amount of time between today and the day you will need your funds for retirement.

Of course, such articles always derive a good bit of push back suggesting that individuals cannot effectively manage their own money, therefore, indexing is their only choice. I simply disagree.

Yes, managing risk in a portfolio will create underperformance over short-term periods BUT much less than being overly exposed to equities during a period of decline.

Let’s assume that I am wrong in my current downside risk assessment and the markets reverse course and begins to rise strongly. The market will have to effectively hit all-time highs at this point to reverse the bearish trends that are currently in place.

However, if the market does re-establish the previous bullish trend, I will certainly recommend strongly increasing allocations to equity-related risk. Any differential in performance which currently exists, will be quickly absorbed.

But what if I am right?

If I am right, the preservation of capital will be far more beneficial. As I have stated previously, participating in the bull market over the last seven years is only one-half of the job. The other half is keeping those gains during the second half of the full market cycle.

If the market breaks support, the subsequent decline will quickly wipe out what few gains currently exist. The probability of that happening in the months ahead is still very high. The purpose of risk management is to protect investment capital from erosion which has two very negative consequences.

First, when investment capital is destroyed, there is less capital to reinvest for future gains. The second, is the destruction of compounded returns. Small losses in principal can quickly erode years of gains in wealth.

Raising cash and protecting the gains you have accrued in recent years really should not be a tough decision. Not doing so should make you question your own discipline and whether “greed” is overriding your investment logic.

While the financial press is full of hope, optimism, and advice that staying fully invested is the only way to win the long-term investing game; the reality is that most won’t live long enough to see that play out.

You can do, and deserve, better.

“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.

Yesterday, the markets opened higher but drifted lower into the afternoon as the support behind the markets as of late have continued to remain weak.

As shown in the chart below, the markets remain trapped between the downward price trend from the summer highs and the rising bottoms from the September sell-off. Importantly, the market has maintained support at the all-important breakout level of 2125, for now. This keeps the bull market intact momentarily, but the resolution of the current consolidation will be important as to where the market goes next. 

Importantly, the market has registered a confirmed weekly sell signal as shown in the bottom part of the chart. Considering this signal is being registered at fairly high levels, this suggests there is a potential for a rather deep correction at some point. However, as shown above, this process can take some months to play out.

However, in the longer-term, it is only fundamentals that matter. What is happening between the economic and earnings data is all you really need to know if you are truly a long-term investor.

Unfortunately, you aren’t.

I say that because I would be willing to bet before you even read this article you have already checked on your investments at least once today, looked at the market, and have fretted over some investment you have. True long-term investors don’t do that.

The emotional biases of being either bullish or bearish, primarily driven by the media, keep you from truly focusing on long-term outcomes. You either worry about the next downturn or are concerned you are missing the rally. Therefore, you wind up making short-term decisions which negate your long-term views.

Understanding this is the case, let’s take a look at the technical case for the markets from both a bullish and bearish perspective. From there you can decide what you do next.

THE BULL CASE

1) The Fed Won’t Let The Markets Crash

This is the primary support of the bullish case, and frankly, one that is difficult to argue with. Despite all of the hand-wringing over valuations, economics or fundamental underpinnings, stocks have been, and continue to be, elevated due either to “direct” or “verbal” accommodation.

I discussed this idea in “The Illusion oF Permanent Liquidity:”

“But what ongoing liquidity interventions have accomplished, besides driving asset prices higher, is instilling a belief there is little risk in the markets as low interest rates will continue or only be gradually tightened.”

However, “verbal accommodations” have also been extremely supportive since the end of QE-3 in keeping asset prices elevated.

“Bad news is good news” has been the “siren’s song” for the bulls since the end of direct interventions as “low rates for longer” means the “chase for yield” continues.

2) Stocks Have Made Successful Retest Support

As I discussed in this weekend’s newsletter, support held at the levels where the markets previously broke out to all-time highs.

“The two dashed red lines show the tightening consolidation pattern more clearly.

Currently, the market has been able to defend crucial support at the level where the markets broke out to new highs earlier this year. However, the market now finds itself “trapped” between that very crucial support and a now declining 50-dma along with the previous bull trend support line.  

Importantly, the “sell signal,” which is shown in the lower part of the first chart above, suggests that pressure remains to the downside currently.

However, there is a concerted effort currently to keep prices elevated over the last week. Following the bounce off of the critical 2125 level this past week, the market has consistently fought off weak openings and have rallied back into the close. This is shown in the chart below.”

“The red circles denote when the market had reached extreme overbought levels during the trading day which typically denoted the limit of the upside advance for the day.

The broader point to be made here is that while the market is defending its current support level at 2125, the question is whether the market can muster the momentum to reconstitute the bullish trend into the end of the year. “

Despite weakness in momentum and trends currently, the market has continuously maintained support at 2125. The battle between “bulls” and “bears” is being waged at that level. 

3) Advance-Decline Line Is Improving

The participation by stocks in the recent bullish advance has been strong enough to push the advance-decline line well above the 34-week moving average.

However, it should be noted that such extreme deviations from the long-term moving average do not historically last long. But, the rise in participation supports the bullish momentum behind stocks currently and should not be dismissed.

Currently, as shown above, the short-term dynamics of the market remain bullishly biased. This suggests equity exposure in portfolios remains warranted for the time being. However, let me be VERY CLEAR – this is VERY SHORT-TERM analysis. From a TRADING perspective, this remains a bull market at the current time. This DOES NOT mean the markets are about to begin the next great secular bull market. Caution is highly advised if you are the type of person who doesn’t pay close attention to your portfolio or have an inherent disposition to “hoping things will get back to even” if things go wrong rather than selling.

THE BEAR CASE

The bear case is more grounded in longer-term price dynamics – weekly and monthly versus daily which suggests the current rally remains a reflexive rally within the confines of a more bearish backdrop.

1) Short-Term: Market Momentum Declining, Fails At Resistance

The market rally from the “Brexit” lows was quite impressive as Central Banks globally came to the rescue to offset the risks of the British vote. However, since then, the markets have gone quiet.

The ongoing attempts of the market to rally have consistently failed at the downtrend from the post-Brexit highs. In order for the market to reverse the “bearish” context a breakout above that downtrend resistance will need to occur.

2) Longer-Term Dynamics Still Bearish

If we step back and look at the market from a longer-term perspective, where true price trends are revealed, we see a very different picture emerge. As shown below, the current dynamics of the market are extremely similar to every previous bull market peak in history. Given the deterioration in revenues, bottom-line earnings, and weak economics, the backdrop between today and the end of previous bull markets remains consistent. 

3) Technical Topping Process Still In Play

As shown below, the market continues what appears to be a more distinct topping process with bearish implications. This expanding, or “megaphone,” pattern combined with longer term “sell signals” suggests a corrective action is underway. I have mapped out the possible retracement levels using a Fibonacci sequence.

If the market is able to sustain current levels, work off the longer-term over conditions and realign prices with underlying fundamentals, the resumption of the bull market is entirely feasible. It just hasn’t ever occurred previously without a rather severe corrective process first.

What you decide to do with this information is entirely up to you. As I stated, I do think there is enough of a bullish case remaining to warrant some equity risk on a very short-term basis. 

However, the longer-term dynamics are clearly bearish. When those negative price dynamics are combined with the fundamental and economic backdrop, the “risk” of having excessive exposure to the markets greatly outweighs the potential “reward. “

Could the markets rocket up to 2200, 2300 or 2400 as some analysts currently expect? It is quite possible given the ongoing interventions by global Central Banks.

The reality, of course, is that while the markets could reward you with 250 points of upside, there is a risk of 600 points of downside just to retest the previous breakout of 2007 highs

Those are odds that Las Vegas would just love to give you. 

“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 Tuesday, I noted that a market decision was coming soon. It came sooner than I anticipated with a sell-off that broke the bullish trend line from the February lows. To wit:

“A major decision point is rapidly approaching which will decide the fate of the market for the rest of the year.”

In the daily price chart below, the break of that bullish trend line is clearly evident.

“Notice in the bottom part of the chart the market currently remains on a sell signal. That sell signal is problematic for two reasons:

1) ‘Sell signals’ combined with overbought conditions tend to lead to at least short-term corrections.

2) ‘Sell signals’ formed at very high levels, such as currently, suggests limited upside and larger correction probabilities.” 

Let’s zoom in on the recent price action in the chart above. The chart below is the last 3-months of daily price movement. As you will see, while prices have been quite volatile, there has been virtually no progress in the market during the period.

The most critical aspect of the breakdown currently is the very critical support line that is running at 2125 currently. That support line is, as shown in the next chart below, is the breakout of the market from the May 2015 closing highs. 

Again, you will notice in the bottom part of the chart, a “sell signal” has been triggered from very high levels. This signal alone suggests the market will have trouble making a significant advance from current levels until this condition is resolved. 

Also notice, in the top part of the chart, the market is oversold on a weekly basis currently. However, when that oversold condition existed in conjunction with a “sell signal” previously, there was further downside left in the corrective process. 

With that being said, it is critical for the markets to “hang on” to current support at the previous breakout highs. A failure to do so will put the markets back into the previous trading range that has existed going back to 2014.

From a trading perspective, caution remains elevated and portfolios are underweight equities at this point until the current situation is resolved. Obviously, the biggest threat to investors currently remains to the downside if earnings fail to gain traction particularly due to the stronger dollar backdrop as noted in this past weekend’s missive.

Quick Notes On Oil & Rates

Over the last few weeks, I have touched on the rise in both oil prices and interest rates. Both have now reached the extreme upper limits of their potential intermediate term moves, so it is worth updating that analysis.

Oil prices recently broke above $50/bbl on a “discussion” by OPEC officials to potentially, maybe, possibly, talk about an agreement to cap oil production in November. Maybe. Possibly. 

As I stated initially, the likelihood of such an agreement is slim at best. The reality is there is “no incentive” for these countries to reduce or cap production at a time when revenues are reduced and countries like Saudi Arabia are running a deficit. But what OPEC has figured out is they can raise oil prices with “verbal easing” just like Central Banks have done for asset prices. 

From one OPEC meeting to the next, oil prices have been lifted on promises of production cuts or caps, yet none have actually taken place. In fact, production from OPEC just reached an all-time record in September. 

“OPEC increased output by 160,000 barrels a day to a record 33.64 million barrels a day in September, the IEA said, a rather stark departure from last month’s Algiers agreement where most OPEC members agreed to bring output down to a maximum of 33 million barrels a day.”

The increased production shows, among other things, not only just how farcical the recent oil surge has been on the back of expectations that somehow OPEC will actually not only agree on lower production quotas and more importantly comply with them.

But nonetheless, when looking at the Commitment of Traders report, we find oil longs back near record highs. In fact, as shown below, the last time net longs were this committed to the price of oil was at the peak in 2014.

Furthermore, back to our market commentary, the history of extremely long crude oil contracts and its underlying correlation to the market suggests problems. If oil prices begin to correct, due to a strengthening dollar or further increases in supply, the downside pressure on the markets will increase. 

Lastly, despite hopes of a production cap, what is really needed is a massive cut in production to reconcile the largest supply-demand imbalance since the early 1980’s. With global economies weak, more fuel efficient homes, cars and transportation combined with a shift to alternative forms of energy, the re-balancing of supply to demand could take much longer than currently anticipated.

As shown in the first chart above, with oil prices as overbought now as at the last major peak the downside risk to both the commodity and underlying asset prices has risen. The question is whether OPEC can continue to indefinitely pull a “Yellen” out of their hat to “jawbone” prices higher while simultaneously maintaining higher production levels?

I guess we will see.

Similarly, interest rates, have also reached a major intermediate-term peak in price movements. With interest rates extremely overbought, the reflexive bounce in rates following the flight to “safety” for the “Brexit” is now functionally complete. This rise in rates is both a blessing and a curse.

For investors, the rise in rates has suppressed bond prices now providing an opportunity increase bond holdings in portfolios. While rates could rise as high as 2%, the reward in bonds now heavily outweighs the risk. There is much angst over the potential rise in interest rates, however, outside of an oversold bounce due to the volatility of the markets, the long-term trend in rates remains lower due to economic growth. As shown in the chart below, there is absolutely NO evidence of economic strength that would suggest a level of sustained higher borrowing costs. 

As I have stated previously, interest rates are a function of acceptable borrowing costs in the economy. As economic growth rises, business and individuals can sustain higher borrowing costs as long as revenue and wages are on the rise. However, when rates rise without the ability to absorb higher costs, the negative impact to economic growth comes much quicker.

For the Fed, the biggest problem is the recent rise in interest rates is  front running their efforts to lift overnight lending rates. With economic data already weak, the dollar stronger and default risk on the rise, higher rates will slow further economic growth. The Fed may well find itself once again stuck on the sidelines in December unable to raise rates once again due to “economic uncertainty.”

“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.

Portfolio Changes

As discussed previously, I added a small trading position of equal weight S&P 500 to the core portfolio strategy in portfolios. To wit:

“However, as stated above, I did add a small trading position to the portfolios of an equal weight S&P 500 index ETF. I am maintaining a very tight stop at the current running bullish trend line, as shown below. I am not highly confident in the addition of the position at the current time, but the market has continued to consistently hold the bullish trend line. Again, this is a trading position and NOT a long-term hold at this point.”

I have not yet been stopped out of that position and are currently holding a very small gain.

Yesterday, I added a small position in Gold to portfolios as well. This is a commodity/dollar trade with a decent risk/reward setup. It is not a commentary on the coming collapse of the economy as we know it. Well, at least not yet, that may come later.

The chart below shows the inverse correlation between the U.S. Dollar and Gold. I wrote several weeks ago the dollar would be getting stronger as it was in an uptrend as higher rates in the U.S. attracted foreign flows in the dollar. This is a longer term view that will continue to develop, but as shown in the chart below the dollar is currently very overbought with gold correspondingly very oversold.

As shown, with the dollar now two standard deviations above its 50-dma, and gold more than two standard deviations below, a trade in gold now seems reasonable. With a stop currently at $1240 an ounce and a target of $1320, a 3:1 reward/risk ratio is acceptable.

This is also an important point. Whenever a position is added to a portfolio it should NEVER be initially viewed as a long-term hold. As with gold, every position should have a stop loss and a target sell price BEFORE the position is purchased. If a trading position grows into a long-term hold due to performance, then all the better. However, too many losing positions, which should have been cut short, become long-term holds in the “hope” they will come back. If you aren’t careful, a portfolio can become predominately stocks you are hoping will come back rather than growing your portfolio towards your investment goals.
 

Market Decision Nears

In this past weekend’s missive I noted:

“The market currently remains above the running bullish trend line which has been the rally point for Central Banks to intervene with either actual monetary interventions or promises to do more. Despite concerns of global disruption due to the ‘Brexit,’ or the next potential bank failure with Deutsche Bank, nothing has been able to shake the markets as investor complacency remains elevated.

As shown below, the current price action continues to consolidate in a very tight range which will resolve itself in very short order. A breakout to the upside will clear the markets for a further advance. However, while the technicals suggest a move to 2400, it is quite possible it could be much less. Notice in the bottom section of the chart below.Turning the current ‘sell signal’ back into a ‘buy signal’ at such a high level does not give the markets a tremendous amount of runway.”

“For now, however, the markets remain stuck.”

However, a major decision point is rapidly approaching which will decide the fate of the market for the rest of the year. 

In the daily price chart below the tightening consolidation of the market is evident.

Notice in the bottom part of the chart the market currently remains on a sell signal. That sell signal is problematic for two reasons:

1) “Sell signals” combined with overbought conditions tend to lead to at least short-term corrections.

2) “Sell signals formed at very high levels, such as currently, suggests limited upside and larger correction probabilities. 

Let’s zoom in on the recent price action in the chart above. The chart below is the last 3-months of daily price movement. As you will see, while prices have been quite volatile, there has been virtually no progress in the market during the period.

The two dashed lines so the tightening consolidation pattern more clearly. With the pattern becoming much more compressed it is quite likely a breakout is going to occur within the next few days. The direction of that breakout will be most important.

As I wrote last Tuesday, a breakout to the upside would likely see a push of the markets towards the targeted level of 2400. However, such a move would also require a real improvement in economic growth and earnings to remain supportive of those valuations. Otherwise, the move will likely be very short lived.

“A move to 2400 would once again stretch the limits of deviation from the long-term trend line likely leading to a rather nasty reversion shortly thereafter.”

Conversely, a break to the downside would likely signal a deeper correction in the works which would be consistent with failed expectations of stronger earnings and economic growth, a strong dollar, weaker commodity prices and lower interest rates. These retracement levels are shown below.

I have not only denoted the standard Fibonacci retracement levels, but also the depth of the correction associated with each. Importantly, from current levels, the deepest currently expected correction in the short-term would only be 9.1%. While this doesn’t even register on the scale of a “significant” correction, given the length of time without a 10%-plus correction it will likely “feel” far worse than it actually is.

Importantly, a breakdown in the markets from current levels have two negative short-term consequences:

1. The market will provide a negative return year to investors which, for those depending on compounding returns at 6% annually, set back retirement goals.
2. The “breakout” to new market highs will be nullified as the market returns back into its trading range that began in May of last year.

However, on a longer-term basis, the breakdown would also violate very important bullish trend lines which would denote a significant change in market trends. As shown in the chart below, the “megaphone” topping process, combined with weekly  long-term sell signals, still remains. A downside correction that breaks the bullish trend line from the 2009 lows would suggest a broader reversion in the works. 

Once again applying a standard Fibonacci retracement to the current cyclical bull market, we find the next “bear market” could range from between 26.1% to 42.7%. Given the current extension of valuations, debt and leverage levels, and weak sales growth, a recessionary correction between 34.4% and 42.7% would not be extraordinary. 

As stated, a correction of this magnitude would not be unprecedented and would coincide with the onset of the next recession. But therein lies the problem.

Elena Holodny recently penned the following note from a UBS team led by strategist Julian Emanuel:

“It is worth noting that no US equity bear market of the last 25 years has begun without a recession starting within 12 months following the market top.” 

Unfortunately, that not exactly an accurate statement. As I noted previously in “Think Like A Bear, Invest Like A Bull:”

“However, the ‘lead effect’ is much more coincident in reality. This is due to the fact that recessions are only revealed in hindsight once data is revised lower. This lag effect of the data revisions in shown below.”

Which way is the market going to break?

I have no clue. And neither do you. 

However, focusing my attention to a breakout to the upside, with portfolios already exposed to equities, is of little concern. It is the risk of a break to the downside that poses the most danger. 

The current cyclical bull market is not over as of yet. Momentum driven markets are hard to kill in the latter stages particularly as exuberance builds. However, they do eventually end. That is unless the Fed has truly figured out a way to repeal economic and business cycles altogether. As we enter into the eighth year of economic expansion we are likely closer to the next contraction than not. This is particularly the case as the Federal Reserve continues to build a bigger economic void in the future by pulling forward consumption through its monetary policies.

Will the market likely be higher a decade from now? A case can certainly be made in that regard. However, if interest rates or inflation rises sharply, the economy moves through a normal recessionary cycle, or if Jack Bogle is right – then things could be much more disappointing. As Seth Klarman from Baupost Capital once stated:

“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

We saw much of the same mainstream analysis at the peak of the markets in 1999 and 2007. New valuation metrics, IPO’s of negligible companies, valuation dismissals as “this time was different,” and a building exuberance were all common themes. Unfortunately, the outcomes were always the same. 

“History repeats itself all the time on Wall Street” – Edwin Lefevre

“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 yesterday’s post on the tools companies use to “manipulate” earnings, I referenced a tweet I received discussing the markets next move to 2400.

“Of course, the issue ultimately comes down to valuations. At a price of 2400, based on current earnings per share of $86.92, the market would be trading at the second highest level of valuations in history with a P/E of 27.61.

@LanceRoberts @JLyonsFundMgmt what about 129-133$ forward earnings est?

— Paolo Riccelli (@paolo_riccelli) October 2, 2016

Let’s assume for a moment the $133 EPS estimate was accurate. This would put the forward P/E ratio at just 18x earnings – still well above the long-term historical average P/E of 15.

However, in Paolo’s attempt to justify the bullish meme, the forward earnings estimate is no longer $133/share but, according to S&P, just $122.15 through the end of 2017. IF we assume those estimates are correct, now the forward P/E rises to 19.64x earnings. Certainly not cheap.“

While yesterday’s post was based primarily on the current fundamental underpinnings of the market, which Central Bank interventions have led investors to completely ignore, I wanted to examine this idea of a “2400 moonshot” from a technical perspective as well.

However, before we get to projections, let’s update our current position given the market action yesterday.

Market Review & Update

On Saturday, I discussed the addition of a trading position to portfolios given the ongoing defense of the upward trending bullish trend line.

“The GOOD news is the market has continued to hold support along the bullish trend line which goes back to the February lows. This continued defense of bullish support has been consistent enough to allow us to add a small trading position of an equal weight S&P 500 index ETF to portfolios. Importantly, this is a trading position only currently with a stop set at the bullish trend line support. 

The BAD news continues to outweigh the good, unfortunately. As shown in the chart above, the market was unable to close above the 50-dma keeping that level of resistance intact. Furthermore, the intra-day rally failed at both the average of the previous trading range and the downtrend resistance line from the August highs.”

In other words, I will NOT be surprised to be stopped out of the recent addition of a trading position to portfolios. That is part of portfolio management. However, the bullish trend line remains intact and a break above the “price wedge” would suggest a sharper move higher. This makes the addition of a trading position viable with a very close stop at the current trend line.

But therein lies the question of the day. If the market is able to break above the current resistance levels, the technical trends suggest a move to 2400 is indeed viable. However, while is not discussed by the mainstream media, because it would be considered “bearish,” is a break to the downside could be equally as painful.

But for today, let’s analyze the potential for an upside breakout.

2400 Or Bust

The current belief is that over the next couple of quarters the earnings and economic backdrop will begin to improve providing the catalyst for an upside move in the markets. It is also the becoming a realization that interest rates aren’t going to rise anytime soon, something I have been saying for the last two years. Therefore, “accommodative policy” remains supportive of higher prices for now.

However, it should be noted that despite the monetary backdrop supporting the idea of higher prices in the short-term, longer-term “sell signals” only witnessed during major market topping processes currently remain as shown below.

There has never been an era previously where global Central Banks have stood at the ready to rush to aid to support asset prices at even the slightest hint of a “correction.” It is a logical conclusion that at some point there will be a dislocation which even Central Bank interventions will not be able to cure. It would likely be wise not to be present when that occurs. 

But that is a story for another day.

For now, Central Bankers “rule the world” and their word alone has been enough to push markets higher despite repeated failed forecasts of stronger economic growth. But it is this repeated failure that keeps the “bulls” alive, as each failure by Central Banks to achieve their monetary policy goals simply means leaving accommodative monetary policy in place. Of course, no one has asked the question what happens when they actually do succeed in raising rates?

The market currently remains above the running bullish trend line which has been the rally point for Central Banks to intervene with either actual monetary interventions or promises to do more. Despite concerns of global disruption due to the “Brexit,” or the next potential bank failure with Deutsche Bank, nothing has been able to shake the markets as investor complacency remains elevated.

As shown below, the current price action continues to consolidate in a very tight range which will resolve itself in very short order. A breakout to the upside will clear the markets for a further advance. However, while the technicals suggest a move to 2400, it is quite possible it could be much less. Notice in the bottom section of the chart below. Turning the current “sell signal” back into a “buy signal” at such a high level does not give the markets a tremendous amount of runway.

There is also the issue of deviations above the long-term trend line. Trend lines and moving averages are like “gravity.”  Prices can only deviate so far from their underlying trends before eventually “reverting to the mean.” However, as we saw in 2013-14, given enough liquidity prices can remain deviated far longer than would normally be expected.  (I have extrapolated move to 2400 using weekly price data from the S&P 500.)

A move to 2400 would once again stretch the limits of deviation from the long-term trend line likely leading to a rather nasty reversion shortly thereafter.

We can see the deviation a little more clearly in the analysis below. Once again, the data in the orange box is an extrapolated price advance using historical market data. The dashed black line is the 6-month moving average (because #BlackLinesMatter) and the bar chart is the deviation of the markets from price average.

Historically speaking deviations of such an extreme rarely last long. As discussed above, while it is conceivable that a breakout of the current consolidation pattern could lead to a sharp price advance, it would likely be the last stage of the bull market advance before the next sizable correction. 

So, how big of a correction would we be talking about? The chart below, once again extrapolated to 2400, shows the mathematical retracement levels based on the Fibonacci sequence. The most likely correction would be back to 2000-ish which would officially enter “bear market” territory of 23.6%. However, most corrections, historically speaking, generally approach the 38.2% correction level. Such a correction would be consistent with a normal recessionary decline and bear market. 

Of course, given the length and duration of the current bull-market with extremely weak fundamental underpinnings, leverage, and over-valuations, a 50% correction back towards the 1300 level is certainly NOT out of the question.  Let’s not even discuss what would happen if go beyond that, but suffice it to say it wouldn’t be good.

One-Way Trip

The reality is that a breakout and advance to 2400 is actually quite possible given the confluence of Central Bank actions, increased leverage and the embedded belief “There Is No Alternative (TINA).”  It would be quite naive to suggest otherwise.

Given 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. However, being right or wrong has a very big effect on you.

Yes, a move to 2400 is viable, but there must be a sharp improvement in the underlying fundamental and economic backdrop. Right now, there is little evidence of that in the making. Either that, or a return to some form of QE by the Fed which would be a likely accommodation to offset a recessionary pull. In either case, it will likely be a one-way trip and it should be realized that such a move would be consistent with the final stages of a market melt-up.

Of course, as Wile E. Coyote always discovers as he careens off the edge of the cliff, “gravity is a bitch.”

“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 markets walk along a bullish trend line:

“With the Fed holding still on hiking rates, with a promise to now hike in December (**cough****bullshit****cough), traders came rushing back into the market pushing prices right back into the trading range of the last month.

Consequently, the volatility index was also smashed back to its recent lows as “fear” has been completed eliminated for now.

Basically, if you strip out the past week of volatility, nothing really changed.”

The problem is that while nothing really changed in the past week, it also means that we are STILL not “out of the woods” yet to allow the bulls to claim victory.

Let’s review some charts.

The first chart below is a weekly chart of the S&P 500.  This is the good news.

Despite a rather volatile last couple of weeks, the market maintained support at the intermediate term moving average and remained above the bullish trend line from the February lows. Importantly, the pullback and subsequent rally confirmed the bullish breakout above the previous highs from last year.

The bad news is the market is dangerously close to issuing an intermediate term sell-signal. This does not mean the markets are about to have a major crash, but historically, these signals have generally coincided with  at least short-term market peaks. 

If we move to a shorter-term analysis of the market using daily data, a little different picture emerges. As shown below the bullish trend AND the retest of previous “breakout levels” remain as above.

However, due to the shorter-term nature of the price movements, sell signals have occurred more frequently in this analysis. Currently, the market continues to struggle under an “active sell signal” and the bullish trend support is not far below. If the market fails support of that trend-line expect a bigger correction to ensue.

Combined with current overbought conditions that still need to be resolved, the investment risk remains to the downside currently. This is also confirmed by the next chart below.

The markets remain confined within what currently appears to be a broadening topping pattern, or megaphone, which historically suggest a much bigger correction may be in the works. As with the chart above, the overbought condition of the market, combined with active sell signals, suggests the environment for more aggressive equity exposure is not currently present.

For now, we wait until the market resolves this current process by either breaking out to new highs confirming the bullish trend – OR – breaking the bullish trend line and beginning a larger correction process. Guessing at what happens next tends to not work out well for investors historically.

If we step back from the short-term price action for a moment, the economic data continues to suggest the “profits recovery” story in the second half of the year may be disappointing.

The Most Important Economic Number

While economic numbers like GDP or the monthly non-farm payroll report typically garner the headlines, one of the most useful economic measures is the Chicago Fed National Activity Index (CFNAI). The index is a composite index made up of 85 subcomponents which gives a broad overview of overall economic activity in the U.S. Unfortunately, the media gives it little attention.

The overall index is broken down into four major sub-categories which cover:

• Production & Income
• Employment, Unemployment & Hours
• Personal Consumption & Housing
• Sales, Orders & Inventories

To get a better grasp of these four major sub-components I have constructed a 4-panel chart showing each.

There are a couple of important points to be made in reference to the chart above.

1. The production, employment, and sales components all appear to have peaked for the current economic cycle despite ongoing estimations of stronger economic growth in the last half of 2016. Of course, this has been the case every year since 2011 which has yet to manifest itself. 
2. The consumption and housing component, while it has gotten stronger, remains well below its 2000 levels.

The CFNAI, while volatile, has a very strong historical correlation to economic growth rates due to its broad makeup. I have created a second 4-panel chart below with the CFNAI subcomponents compared to the four most comparable economic reports of Industrial Production, Employment, Housing Starts and Personal Consumption Expenditures.  In order to get a comparative base to the construction of the CFNAI, I used an annual percentage change for these four components.

The CFNAI subcomponents and the underlying major economic reports do show some very high correlations. This is why, even though this indicator gets very little attention, it is very representative of the broader economy.

Currently, the CFNAI is not confirming the mainstream view of stronger “economy” headed into year-end, but rather one that may well be closer to the brink of recession. The chart below shows the diffusion index of the CFNAI index as compared to the S&P 500. Since the markets are reflective of the economy, the diffusion index shows the trend of the 85 subcomponents of the index. As shown, each time the diffusion index has reached current levels previously, the outcome for the economy and the markets was not so good.

The data continues to support the ongoing premise of weaker than anticipated economic growth despite the Central Bank’s ongoing liquidity operations. The current trend of the various economic data points on a broad scale is not showing indications of stronger economic growth, but rather a continuation of a sub-par “muddle through” scenario of the last five years.

While this is not the end of the world, economically speaking, such weak levels of economic growth do not support stronger employment, higher wages or justify the markets valuations. The weaker level of economic growth will continue to weigh on corporate earnings which, like the economic data, appear to have reached their peak for this current recovery cycle.

As first stated above, the short-term outlook remains bullishly constructive for the moment as long as the market can maintain the bullish trend line from the February lows. However, on a longer-term basis, the economic and fundamental data is having a much more difficult time trying to support current price and valuation levels. As shown in the chart below of quarterly data, the market is currently at levels that have historically ALWAYS been associated with a major peak.

The economic data must take a sharp turn for the positive in the weeks ahead or prices are going to have a difficult time advancing through the end of the year. More importantly, if the CFNAI is correct, the expected hockey stick recovery of earnings into year end may come with the bitter taste of disappointment.

Do you really want to believe this time is different?

“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 markets walk along a bullish trend line:

“There is little reason to believe, at the moment, the current bull market has ended. I say this for the following reasons:

1. Central Banks are still engaged globally which continue to provide liquidity support for the markets. 
2. The Federal Reserve is unlikely to tighten monetary policy in September.
3. Overall investor sentiment is still in “greed mode.” 
4. Intermediate-term “buy” signals remain intact currently.
5. Bullish trend lines remain supportive.
6. Short-term oversold conditions have been achieved.”

The chart below shows the support the bullish trend lines from the February lows are currently providing.

However, a key difference to note is the bottom of the chart which shows a “sell signal” registered from very high levels. While this DOES NOT mean the market cannot advance from current levels, it does suggest that any advance will be very limited and likely volatile.

Importantly, the market is currently trading below its 50-day moving average which will provide some resistance to a short-term advance in the market. Given the markets remain overbought in the near term the most risk of a further correction from current levels remains elevated.

Stepping back to a longer-term view, a little different picture emerges. The chart below is a WEEKLY view of price data to smooth out the volatility of daily price action. I like weekly and monthly views from a portfolio management process as it reduces knee-jerk reactions, whipsaws, and overall turnover. 

As shown, the market is currently very overbought on a weekly basis and on a sell signal (vertical dashed black lines). Importantly, as I have noted with the yellow highlights, the last time the overbought condition coincided with a “sell signal” the markets struggled to make an advance. Of course, the end result was the “Brexit” decline that was met with a flurry of Central Bank activity to propel the markets higher. 

The difference, this time, is the liquidity spigots may not come readily to the rescue to prevent a further decline to resolve the current overbought conditions. Note previously, that similar setups led to deeper corrections. Importantly, the yellow highlights note a potential correction process over the next couple of months. Such a process would also coincide with the more important longer-term topping process as I pointed out a couple of weeks ago.

“Furthermore, on a longer-term basis, the market continues within a “broadening topping process” or a ‘megaphone’ pattern. While these patterns do not always come to fruition, the fact this one is combined with dual sell-signals, which was only registered prior to the financial crisis, does provide some cause for concern. “

If we step back to a longer-term picture we see a very similar pattern setting up which confirms the potential risk to investors. The chart below is a weekly chart going back to 1925. Previous levels of such extreme deviation from the long-term trend, combined with extreme overbought conditions, have led to less than favorable outcomes for investors.

Sure, this time could be different. However, since every previous similar condition turned out “not to be” are you willing to risk your retirement on it?

This is why, despite the mainstream media’s contention you are NOT smart enough to manage your money and should just “buy and hold,” taking some action with respect to preservation of principal is critical at this late stage of the investment cycle.

The difference between a successful long term investor and an unsuccessful one really comes down to following these very simple rules. Yes, I said simple rules, and they are – but they are the most difficult set of rules for any one individual to follow because of the simple fact that they require you to do the exact OPPOSITE of what your basic human emotions tell you do – buy stuff when it is being liquidated by everyone else and sell stuff when it is going to the moon.

The 7 Impossible Trading Rules To Follow:

So, how are you supposed to do that? There are rules. These rules are not unique or new. They are time tested and successful investor approved. Like Mom’s chicken soup for a cold – the rules are the rules. If you follow them you succeed – if you don’t, you won’t.

1) Sell Losers Short: Let Winners Run: It seems like a simple thing to do but when it comes down to it the average investor sells their winners and keeps their losers hoping they will come back to even.

2) Buy Cheap And Sell Expensive: You haggle, negotiate and shop extensively for the best deals on cars and flat screen televisions. However, you will pay any price for a stock because someone on television told you too. Insist on making investments when you are getting a “good deal” on it. If it isn’t – it isn’t, don’t try and come up with an excuse to justify overpaying for an investment. In the long run – overpaying will end in misery.

3) This Time Is Never Different: As much as our emotions and psychological makeup want to always hope and pray for the best – this time is never different than the past. History may not repeat exactly but it surely rhymes awfully well.

4) Be Patient: As with item number 2; there is never a rush to make an investment and there is NOTHING WRONG with sitting on cash until a good deal, a real bargain, comes along. Being patient is not only a virtue – it is a good way to keep yourself out of trouble.

5) Turn Off The Television: Any good investment is not dictated by day to day movements of the market which is merely nothing more than noise. If you have done your homework, made a good investment at a good price and have confirmed your analysis to correct – then the day to day market actions will have little, if any, bearing on the longer-term success of your investment. The only thing you achieve by watching the television from one minute to the next is increasing your blood pressure.

6) Risk Is Not Equal To Your Return: Taking RISK in an investment or strategy is not equivalent to how much money you will make. “Risk” only relates to the permanent loss of capital that will be incurred when you are wrong. Invest conservatively and grow your money over time with the LEAST amount of risk possible.

7) Go Against The Herd: The populous is generally right in the middle of a move up in the markets but they are seldom right at major turning points. When everyone agrees on the direction of the market due to any given set of reasons – generally something else happens. However, this also cedes to points 2) and 4) – in order to buy something cheap or sell something at the best price – you are generally buying when everyone is selling and selling when everyone else is buying.

These are the rules. They are simple but impossible to follow for most. However, if you can incorporate them you will succeed in your investment goals in the long run. You most likely WILL NOT outperform the markets on the way up but you will not lose as much on the way down.

Remember, while you can always replace a lost opportunity, and even eventually regain lost capital, you can NEVER replace time lost in “getting back to even.” 

“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 return of volatility to the market:

“While it seemed for a while that volatility had been completely eliminated from the market by an ever present Fed, I warned this was a dangerous assumption to make.

On Friday, volatility returned with a vengeance.”

(I closed out my VXX long on Monday which served its purpose of protecting declines in portfolios this past Friday.)

“Analysts, the media, and Wall Street talking heads rushed to grab every excuse available to explain the sudden sell-off on Friday from the Fed, ECB, and Japan to interest rates and the dollar. However, the reality is I have been warning about a pending correction over the last month as market extensions had reached extremes.”

Of course, discussing the potential of a market correction is almost always perceived as being “bearish” and by extension must mean that I am either out of the market completely or short the market and have “missed out” on previous advances. This is particularly the case when you have a “round trip” market advance like we did yesterday which leaves investors sitting “flat footed” and unsure about what to do next. 

This reminds me of something famed Morgan Stanley strategist Gerard Minack said once:

“The funny thing is there is a disconnect between what investors are saying and what they are doing. No one thinks all the problems the global financial crisis revealed have been healed. But when you have an equity rally like you’ve seen for the past four or five years, then everybody has had to participate to some extent.

What you’ve had are fully invested bears.”

While the mainstream media continues to misalign individuals expectations by chastising them for “not beating the market,” which is actually impossible to do, the job of a portfolio manager is to participate in the markets with a predilection toward capital preservation. It is the destruction of capital during market declines that have the greatest impact on long-term portfolio performance.

It is from that view, as a portfolio manager, the idea of “fully invested bears” defines the reality of the markets that we live with today. Despite the understanding that the markets are overly bullish, extended and valued, portfolio managers must stay invested or suffer potential “career risk” for underperformance. What the Federal Reserve’s ongoing interventions have done is push portfolio managers to chase performance despite concerns of potential capital loss. We have all become “fully invested bears” as we are all quite aware that this will end badly, but no one is willing to take the risk of being grossly underexposed to Central Bank interventions.

Therefore, as portfolio managers and investors, we must watch the markets carefully for signs that the “worm has turned” and then react accordingly. This is something I cover explicitly each week in the Real Investment Report (click here for free weekly e-delivery) but wanted to share five charts that I am watching very closely. These charts are all sending an important message, but it is only when the market begins to listen that they will truly matter. But when it happens, the message will matter, and it will matter a lot.

Valuations

One of the consistent drivers behind the bull market over the last few years has been the idea of the “Fed Put.” As long as the Federal Reserve was there to “bail out” the markets in the event that something went wrong, there was no reason not to be invested in equities. In turn, this has pushed investors to not only “chase yield,” due to artificially suppressed interest rates but to push valuations on stocks back to levels only seen prior to the turn of the century.

According to a recent note from Goldman Sachs:

“Stock valuations remain extended. The S&P 500 trades at the 84th percentile of historical valuation, while the median stock is at the 98th percentile.”

Of course, these valuation extensions are occurring against a backdrop of deteriorating economic growth. The combination of which, as shown in the chart above, has not worked out well for investors in the past.

Junk Bonds

With the Fed standing behind the markets at every turn, and with interest rates plumbing historic lows, investors were emboldened to “chase yield” in the credit markets. While the financial product marketers (pronounced Wall Street) delivered a smorgasbord of “high yield” investments for consumption, many retail investors had very little clue that “high yield” actually meant “junk bonds.”

With little concern for the additional risk being plowed into portfolios in expectation of greater return, the yields on “junk credits” were pushed to historic lows. However, those yields have begun to rise as of late and historically this has been a sign that the “love affair” with excess risk may be coming to an end. As shown above, the recent deviation between junk bond yields and the S&P 500 has been a warning sign in the past that should be paid attention to.

The chart below shows the ratio between high yield credits and government treasuries. When this ratio is rising, and overbought (blue dashed lined) it has generally been near corrective peaks. 

Margin Debt

No risk in the markets? Why not double down by leveraging up? Margin debt has recently hit historic highs in the market on a variety of different measures. Importantly, rising margin debt is NOT the problem. The problem comes when the excess leverage is forced to unwind due to rapidly falling asset prices. Margin debt, like gasoline on a fire, amplifies the downturn in stocks as falling prices trigger margin calls which forces more selling. That vicious cycle is what leads to extremely rapid market declines that leave investors watching, paralyzed with fear, as their capital vanishes.

The explosion in margin debt, which has led to historically large credit balances, was seen at both previous market peaks. Could it be different this time? Sure, but if it isn’t, there is plenty of “fuel for the fire” when the next market reversion begins.

Deviation

I have written many times in the past that the financial markets are not immune to the laws of physics. What goes up, must and will eventually come down. The example I use most often is the resemblance to “stretching a rubber-band.” Stock prices are tied to their long-term trend which acts as a gravitational pull. When prices deviate too far from the long-term trend they will eventually and inevitably “revert to the mean.”

See Bob Farrell’s Rule #1

Currently, that deviation from the long-term mean is at the highest level since the previous two bull-market peaks. Does this mean that the current bull market is over? No. However, it does suggest that the “risk” to investors is currently to the downside and some caution with respect to direct market exposure should be considered.

Sentiment

Lastly, is investor sentiment. When sentiment is heavily skewed toward those willing to “buy,” prices can rise rapidly and seemingly “climb a wall of worry.” However, the problem comes when that sentiment begins to change and those willing to “buy” disappear. It is this “vacuum” of buyers that leads to rapid reductions in prices as sellers are forced to lower their price to complete a transaction. This problem becomes rapidly accelerated as “forced liquidation” due to “margin calls” occur giving what few buyers that remain almost absolute control at what price they will participate. Currently, there is a scarcity of “bears.”

See Bob Farrell’s Rule #6

With sentiment currently at very high levels, combined with low volatility and excess margin debt, all the ingredients necessary for a sharp market reversion are currently present. Am I sounding an “alarm bell” and calling for the end of the known world? Should you be buying ammo and food? Of course, not.

However, I am suggesting that remaining fully invested in the financial markets without a thorough understanding of your “risk exposure” will likely not have the desirable end result you have been promised. All of the charts above have linkages to each other, and when one goes, they will all go. So pay attention to the details.

As I stated above, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered “bearish” to point out the potential “risks” that could lead to rapid capital destruction; then I guess you can call me a “bear.” However, just make sure you understand that I am an “almost fully invested bear” for now. But that can, and will, rapidly as the indicators I follow dictate.

“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 for the holiday, there is nothing to really update from this past weekend’s “Market Review & Update.”

My friends over at the wonderful investing site “Seeking Alpha”, which should be part of your daily reading, picked up the newsletter which generated several comments. The most interesting of which was the following:

“Thanks for the good dialogue concerning the markets. I will say that most often after I read your articles, I am ready to dig the bunker deeper to the next level lower and load it with another month of food and water. Hopefully, I can muster the courage to manage coming market volatility.”

While I certainly appreciate the comment, and understand his concerns, it also highlights one of the biggest mistakes many investors make over the long-term.

You Think Like A Bear But Invest Like A Bull?

The answer to this question is what I have come to term the “Broken Clock Syndrome.” There is relatively little argument that Dr. John Hussman is probably one of the smartest individuals in Finance. His analysis of market valuations, understanding of market dynamics and long-term secular cycles is rarely disputed. His analysis, along with many others such as Crestmont Research, John Mauldin, and even Jack Bogle, has suggested that forward returns in the markets should remain low.

Even the math suggests the same as I pointed out previously.

“If we use a market cap / GDP ratio of 1.25 and an S&P 500 dividend yield of just 2%, what might we estimate for total returns over the coming decade using John Hussman’s formula?

(1.063)(0.63/1.25)^(1/10) – 1.0 + .02 = 1.3% annually.

We can confirm that math by simply measuring the forward TOTAL return of stocks over the next 10-years from each annual valuation level.”

“Forward 20-year returns get worse.”

This suggests our commenter is correct and that cash is likely to be the best investment going forward. However, the flood of liquidity by Central Banks globally continues to elevate asset prices at historic extremes. The “Broken Clock Syndrome” is where investment decisions based solely on fundamental analysis can lead to poor outcomes when other dynamics take charge.

Like Hussman, and many others, I too am a value-oriented investor and prefer to buy assets when they are fundamentally cheap based on several factors including price to sales, free cash flow yield and high return on equity. However, being a strict value investor can eventually lead to a variety of investment mistakes, which I will discuss momentarily, when markets become both highly correlated and driven by speculative excess.

Currently, there is little value available to investors in the market today as prices have been driven higher by repeated Central Bank interventions and artificially suppressed interest rates. Eventually, the markets will begin a mean reversion process of some magnitude which will suppress the value of highly inflated “value” stocks that have been driven higher by investor’s “yield chase.”

However, when that reversion process occurs is anyone’s guess.

Therefore, while the analysis suggests that portfolios should be heavily under-weighted “risk,” having done so would have led to substantial underperformance and subsequent career risk.

This is why a good portion of my investment management philosophy is focused on the control of “risk” in portfolio allocation models through the lens of relative strength and momentum analysis.

The effect of momentum is arguably one of the most pervasive forces in the financial markets. Throughout history, there are episodes where markets rise, or fall, further and faster than logic would dictate. However, this is the effect of the psychological, or behavioral, forces at work as “greed” and “fear” overtake logical analysis.

I have discussed previously the effect of “full market cycles” as shown in the chart below.

What is also important to note is that these full market cycles are ultimately driven by the economic cycle. As shown in the next chart, the sector rotation appears to lead the economic cycle.

However, the “lead effect” in reality is much more coincident in nature. This is due to the fact that recessions are only revealed in hindsight once data is revised lower. This lag effect of the data revisions in shown below.

Importantly, it should be noted that investment styles also shift during the broader cycle.

• During recessionary bottoms, when assets are truly selling at “bargain basement” prices, deep discount value strategies tend to perform the best as investors are panic selling to find safety over risk.
• As markets begin to recover investor’s begin to cautiously re-enter the markets and begin to seek some risk with a degree of safety. Value oriented investment strategies will still work during while these early recovery cycles and growth strategies began to gain momentum.
• During the latter stages of the economic cycle, growth and value give way to pure momentum as investor “greed” and “exuberance” began to view “value” as “out of favor.” 

It is during this stage of the cycle that “fundamentals appear not matter” as the fundamentally worst stocks lead the markets higher.

In other words, we begin hearing discussions of why “This Time Is Different (TTID)” and “There Is No Alternative (TINA).” 

This cycle does end, and the reversion process back to value has historically been a painful one. It as this point investor’s begin to discuss being “F***ed Up Beyond All Recognition (FUBAR)”

Understand It, But Don’t Fear It

Currently, there is little doubt that we are in both the late stages of an economic cycle and a momentum driven market. Therefore, investment focus must be adjusted to current market dynamics that requires a focus on relative strength and momentum as opposed to valuation-based strategies.

There have been many studies published that have shown that relative strength momentum strategies, in which as assets’ performance relative to its peers predicts its future relative performance, work well on both an absolute or time series basis. Historically, past returns (over the previous 12 months) have been a good predictor of future results. This is the basic application of Newton’s Law Of Inertia, that states “an object in motion tends to remain in motion unless acted upon by an unbalanced force.”

In other words, when markets begin strongly trending in one direction, that direction will continue until an “unbalanced” force stops it. Momentum strategies, which are trend following strategies by nature, have been proven to work well across extreme market environments, multiple asset classes and over historical time frames.

While there is substantial evidence that market valuations and fundamentals are not supportive of asset prices at current levels, investor psychology has likewise reached extremes. In such an environment, it is also beneficial for investors to shift focus to momentum based strategies as trend-following strategies reflect the behavioral factors such as anchoring, herding, and the disposition effect.

Let me explain.

Fundamentally based investors are slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late cycle stages.

The other inherent problem of primarily data-based investors is the “herding” effect. As prices move higher, valuation arguments lose relevance. However, the need to produce investment performance in a rising market, leads to “justifications” to explain over-valued holdings. In other words, buying begets more buying.

Lastly, as the markets turn, the “disposition” effect takes hold and winners are sold to protect gains, but losers are held in the hopes of better prices later. The end effect is not a pretty one.

By applying momentum strategies to fundamentally derived investment portfolios it allows the portfolio to remain allocated during rising markets while managing the inherent risk of behavioral dynamics.

This is why, despite the fact that I write like a “bear,” the portfolio model has remained allocated like a “bull” during the market’s advance. The point is simple, our job as investors is to make money when markets are rising and too avoid potentially catastrophic losses when trends change.

It would be simple to regurgitate the bullish media mantra’s about why markets might go higher from here. You have CNBC for that. My job is to analyze the data for what potentially might go wrong and manage the risks related to loss.

We can debate the valuation metrics and argue with each other why markets should not be rising, and eventually those arguments will be correct. However, for now markets are rising, and we need to participate until the trends change to the negative. Of course, if your current portfolio management philosophy doesn’t have a method to understand when “trends” have changed, how will you know when it is time to step away from the poker table? 

As Kenny Rogers once sang:

“If you’re gonna play the game, boy…You gotta learn to play it right.  Every gambler knows that the secret to survivin’ is knowin’ what to throw away
and knowin’ what to keep. ‘Cause every hand’s a winner. And every hand’s a loser. You’ve got to know when to hold’em and know when to fold’em.” 

“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, as the Fed wrapped up their annual Jackson Hole confab, the markets sold off following suggestions the Fed might just hike rates in September after all. On Monday, the markets rallied to recover a majority of that lost ground keeping the markets confined within the very narrow, low volatility, range that has existed for the last 35-trading days.

I discussed in this past weekend’s missive the likely range of outcomes that currently exist. (Charts updated through Monday’s close.)

“The weekly full-stochastic indicator as shown in the chart below has issued a ‘sell signal.’ Combined with the volatility index turning up from extremely low levels, it suggests a near-term potential for a continued corrective action.”

The chart above is also being confirmed by a short-term momentum “sell signal” from very high levels which has historically led to short-term pullbacks or deeper corrections.

Of course, following the “Brexit” surge as Central Banks rushed to infuse capital into the markets to offset a “crisis that didn’t occur,” the market has remained in suspended animation over the last several weeks.

With the markets, on a short-term basis, remaining in overbought territory, there is little “fuel” presently available to push the prices higher currently. Therefore, downside risk outweighs the potential for upside returns in the market currently.

What September Bringeth

BofAML wrote last week:

“History is working against the market. September is typically the weakest month of the year; since 1928, the S&P 500 has dropped in September 56% of the time.”

We can confirm BofAML’s point by looking at the analysis of each month of September going back to 1960 as shown in the chart below.

As shown, the average return for all months of September is -.70% with a median return of -.42%. More importantly, the statistics for September are universally negative. The number of losing months outweighs winning months by 31 to 25 which gives September a 55% chance of being negative historically speaking. While the “average and median” losses are less than 1%, this analysis obscures the fact that many September months registered losses of greater than 3%.

The chart below shows the daily growth of $1 invested at the beginning of September going back to 1960 with the average growth of $1 of all Septembers in red.

As Donald Trump would say: “Not so good. Not so good.”

The current consolidation of the market will end and it will likely end within the next 30-days. Given the high-levels of complacency, low volume, overbought conditions and the triggering of short-term sell signals, I would have lean towards a break to the downside. This is especially the case if the Fed does follow through with a rate-hike in September which could disrupt the markets as we saw in January of this year. 

I have laid out a series of potential correction levels. Given the current levels of bullish support for the markets, I don’t expect a deep correction prior to the election. The most likely correction process in September would be a decline back to the previous market highs or previous support at 2080. While a 3-5% correction does not seem like much, it would be enough to work off the current overbought conditions of the market allowing for a safer entry point to increase equity exposures. A “worst case” correction currently would likely be an 8.5% drawdown from the recent peaks back to major support. Of course, for most individuals, even such a small correction would likely feel far more damaging.

The bottom line is there is a real possibility of a correction developing over the next 30-days. While I don’t expect a “major market correction” to begin next month, the risk of a deeper than expected “sell off” does exist. The risk/reward ratio continues to remain negative currently. Caution remains advised.

Why Rates Are Going To Zero

I have been discussing over the last couple of weeks why the death of the bond bull market has been greatly exaggerated in recent months. To wit:

“There is an assumption that because interest rates are low, that the bond bull market has come to its inevitable conclusion. The problem with this assumption is three-fold:

1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields which push rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largesse in the future, the budget deficit is set to swell back to $1 Trillion or more in the coming years. This will require more government bond issuance to fund future expenditures which will be magnified during the next recessionary spat as tax revenue falls.
3. Central Banks will continue to be a buyer of bonds to maintain the current status quo, but will become more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion which will push the 10-year yield towards zero.”

In this past weekend’s missive “Yellen Speaks Japanese” and yesterday’s post “Debt, Deficits & Economic Warnings” I laid out the data constructs behind the points above.

With Yellen pushing the idea of more government spending, the budget deficit already expanding and economic growth running well below expectations, the demand for bonds will continue to grow. However, from a technical perspective, the trend of interest rates already suggest a rate of zero during the next economic recession.

Outside of other events such as the S&L Crisis, Asian Contagion, Long-Term Capital Management, etc. which all drove money out of stocks and into bonds pushing rates lower, recessionary environments are especially prone at suppressing rates further. Given the current low level of interest rates, the next recessionary bout in the economy will very likely see rates near zero.

Furthermore, given rates are already negative in many parts of the world, which will likely be even more negative during a global recessionary environment, zero yields will still remain more attractive to foreign investors. This will be from both a potential capital appreciation perspective (expectations of negative rates in the U.S.) and the perceived safety and liquidity of the U.S. Treasury market. 

Lastly, my recent points on current levels of volatility, and the expectation of a reversal, also support the idea of lower interest rates. As I stated:

“In my opinion, there seems to be a higher than normal probability that volatility will take a turn higher sooner rather than later. As such as I have added a net long position in portfolio betting on a rise to hedge against the coincident decline in my net long equity holdings at the current time.” 

Not surprisingly, increasing rates of volatility that coincide with declines in asset prices have also coincided with declines in interest rates. As shown in the chart below, while interest rates are currently at oversold levels on a monthly basis, and could bounce towards 2%ish, the next “risk-off” phase that coincides with a rise in volatility will push rates towards the zero bound.

Here is the point, while the punditry continues to push a narrative that “stocks are the only game in town,” this will likely turn out to be poor advice. But such is the nature of a media driven analysis with a lack of historical experience or perspective.

From many perspectives, the real risk of the heavy equity exposure in portfolios is outweighed by the potential for further reward. The realization of “risk,” when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.

In other words, I get paid to hedge risk, lower portfolio volatility and protect capital. Bonds aren’t dead, in fact, they are likely going to be your best investment in the not too distant future.

In the short-term, the market could surely rise. This is a point I will not argue as investors are historically prone to chase returns until the very end. But over the intermediate to longer-term time frame, the consequences are entirely negative.

As my mom used to say:

“It’s all fun and games until someone gets their eye put out.” 

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In

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“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 covered the extremely low levels of volatility in the market and the building potential for a snap back reversal which would likely coincide with a decline in the market. To wit:

“The level of ‘complacency’ in the market has simply gotten to an extreme that rarely lasts long.

The chart below is the comparison of the S&P 500 to the Volatility Index. As you will note, when the momentum of the VIX has reached current levels, the market has generally stalled out, as we are witnessing now, followed by a more corrective action as volatility increases.”

“More to this point, the chart below shows the S&P 500 as compared to the level of volatility as represented by the 6-month average of the Volatility Index (VIX). I have provided three different bands showing levels of investor sentiment as it relates to volatility. Not surprisingly, as markets ping new highs, volatility is headed towards new lows.”

“In my opinion, there seems to be a higher than normal probability that volatility will take a turn higher sooner rather than later. As such as I have added a net long position in portfolio betting on a rise to hedge against the coincident decline in my net long equity holdings at the current time. 

For my, the question really isn’t ‘IF’ it will happen, but simply ‘WHEN.'” 

Since then, there have been a plethora of articles written on the extremely low volatility levels with various explanations as to the causes. As James Mackintosh just penned for the WSJ:

“Excuses can be made for the low level of the VIX, too. The implied volatility measured by the VIX should offer a premium to realized volatility, a reward for the risk taken by option sellers. Excessive complacency should show up in a shrinking risk premium, but at the moment, the gap between the VIX and realized volatility is roughly in the middle of its range from the past 20 years.

The same is true for the gap between implied volatility of the next few months and further ahead. Investors seem to think volatility will pick up a bit, and again the oddity is where it stands now, not what investors are doing.“

It is an interesting point. However, as the monthly chart below shows, the ratio between the Mid-Term Futures and Short-Term Futures has gone parabolic since the beginning of this year. Currently, at 3-standard deviations of the 24-month (2-year) moving average, extreme complacency would be the proper assessment. 

I agree with James’ conclusion:

“If the Fed offers free insurance, there is no point buying your own, which ought to keep the price of puts—that is, implied volatility—down.

Faith in how far central banks will protect against losses comes and goes, though. In market-speak, the Yellen put is less out of the money if a smaller price fall pushes the Fed to act. At the moment, investors seem to think the put is barely out of the money at all.

The danger, then, is not so much complacency about markets, but complacency about central banks. The lesson of the past seven years is that policy makers will step in every time disaster strikes. But investors tempted to rely on the central banks should note that disasters did still strike, and markets had big falls before help arrived. The time to buy insurance is when it is cheap, and for the U.S. stock market, that is now.”

As I noted last week, I began buying “insurance” for portfolios specifically for this reason.

Bond Bull Market Lives

The death of the bond bull market has been greatly exaggerated in recent months. There is an assumption that because interest rates are low, that the bond bull market has come to its inevitable conclusion.  The problem with this assumption is two-fold:

1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields which push rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largesse in the future, the budget deficit is set to swell back to $1 Trillion or more in the coming years. This will require more government bond issuance to fund future expenditures which will be magnified during the next recessionary spat as tax revenue falls.
3. Central Banks will continue to be a buyer of bonds to maintain the current status quo, but will become more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion which will push the 10-year yield towards zero.

Furthermore, as shown in the chart below there is a correlation between spikes in market volatility, brought on by declines in asset prices, and declines in interest rates. This should be of no surprise as market participants rotate from “risk” to “safety” during market routs.

While individuals continue to “chase a diminishing yield” in stocks, the likelihood of continued capital appreciation in bonds for the foreseeable future will likely continue particularly when the need for “safety” trumps the desire for “risk.”

Gary Shilling summed this up well recently:

“Nevertheless, many stock bulls haven’t given up their persistent love of equities compared to Treasuries. Their new argument is that Treasury bonds may be providing superior appreciation, but stocks should be owned for dividend yield.

That, of course, is the exact opposite of the historical view, but in line with recent results. The 2.1% dividend yield on the S&P 500 exceeds the 1.50% yield on the 10-year Treasury note and is close to the 2.21% yield on the 30-year bond. Recently, the stocks that have performed the best have included those with above average dividend yields such as telecom, utilities, and consumer staples (Chart 13).”

“Then there is the contention by stock bulls that low interest rates make stocks cheap even through the S&P 500 price-to-earnings ratio, averaged over the last 10 years to iron out cyclical fluctuations, now is 26 compared to the long-term average of 16.7 (Chart 14). This makes stocks 36% overvalued, assuming that the long-run P/E average is still valid. And note that since the P/E has run above the long-term average for over a decade, it will fall below it for a number of future years—if the statistical mean is still relevant.”

“Instead, stock bulls point to the high earnings yield and the inverse of the P/E, in relation to the 10-year Treasury note yield. They believe that low interest rates make stocks cheap. Maybe so, and we’re not at all sure what low and negative nominal interest rates are telling us.

We’ll know for sure in a year or two. It may turn out to be the result of aggressive central banks and investors hungry for yield with few alternatives. Or low rates may foretell global economic weakness, chronic deflation and even more aggressive central bank largess in response. We’re guessing the latter is the more likely explanation.”

Whether or not you agree there is a high degree of complacency in the financial markets is largely irrelevant. The realization of “risk,” when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.

In other words, I get paid to hedge risk, lower portfolio volatility and protect capital.

Bonds aren’t dead, in fact, they are likely going to be your best investment in the not too distant future.

“I don’t know what the seven wonders of the world are, but the eighth is compound interest.” – Baron Rothschild 

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In

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“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 hit new “all-time highs.” That’s the good news.

The bad news is that such is occurring on a rapid decline in volume as shown in the chart below.

While volume by itself is not a great indicator from which to manage money by, it does lend credence to the level of participation in the market’s advance. Volume, like volatility which we will discuss in a moment, is most useful in denoting turning points in the market. Historically, volume tends to begin increasing just prior to, and during, a market decline.

While declining volume does not suggest the current advance is over, it is worth paying attention to when it turns higher.

Furthermore, with the extension of the market now 7.5% above the 200-day moving average, a reversion at some point in the not-s0-distant future becomes much more likely. This is particularly the case given the current overbought conditions combined with weakness in price momentum from high levels as denoted by the red circles below.

But such “bear markings” seem to provide little worry to the “bulls” which brings me to my point for today.

A Bull Market In Complacency

In this past weekend’s newsletter, I touched on the volatility index stating:

“The level of “complacency” in the market has simply gotten to an extreme that rarely lasts long.

The chart below is the comparison of the S&P 500 to the Volatility Index. As you will note, when the momentum of the VIX has reached current levels, the market has generally stalled out, as we are witnessing now, followed by a more corrective action as volatility increases.”

Importantly, I quoted Eric Bush, CFA from GaveKal Research as he identified a key point in his analysis of the relationship between the VIX and the spread between high-yield bonds. To wit:

More to this point, the chart below shows the S&P 500 as compared to the level of volatility as represented by the 6-month average of the Volatility Index (VIX). I have provided three different bands showing levels of investor sentiment as it relates to volatility. Not surprisingly, as markets ping new highs, volatility is headed towards new lows.

In my opinion, there seems to be a higher than normal probability that volatility will take a turn higher sooner rather than later. As such as I have added a net long position in portfolio betting on a rise to hedge against the coincident decline in my net long equity holdings at the current time. 

For my, the question really isn’t “IF” it will happen, but simply “WHEN.” 

This view was reinforced by Tyler Durden yesterday when discussed the record levels of speculative “short interest” on the VIX. To wit:

“Speculative bullish positions all added this week with VIX shorts and Dow longs now at all-time record highs.. and Nasdaq longs soaring…”

Importantly, it is worth noting the “record short” positions on the VIX are distorting the pricing on the various ETF’s that are designed to mimic the VIX. However, when those short positions begin to unwind, it will likely exacerbate the move higher of the VIX related ETF’s as short-covering fuels the buying spree.

With professional investors, as represented by the IINV Sentiment Survey, pushing more exuberant levels of bullishness the potential for a short-term reversal in the markets is more than elevated.

As I have noted over the last several weeks, with the markets overly extended, bullish and complacent, the risk of a correction has risen markedly. 

As shown in the chart above, I continue to expect a correction to relieve some of the exuberant conditions that currently exist. However, the timing, cause, and magnitude of such a correction can not be accurately predicted. 

It is for this reason that I am currently:

• Carrying higher levels of cash in portfolios than normal
• Have recently increased bond exposures which will benefit from the flow of capital from “risk” back to “safety”
• Added a volatility hedge to portfolios
• Continue to “trim, prune and weed” the garden accordingly.

Importantly, I will not stay this way forever. If the markets prove me wrong, then I will unwind hedges and increase long exposures accordingly. However, given the current dynamics of the market from a historical perspective, the risk/reward is currently tilted in my favor.

For now, I patiently wait as I see no long-term benefit of excessive risk taking in the market currently. But then again, as John Maynard Keynes once quipped:

“Nothing is more suicidal than a rational investment policy in an irrational world.” 

We do live in interesting times.

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In

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“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 reviewed the current state of the market and the problem for Janet Yellen holding off on hiking rates given the recent strength of employment data on the surface. I say on the surface, because if you dig just a little you will find the inherent problems as I noted.

“The +85k unadjusted number also confirms the trends of fixed and non-private residential investment. Businesses hire against the demand for their products and services. This is why, as shown in the chart below, the historical relationship between employment and fixed investment is extremely high….until now.”

“Importantly, there are two takeaways from this data:

1. Currently, the markets don’t care about what is really happening in the economy, but whether the data keeps the“punch bowl” available. Liquidity is key to supporting asset prices at current levels.
2. However, eventually, the markets WILL care about this data when the economy slows to a point where recessionary forces are no longer deniable.

For now, we are not at the second point as of yet. Therefore, the bullish bias remains intact as long as Central Bankers remain accommodative and keeps interest rates suppressed. Of course, the ongoing liquidity push is distorting market dynamics to a point that will lead to some very bad things in the future.”

As I have noted over the past couple of weeks, the market continues in its process of digesting an extreme overbought condition. This is shown in the chart below.

The market, on a short-term basis, remains in extreme overbought territory. This needs to be relaxed somewhat before additional equity exposure is added to portfolios. As shown, a reversion to the current bullish trend line, which coincides with the markets recent breakout levels, is a likely target in the short-term. 

However, there is a more than reasonable chance, as I laid out two weeks ago for a deeper correction in the next 60-days.  The chart below shows the potential drawdowns from current levels.

Here is the point. It would take a correction from current levels to break 2000, very important support for the markets currently, to even register a 10% correction. Given the current bullish exuberance for the market, this is probably unlikely between now and the election. Therefore, even a “worst case” correction currently would likely be an 8.5% drawdown back to major support.  Of course, for most individuals, even such a small correction would likely feel far more damaging.

Such a correction back to support levels would reduce the current excessively overbought conditions and allow for further analysis of the risk/reward ratio of increasing equity exposure at that point. Of course, we will simply have to wait for the opportunity to present itself.

In the meantime, let’s talk about oil.

Is The Bottom For Oil Finally In?

If you have been reading my commentaries for very long, you are already aware that I live in Houston, Texas which is the energy capital of the world. While the Houston economy has transformed since the “oil bust” in the 80’s, do not be misled about the importance of energy as a critical support of the Houston economy.

Beginning in late 2013, I begin discussing on my daily radio show that it was likely time to begin evaluating energy based holdings and reducing some of the related risks. The reasoning then was simple: everything cycles. Therefore, as the adage goes, it was important to “make hay while the sun shines.” 

As you can imagine, I was vilified for making such an outlandish commentary. I received literally hundreds of emails explaining the “new paradigm” in energy due to the “fracking revolution.”  That emerging markets, primarily China, would continue to drive the demand for oil/energy for decades to come. It was all the usual arguments for why “this time is different.”

Then, in the June 2014 weekly newsletter, I made my first written call with respect to energy-related holdings as follows:

“In early May I set a target for oil prices at $106. That target has now been reached. With oil prices extremely overbought, now is a good time to profits in energy-related stocks. This is particularly the case in operators and drillers that are directly impacted by changes in oil prices.”

However, the most important warning came in early August of 2014.

“While oil prices have surged this year on the back of geopolitical concerns, the performance of energy stocks has far outpaced the underlying commodity. The deviation between energy and the price of oil is at very dangerous levels. Valuations in this sector are also grossly extended from long-term norms.

If oil prices break below the consolidation channel OR a more severe correction in the markets occurs, the overweighting of energy in portfolios could lead to excessive capital destruction.”

Chart Updated To Current Levels

Unfortunately, my predictions in 2014 were correct.

With the deviation between energy stock prices and the underlying commodity once again deviated from their historical relationship, the pain is likely not over yet. With oil prices still overbought currently, and registering a short-term sell signal, the recent bounce is likely best used to sell into.

Valuable Lessons Learned & Relearned

August 2015:

“What this background teaches is, as always, ‘this time is not different.’ Investors have once again been taught the folly of performance chasing and the belief that fundamentals will trump human psychology in the short-term.

There is currently a growing belief that oil has reached a bottom in the low 40’s. Of course, that was also the belief a couple of months ago with oil was in the low 50’s. These beliefs currently appear to be based more on ‘hope’ rather than fundamental underpinnings.

There is a basic supply/demand imbalance currently operating within the oil complex. As shown in the chart below, despite the collapse in oil prices and rig counts, supply has steadily grown over the last several months.”

One year later, that statement is as salient today as it was then.

As shown above, the last time that supply was this high, it was the peak of oil prices for almost 20-years as the imbalance in supply was resolved. The subsequent surge in oil prices, from extremely suppressed levels of production, supported the push into the “fracking” boom and a massive surge in supply without a subsequent increase in the demand to consume it.

The ending was inevitable and just a function of timing. Importantly, the current surge in supply is once again exceeding a weakness in global demand. Given the current backdrop of the structural shift in employment dynamics and excessive indebtedness, it is unlikely that economic growth will accelerate to a point to markedly increase the demand side of the equation.

This suggests that oil prices may remain mired within a lower trading range for many years to come as the reversion process clears the excess supply overhang.

The problem for marginal industry players remains access to cheap capital has now been cut off, and even larger producers are having a tougher time obtaining capital. If oil prices remain at substantially lower levels in the months ahead, as I currently suspect (notwithstanding oversold bounces), there is likely going to be a good bit of turmoil in the energy space continuing into next year.

Currently, the number of net reportable contracts remains heavily biased to the long-side. If oil prices break $40/bbl, you should expect to see a rather rapid unwinding of contracts, and subsequently oil prices, to lower levels. I would suspect that my recent target of $30-35/bbl will prove very realistic.

Furthermore, there is a high correlation between oil contracts and the S&P 500 historically speaking.

The current deviation between the S&P 500 and oil contracts will likely not last long. Either the S&P 500 is due for a more meaningful correction, as discussed above, or there is about to be a rapid rise in oil prices. The latter is unlikely.

I certainly understand the “temptation” to jump into the beaten down energy space currently, I would recommend only doing so in small amounts and with a very long time horizon measured in years rather than months.

The supply/demand dynamics currently suggest that oil prices and energy-related investments could find a long-term bottom within the next year or so following the next recession. However, it does not mean those investments will repeat the run witnessed prior to 2008 or 2014. Such is the hope of many investors currently as their “recency bias” tends to overshadow the potential of the underlying fundamental dynamics.

I am suggesting that an argument can be made that oil prices could remain range-bound for an extremely long period of time as witnessed in the 80’s and 90’s. It is here that lessons learned in the past will once again be re-learned with respect to the dangers of commodities, fundamentals, leverage and greed.

For the Houston economy, there is likely more pain to go through before we reach the end of this current cycle. There are still far too many individuals chasing yields in MLP’s and speculating on bottoms in energy-related companies to suggest a true bottom has been reached.

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In

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“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 reviewed the current state of the market and the risks of an August/September correction from a statistical standpoint.

However, the important point was the stagnation of the market over the last couple of weeks following the breakout above previous resistance levels to all-time highs despite rampant concerns about the effect of the “Brexit.”  This, of course, has been the result of a rapid response by global Central Banks to push enough liquidity into the system to offset any potential negative impact from the vote. 

As I have noted over the past couple of weeks, the market is in the process of digesting an extreme overbought condition. As I stated this past weekend, there are two ways to accomplish this:

“Importantly, there are TWO ways to solve an overbought and overextended market advance.

The first is for the market to continue this very tight trading range long enough for the moving average to catch up with the price.

The second is a corrective pullback, which is notated in the chart below. However, not all pullbacks are created equal. 

1. A pullback to 2135, the previous all-time high, that holds that level will allow for an increase in equity allocations to the new targets.
2. A pullback that breaks 2135 will keep equity allocation increases on ‘HOLD’ until support has been tested.
3. A pullback that breaks 2080 will trigger ‘stop losses’ in portfolios and confirm the recent breakout was a short-term ‘head fake.’

With the markets still at a rather extreme deviation from the intermediate-term moving average, the likelihood of a corrective action in the short-term outweighs the probability of a further advance.”

There is one other point of concern at the moment. One of the more important supports of the bull market advance has been a strong flow of foreign funds into the domestic markets to chase a higher yield. The last time we saw a reversal of flows of this magnitude was during more important domestic and globally related events that led to market contractions. Via Bloomberg:

“In May, official institutions abroad raced out of U.S. stocks and bonds with $26 billion of outflows. Private buyers abroad were, by contrast, net buyers of U.S. securities, but that wasn’t enough to keep the total positive: foreign flows out of U.S. securities totaled $11 billion, according to the most recently available data in May, sharply reversing April’s $80.4 billion of inflows.”

Interesting.

No Asset Bubble?

Speaking of previous asset bubbles, what really struck me as of late is the universal belief by a large majority of analysts, economists, and commentators, suggesting there is currently “no evidence” of an asset bubble.

Maybe that is true.

However, it should be remembered “asset bubbles” are only seen after the fact. None of the individuals currently suggesting the lack of a bubble either weren’t in the markets during the last two OR didn’t see it until well after the fact. Hindsight is not very useful when it comes to investing.

While I am not stating that we are in a bubble currently, there is some rather compelling evidence we might be.

Corporate Profits

Looking at corporate profitability in a vacuum can be a bit misleading. Today, there are contributing factors to corporate profitability that did not exist previously such as the change to FASB Rule 157 which changed mark-to-market accounting, the excessive use of loan-loss reserves and other accounting gimmickry. Regardless, what is more important than the level of profits is the relative growth trend of those profits.  The chart below shows top line sales versus reported and operating earnings.  The last two major market peaks have coincided with earnings topping, and beginning to weaken, much like we are seeing currently.

While the level of corporate profitability is certainly important – corporate profits are more of a reflection of the issues that have historically led to asset bubbles. Increases in leverage, speculative investing and the push for yield, are more attributable to historic asset bubbles from the peak in 1929, the technology bubble in 2000 or the housing bubble in 2008. For example, the housing bubble that started in 2003, which was built around excess credit and leverage as homes were turned into ATM’s – led to a surge in corporate profitability and economic growth. However, the growth of corporate profitability did little to deter what happened next.

Let’s look at those three “road signs” more closely.

Chasing Safety

The current “chase low volatility/safe haven assets” is very likely the bubble that will be identified in hindsight.

When investors have little, or no, fear of losing money in the market they begin to seek the things with the greatest returns. Over the last few years the chase for yield, due to the Fed’s consistent push to suppress interest rates, has driven investors into taking on additional credit risk to increase incomes. That same yield chase has manifested itself also in a massive outperformance of “dividend yielding stocks” over the broad market index.

The chart shows investors are rapidly taking on excessive credit risk which is driving down yields in bonds and pushing up valuations in traditionally mature companies into stratospheric valuations. As noted recently by Jesse Felder during historic market corrections, money has traditionally hidden in “safe assets.” This time, such a rotation may be the equivalent of jumping from the “frying pan into the fire.” 

Are Those Safe Haven Assets Safe Anymore? https://t.co/sauqge6ufl ht @TN pic.twitter.com/eWtFvp1f9H

Loving Leverage

The downfall of all investors is ultimately “greed.” Greed can be measured a couple of ways. The first, as noted by Dana Lyons just recently, is the allocation to equities. Historically, this has been a good measure of the “risk appetite” of investors.

“That said, regardless of the investment acumen of any group (we think it is very high among NAAIM members), once the collective investment opinion or posture becomes too one-sided, it can be an indication that some market action may be necessary to correct such consensus. As we mentioned, that may indeed be the case with the NAAIM Exposure Index, as last week’s survey indicated an average of over 100% exposure to U.S. equities by its respondents. That is just the 6th reading over 100% in the survey’s 10-year history.”

We can also look at how much leverage investors are taking on. The chart below is the amount of investor’s relative positive or negative net credit balances as compared to the index itself.

With both margin debt and negative net credit balances reaching levels not seen since the peak of the last cyclical bull market cycle it should raise some concerns about sustainability currently.  It is the unwinding of this leverage that is critically dangerous in the market as the acceleration of “margin calls” lead to a vicious downward spiral.  While this chart does not mean that a massive market correction is imminent – it does suggest that leverage, and speculative risk taking, are likely much further along than currently recognized.

Pushing Extremes

Prices are ultimately affected by physics. Moving averages, trend lines, etc. all exert a gravitational pull on prices in both the short and long-term. Like a rubber-band, when prices are stretched too far in one direction, they tend to snap back quickly. It is these reversions, both short and long-term, that generally take investors by surprise because they happen so quickly.

The current deviation of over 9% from the long-term trendline is one of the larger in history. This deviation also comes at a time when long-term MACD and Momentum measures are on historic “sell signals.” Such a combination has not turned out well for investors in the past.

The ongoing monetary actions by global Central banks has created a “Pavlovian” response in the markets. When Central Banks ring the proverbial “bell,” investors have rushed to buy in some of the most speculative areas of the market under the assumption they will always be bailed out. However, such is unlikely to always be the case and the massive increase in speculative risks, combined with excess leverage, leave the markets vulnerable to a sizable correction at some point in the future.

The only missing ingredient for such a correction currently is simply a catalyst to put “fear” into an overly complacent marketplace. There is currently no shortage of catalysts to pick from an economic disruption, another Eurozone related crisis, or an unexpected shock from an area yet to be on our radar.

In the long term, it will ultimately be the fundamentals that drive the markets. Currently, the deterioration in the growth rate of earnings, and economic strength, are not supportive of the speculative rise in asset prices or leverage.  The idea of whether, or not, the Federal Reserve, along with virtually every other central bank in the world, are inflating the next asset bubble is of significant importance to investors who can ill afford to once again lose a large chunk of their net worth.

It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words:

“Stocks have now reached a permanently high plateau.” 

The clamoring of voices that the bull market is just beginning is telling much the same story.  History is replete with market crashes that occurred just as the mainstream belief made heretics out of anyone who dared to contradict the bullish bias.

Does an asset bubble currently exist? Ask anyone and they will tell you “NO.”  However, maybe it is exactly that tacit denial which might just be an indication of its existence.

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In

“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 was on my annual family vacation which didn’t afford me the opportunity to publish my normal weekly commentary and portfolio model updates (subscribe for free e-delivery). What is interesting, however, is that relatively little has changed during that time frame.

For continuity, let me begin this week’s “Technically Speaking” update from where I left off previously.

“As shown below, the market is currently 3-standard deviations above its 50-day moving average. This is ‘rarefied air’ in terms of price extensions and a pullback is now necessary to provide a better entry point for increasing equity allocations.”

Chart updated through Monday’s close

“However, as I have noted, there is a difference in pullbacks.

1. A pullback to 2135, the previous all-time high, that holds that level will allow for an increase in equity allocations to the new targets. 
2. A pullback that breaks 2135 will keep equity allocation increases on ‘HOLD’ until support has been tested. 
3. A pullback that breaks 2080 will trigger “stop losses” in portfolios and confirm the recent breakout was a short-term ‘head fake.'”

Over the past week, as shown in the chart above, the market has failed to make any significant movement as traders anxiously await the next Fed meeting. With the markets still at a rather extreme deviation from the intermediate-term moving average, the likelihood of a corrective action in the short-term outweighs the probability of a further advance.

Red Flags

But it is not just the deviation that concerns me. Other “red flags” also suggest a corrective action is coming which aligns with my previous suggestions of a repeat of an August/September correctionary phase.

As Tom McClellan noted recently, the “14-day Choppiness Index,”which tracks the path of a short-term trend, suggests Wall Street’s “uptrend is getting tired.” As McClellan notes, the very linear path for the index implies that the trend is likely to come to an end soon, while more volatile, or choppy, action suggests the opposite. A low reading in McClellan’s index signals a fairly straight-line, or linear, move. And presently, his choppiness index is at its lowest level in two decades.

“The reading on Monday (7/18/16) was the lowest since Feb. 12, 1996 (yes I scrolled all the way back that far to find a lower one). And in case you are interested, that 1996 instance marked a price top which was not exceeded until 3 months afterward. Linear trends either upward or downward are very exhausting, requiring a lot of energy from either the bulls or the bears to keep everyone in formation and marching together. The market tends toward entropy, so excursions like this toward extreme organization cannot last for very long.”

Furthermore, with volatility levels at extremely low levels the probability of a further advance, without a pullback first, is extremely limited.

My friend, Salil Mehta made a great comment on this recently noting that at current levels there is only about a 20% probability of further declines in volatility.

“At 11 [in the VIX] you are really close to the floor. chances are higher that you won’t go lower on VIX and will instead pop up on some risk-off day,”

Furthermore, the deviation between global and domestic markets shows the chase for yield continues in both domestic stocks and bonds as the world grinds towards slower economic growth as recently noted by Jesse Felder:

US vs World pic.twitter.com/dONUqBTwwv

— Jesse Felder (@jessefelder) July 25, 2016

Lastly, the rotation from bonds to stocks, which confirmed the push higher in the markets beginning in July appears to have come to an end. As I previously stated:

“Much of the sustainability of the rally going forward is dependent upon the ongoing rotations from ‘safety’ back into ‘risk.’” 

I closed my interest rate short (TBT) on Monday that I had put on previously with rates at 1.37%. With the markets are overly extended, overly bullish and excessively complacent the risk of a correction has markedly increased. During a correctionary process interest rates will fall back towards recent lows as money once again rotates from “risk” back into “safety.” 

Understanding The Risks

As I stated in the last newsletter, the safest course of action for those more “bullishly” inclined is to wait for a pullback in prices increasing exposure to risk assets.

There are clearly substantial reasons to be pessimistic of the markets longer-term. Economic growth, excessive monetary interventions, earnings, valuations, etc. all suggest that future returns will be substantially lower than those seen over the last eight years. Bullish exuberance has erased the memories of the last two major bear markets and replaced it with “hope” that somehow “this time will be different.”

Maybe it will be. Probably it won’t be.

That doesn’t change our job as investors which is to navigate the waters within which we sail currently. This is why I repeatedly focus on investing from a risk managed basis. Greater returns are generated from the management of “risks” rather than the attempt to create returns by chasing markets. That philosophy was well defined by Robert Rubin, former Secretary of the Treasury, when he said;

“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.”

It should be obvious that an honest assessment of uncertainty leads to better decisions, but the benefits of Rubin’s approach, and mine, goes beyond that. For starters, although it may seem contradictory, embracing uncertainty reduces risk while denial increases it. Another benefit of acknowledged uncertainty is it keeps you honest.

“A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions.  It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.”

We must be able to recognize, and be responsive to, changes in underlying market dynamics if they change for the worse and be aware of the risks that are inherent in portfolio allocation models. The reality is that we can’t control outcomes. The most we can do is influence the probability of certain outcomes which is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In

“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.

Yesterday, I discussed the importance of risk management and reviewed the 15-rules that drive my portfolio management discipline. I needed to lay that groundwork for today’s discussion of why those rules need to be implemented right now.

As shown in the chart below, the market has currently surged nearly 9% from the “Brexit” fear lows driven by a massive increase in Central Bank interventions.

The problem, as I have pointed out previously, continues to be that while prices are increasing, that increase in price is coming at the expense of declining volume. While volume is not a great timing indicator for trading purposes, it does provide insight to the “conviction” of participants to the advance of the market.

But do not be mistaken about the importance of the drivers behind the advance. As Doug Kass recently penned:

“Global economic growth’s weak trajectory and Washington’s stark partisanship have combined to produce fiscal inertia. This puts the responsibility for stimulus on central banks, which have in many cases taken interest rates into negative territory. This has disadvantaged savers and put investors and traders on an arguably dangerous path of malinvestment in a search for yield.“

The current market extension has currently extremes which are more normally associated with short to intermediate term-corrections. As shown in the next chart, on a daily basis the market is pushing 3-standard deviations of its 50-dma moving average.

Like stretching a “rubber band” as far as you can in one direction, the band must be relaxed before it can be stretched again.

However, as noted in the chart above, there is a difference in pullbacks.

1. A pullback to 2135, the previous all-time high, that holds that level will allow for an increase in equity allocations to the new targets.
2. A pullback that breaks 2135 will keep equity allocation increases on “HOLD” until support has been tested.
3. A pullback that breaks 2080 will trigger “stop losses” in portfolios and confirm the recent breakout was a short-term “head fake.”

The magnitude of the current extension of the market above its 50-day moving average can be seen if put into context of a long market cycle. The chart below shows the number of times the market has reached 3-standard deviations of the 50-dma. In the vast majority of cases, it was not long until the market experienced a pullback, correction or worse.

We can see the same idea by slowing down the price action from daily to weekly. While there are fewer occurrences, the importance of extreme extensions becomes clearer.

Of course, at the same time market prices have advanced sharply higher, the “fear of a correction” by investors, as measured by the volatility index, has dropped sharply lower. Again, as with extreme extensions, sharp drops in volatility have been historically associated with near-term peaks, and potential starts of deeper corrections. 

Doug noted the same:

“Stocks continue to defy all odds and reject untoward events of almost any kind, but I remain wary. It’s true that stocks and bonds’ recent relentless climb has calmed most investors — making them far less fearful of a possible major downturn (what I call the Bull Market in Complacency).”

What is clear is the risk of at least a short-term correction is near. For many individuals, the recent parabolic advance has bailed them out from what could have been a more painful correction had Central Banks not bailed out the markets once again. Therefore, it is prudent to use this recovery to clean up portfolios and rebalance risk accordingly. These actions would include:

1. Tightening up stop-loss levels to current support levels for each position.
2. Hedging portfolios against major market declines.
3. Taking profits in positions that have been big winners
4. Selling laggards and losers
5. Raising cash and rebalancing portfolios to target weightings.

There is no rule that states that you MUST be fully exposed to the markets at all times. This is the equivalent of betting “all in” on every hand in poker. You may think you are getting wealthy while your “hand is hot” but you are eventually guaranteed to leave poorer than when you started.

This market is no different currently, and the “hot hand” being dealt has gotten investors once again over confident in their own abilities. This tends to end badly more often than not.

Anthony Mirhaydari nailed this point yesterday:

“Bond investors — and by extension, stock market investors — should be feeling very, very nervous. The global financial system is incredibly complex and increasingly threadbare. And a surge in central bank asset purchases to levels not seen since 2013, combined with hopes of even more purchases, has helped push stocks to fresh highs.

But stocks are incredibly vulnerable. Only 28 stocks in the S&P 500 (less than 6 percent of the index) are at new highs. Less than 72 percent of the stocks in the S&P 500 are even in uptrends.

Any hiccup, from a reversal in the yen; a backup in rates; indications that the Fed is sticking to its two-quarter-point rate hike forecast for 2016; disappointment in the BoJ; realization that valuations and earnings are a problem; a return of geopolitical fears; a continuation of recent energy price weakness (with U.S. oil rig counts growing at the fastest pace since 2011); or even a realization that anti-establishment/anti-globalization candidate Donald Trump has risen in some polls (especially in critical swing states) against global elitist/status quo candidate Hillary Clinton could quickly reverse the gains we’ve seen over the last three weeks.

You know the old adage: Stocks take the stairs up but the elevator down. With everything so expensive, the bull market among the oldest in history, and risks multiplying as fundamentals fade, caution is a virtue here.“

I agree. Taking in some profits from the recent advance will likely look smart sooner rather than later.

But that is just my “Thoughts From The Beach (TFTB)” for today.

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In

“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.

Back in April, as the market surged off of the February lows, I discussed that the “Bear Market Was Over…For Now.” To wit:

“Over the last couple of weeks, in both the daily blog and weekly newsletter, I have been laying out the technical case for a breakout above the downtrend. Such a breakout would demand a subsequent increase in equity risk in portfolios.

The breakout above the downtrend resistance suggests a moderate increase in equity exposure is warranted. The breakout also suggests that markets will now try to advance back to old highs from last year.”

As noted, the breakout back in April has indeed allowed the market to advance back to, and break above, the previous highs from last year as shown in the chart below.

However, while the breakout has occurred, it is also critical that the breakout holds through the end of this week as I stated in this past weekend’s newsletter. (Free E-Delivery Subscription)

“The push on Friday was enough to trigger a short-term buy signal and set the market up for a push to all-time highs. However, don’t get too excited just yet. There are several things that need to happen before you going jumping head first into the pool.

1. We have seen repeated breakout attempts on Friday’s previously which have failed to hold into the next week.Therefore, IF this breakout is going to succeed, allowing us to potentially increase equity allocation risk, it must hold through next Friday.
2. The overbought condition on a weekly basis needs to be resolved somewhat to allow enough buying power to push stocks above 2135 with some voracity. A failure at that resistance level could lead to a bigger retracement back into previous trading range of 2040-2100.
3. Interest rates, as shown below, need to start “buying the rally” showing a shift from “safety” back into “risk” as seen following the April deviation. (Gold bars show declining rates correlated with falling asset prices. Green bars are rising rates correlated rising assets.) 
4. Volume needs to start expanding, second chart below, to confirm “conviction“ to a continuation of the “bull market.”

The next chart looks at each of these points to examine if there are the beginnings of a more “bullish” change to market dynamics. While the breakout has yet to be confirmed through the end of this week, interest rates have turned up suggesting a rotation, at least temporarily, from “safety” back into “risk.” Unfortunately, a pickup in volume to confirm conviction to the move is still lacking at the moment.

It is worth reminding you, that while the markets are moving higher and pushing new highs currently, it is doing so against a backdrop of weak fundamentals, high valuations, and deteriorating earnings. While these measures are not good timing indicators, they are important, historically speaking, to the longer term viability of a bull rally. As shown below, the history of the markets making new highs during an ongoing market topping process is not unprecedented. 

While earnings are set to decline again this quarter which will push valuations even further into the proverbial stratosphere, the real risk to watch is the US Dollar. While Central Banks have gone all in, including the BOJ with additional QE measures of $100 billion, to bail out financial markets and banks following the “Brexit” referendum, it could backfire badly if the US dollar rises from foreign inflows. As shown below, a stronger dollar will provide another headwind to already weak earnings and oil prices in the months ahead which could put a damper on the expected year-end “hockey stick” recovery currently expected. 

As mentioned…the earnings outlook could be in jeopardy. The chart below compares recent months to where estimates stood in January of this year.  As of July 1st, forward estimates are at their lowest levels. (Let the “beat the earnings” game begin.)

Let me be very clear.

• The market broke out to all-time highs after a long consolidation period. This is bullish.
• Central banks globally are pushing liquidity into the markets. This is also bullish.
• Interest rates are ticking up as money moves from “safety” to “risk.” Also bullish.
• As shown below, all buy signals in the model allocation are triggered suggesting an increase in equity exposure. Again, bullish.

While there are more than sufficient bearish arguments currently to suggest fading the current rally and raising cash, the price action is bullish. No more no less. However, as is always the case, I am increasing exposure with very tight stops and a risk management discipline in tow.

Where To Now?

The obvious question is now: “Where is the market headed to?” 

From a technical basis looking at the structure of the trend, and given the probability it is in the latter stages of this particular bull market, we have likely seen the S&P 500 just complete a large consolidation, as mentioned above, concluding Wave 4 of the Elliott Wave principals. This suggests that a Wave 5 has begun (the last part of the trend sequence) which will coincide with the “market melt-up” phase of this advance before the next major correction begins.

Theoretically, once a small correction action that maintains the current bullish-trend works off the current “overbought” condition, the blow-off speculative Wave 5 impulse move should begin.

Wave 5, “market melt-ups” are the last bastion of hope for the “always bullish.” Unlike, the previous advances that were backed by improving earnings and economic growth, the final wave is pure emotion and speculation based on “hopes” of a quick fundamental recovery to justify market overvaluations. Such environments have always had rather disastrous endings and this time, will likely be no different.

Buying Because I Have To. You Don’t.

Let me repeat what I wrote the last time as things have not changed.

“I am buying this breakout because I have to. If I don’t, I suffer career risk, plain and simple.

But you don’t have to. If you are truly a long-term investor, this rally is just a rally. There is no confirmation fundamentally the bull market has yet resumed. Such leaves investors with a tremendous amount of downside risk relative to the reward that is currently being offered.

However, investor patience to remain conservatively invested while what seems like a “bull market” is in force is an extremely difficult thing for most to do.

So, if you buy the breakout, do so carefully. Keep stop losses in place and be prepared to sell if things go wrong.

It is important to remember that the majority of those touting the bull market are simply just getting back to even after an almost year-long sludge. For now, things are certainly weighted towards the bullish camp.

However, such will not always be the case.”

As my Dad used to say:

“If you are going to walk through a bed of snakes, I would suggest doing so very carefully.” 

He was probably right.

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In

“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 for the annual “Independence Day” holiday, the technical analysis from the past weekend’s missive still holds. As I stated:

“I discussed the likelihood of Central Banker’s leaping into action to stabilize the financial markets following the British referendum to leave the E.U. 

Then on Thursday more announcements came from both the Bank of England and ECB:

• BOE: SOME MONETARY POLICY EASING LIKELY OVER SUMMER
• BOE: MPC WILL DISCUSS FURTHER POLICY INSTRUMENTS IN AUG
• ECB: TO WEIGH LOOSER QE RULES AS BREXIT DEPLETES ASSET POOL
• ECB: OPTIONS TO INCLUDE MOVING AWAY FROM QE CAPITAL KEY
• ECB: CONCERNED ABOUT SHRINKING POOL OF ELIGIBLE DEBT

“While many had predicted a market crisis of magnitude stemming from the “Brexit” vote, the reality was a 100-point swing in the markets in just one week. No matter how you bet, you were probably wrong.”

“So, yes, from “Brexit Fears” to “Brexit MEH” in just one week. Talk about volatility.”

Over the weekend, the Bank of England (BOE) took further action to stabilize currency and bond markets yesterday:

“The Financial Policy Committee’s measures on Tuesday included reducing capital requirements for banks, which Carney called a “major change.” The countercyclical capital buffer was cut to zero from 0.5 percent of risk-weighted assets, a move the FPC said would raise the capacity for lending to companies and households by as much as 150 billion pounds ($197 billion). 

The buffer — designed to be bolstered in good times and eased in downturns to support lending — had been increased, effective in March next year. Officials now see it staying at zero until at least June 2017. 

Carney and the FPC gave a stark warning to banks that they should not use the extra funding they now have to increase dividend payouts.“

I am sure the banks will absolutely NOT use the funding for the creation of additional profits or increasing payouts to shareholders. (sarcasm)

Of course, while everyone is currently focusing on Britain following the recent referendum, it is a variety of other issues that are weighing on the markets.

• Bear Stearns 2.0: Standard Life & Aviva Property Halt Redemptions (Zerohedge)
• The Italian “Debt Job”, The Next Crisis (WSJ)
• Swiss Yield Curve Negative Out To 50 Years (Zerohedge)
• China’s Debt Frenzy Leading To Depression Event (MarketWatch)
• Bond Yields Pricing In Something Very Bad (The Telegraph)

While global Central Banks continue to perpetuate the illusion that “everything is going according to plan,” the reality is the debt bubble has only grown bigger. Of course, while Central Banks continue to “rearrange deck chairs” by shuffling bad debt around the globe and fostering continued bailouts of banks and hedge funds, the “ship is still slowly sinking.” 

What Do Bonds Know?

This brings me to my point for today. Central Bank interventions are creating a massive debt bubble by encouraging speculation in the riskiest of debt structures by institutions. Of course, why wouldn’t institutions buy high-risk debt when they are backstopped by Central Banks in the event of a creditor default. Of course, that speculation, demand for bonds, continues to drive interest rates lower as money chases yield.

This morning the interest rate on the 10-year U.S. Treasury reached 1.39% which is the lowest level on record following the 2012 low as the nation fretted over a “debt default from a Government shutdown.”  Of course, falling U.S. bond yields at that time, as investors piled into U.S. debt for safety, showed that fears of a default were unprecedented.

Today, investors are piling once again into the safety of the U.S. Treasury for a higher yield versus just about every other creditworthy sovereign issuer globally.

It is also worth noting that the current market action following the “Brexit” is not so dissimilar to what we saw in 2008. From the WSJ: 

“After Lehman Brothers fell over in September 2008, equities slumped, then rallied back to their previous levels within a week. Brexit isn’t Lehman, but the stock market is behaving similarly.

In 2008, shareholders made an epic mistake: They assumed Lehman would be manageable. This time the assumption is that central banks will ride to the rescue and corral any problems. Investors expect global easy money, adding yet another central-bank prop to the stockade protecting shares from weak economic growth. The result is some unusual, and worrying, behavior in the bond market.

Since the Brexit vote, Treasury yields have tumbled, and they kept falling even as shares recovered. On Friday, 10-year and 30-year yields set new lows, as did British and Japanese benchmarks. Bondholders think central banks will worry about the economic impact of Brexit, keeping rates lower for longer. This is quite different from what happened after Lehman, when bond yields rebounded with shares, as bond investors made the same mistaken judgment that there would be few long-run effects from a midsize U.S. bank failure.”

The ratio between stocks and bonds is sending a clear warning.

As shown above, the dark blue solid line is the ratio between stock prices and bond prices. Not surprisingly there is a high level of correlation between this ratio and the rise and fall of stock prices. This is with the exception of just two periods: the run-up of asset prices during QE3 and leading up to and following the “Brexit” vote.

“Last week’s divergence of bonds and equities isn’t healthy. Bond markets are screaming that the world economy is slowing, and shareholders have their fingers in their ears singing ‘la-la-la I can’t hear you.’ Stocks are no longer about growth, but about a desperate search for safe alternatives to low-yielding bonds.”

Since Brexit, the drive for bonds has been particularly sharp. However, as James stated, the drive for yield is not just about bonds but also about anything that pays a yield. Utilities, consumer staples, health care and telecommunications have been the leading sectors as they pay the highest dividends.

However, DO NOT be mistaken. This chase for yield is not something new but has been a growing bubble born of Central Bank interventions since the end of the financial crisis. As shown the dividend yielding stocks of the S&P 500 have outperformed every other major asset equity asset class. This should not have happened.

The result has been a push of valuations of mature, dividend-paying, low growth companies to extreme levels. The result will be, not surprisingly, a reprisal of the “Nifty Fifty” crash from the late-70’s. In other words, with the defensive sectors at extreme overbought levels, during the next major-market reversion there will be no “safe place” to hide for investors.

The same goes for bonds and I agree with Doug Kass’ recent commentary:

“I believe that fixed-income markets around the world are in a bubble of monumental proportions — and as is the case with most bubbles, the irrational is being rationalized. 

I can say with a high degree of probability that when this whole bond bubble blows up, it will wipe out years of profits for many!”

Now, let’s be clear, while I agree with Doug that bonds are extremely overbought currently, it also does not mean rates will go soaring off to the moon either. The chart below shows the current condition and the expected levels of the rebound. 

It is unlikely that rates in the U.S. will exceed 3.0% currently. A rapid rise in rates, will lead to a whole variety of bad economic consequences and ultimately a recession from such low levels of current growth. Such a spike in rates will also coincide with a fairly substantial major market reversion unlikely to be contained or controlled by the Fed and the damage will be felt across virtually every asset class in the market.

However, while “Brexit” is the continued focal point of Central Banks globally, the real “risk” for asset markets is never what is “seen” but rather what is “unseen.”  That problem can be summed up in just one word: “China.” I agree with Mark St. Cyr on this point.

“All it will take is just one time, or one player to upset this apple cart of illusion which is desperately being maintained, and it all unravels. And as I’ve iterated many times previous I believe that player is China.

As central banks keep intervening mightily within the capital markets as I have stated before: to think China will idly stand by and just ‘suck up’ the consequences of those actions is a fools game. And as proof I would like to point out that as the central banks were busily propping up the markets before, during, and after the Brexit vote. China (once again) devalued the Yuan in a move not seen, and reminiscent in size and scope of August last year. You know, when everything was seeming to come off the rails – once again.”

Of course, it could be something else entirely.

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In

“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.

Well, that didn’t take long to come to fruition.

In this past weekend’s commentary, I discussed the likelihood of Central Banker’s leaping into action to stabilize the financial markets following the British referendum to leave the E.U. To wit:

“Of course, the reality is that we will likely see a globally coordinated Central Bank response to the financial markets over the next few days if the selling pressure picks up steam. This will come in the form of:

• Further interest rate reductions
• Deeper moves into negative rate territories
• Increased/accelerate bond purchases by the ECB
• A potential short-term QE program by the Federal Reserve
• A pick up of direct equity/bond buying by the BOJ.
• Liquidity supports through FX swaps or direct intervention
• Lot’s and Lot’s of “Verbal Easing”

Not to be disappointed, Mario Draghi sprung into action on Tuesday suggesting a greater alignment of policies globally to mitigate the spillover risks from ultra-loose monetary measures.

“We can benefit from the alignment of policies. What I mean by alignment is a shared diagnosis of the root causes of the challenges that affect us all; and a shared commitment to found our domestic policies on that diagnosis.” – Mario Draghi at the ECB Forum in Sintra, Portugal.

Furthermore, as noted by John Plassard, a senior equity-sales trader in Geneva at Mirabaud Securities via Bloomberg:

“Stocks are rebounding on the expectation that there will be a coordinated intervention by central banks. What central banks can do is put confidence back in the market by telling everyone that they are here and ready to act. If we don’t get that sort of support, we’ll see further declines.”

What Do They Know?

While I am not surprised by global Central Banker’s rush to action, it is important to keep things in perspective. Take a look at the chart below.

The highlighted blue circles are what I want you to focus on.

Since the end of QE3 in October of 2014, the markets have made little real progress despite a marked pickup in price volatility. Almost like clockwork, as the markets approach short-term “oversold” conditions the market reverses course and rises back to “overbought” levels before the next decline. Tick. Tock.

Against a backdrop of weakening fundamentals and economic data, the markets have drifted from one Central Bank action to the next. As shown above, the drop last summer of -12.2% spurred Fed members to assure markets there was no rush to hike interest rates. The “relief rally” that ensued drove markets higher by 13.1% only to be tripped up by the rate hike Bullard said the Fed was in no rush to do.

The tightening of monetary accommodation, and threats of four more in 2016, led to a rebalancing of risk at the beginning of 2016 and a decline of -14.4%. That decline spurred the Fed in February to coordinate with the ECB and BOE to coordinate monetary support, combined with the coming ECB’s monetary “bazooka” in March that drove markets higher by 17.1%.

Despite the increased size of advances and declines, each rally and decline remain confined within the continuing range of October 2014 lows and the May 2015 highs.

Here is the point. It took previous declines in excess of 10% before global Central Banks took action to support prices. Following the “Brexit,” it only took a -6.2% decline before Central Banks went to work.

The “invisible hand” of Central Bank interventions has been clearly evident since the end of QE3. With global interest running at, or below, the zero bound, there are few policy tools available to support already anemic economic growth.

The question that should be asked is “what do they know that we don’t?”

Technical Deterioration

Stepping back from the fundamental/Central Bank discussion for a moment, a look at recent price action denotes an increased risk for investors currently. This past weekend, (subscribe for FREE E-delivery) I laid out critical support levels and actions to take:

“While I stated above that you should ‘do nothing’ over the next day or two until the initial ‘panic’ subsides, it is prudent that over the next few days you continue to take prudent portfolio and risk mitigation actions.

Continue with the steps laid out in the “Monday Morning Call” Section a couple of weeks ago:

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

Importantly, two things have currently occurred worth paying close attention to. The “head and shoulder” technical formation on a short-term basis has now been violated.

With the market oversold on a short-term basis, the rally today was not unexpected. However, with “sell signals” in place and neckline support at 2040 now violated, the downside risk currently outweighs the reward. Therefore, the recommendations to rebalance and reduce risk remain intact for this rally.

From a portfolio management perspective, I use WEEKLY price charts to reduce the day to day volatility of market swings to reduce the occurrence of “head fakes” and portfolio turnover. As shown in the weekly price chart below, the markets are currently holding support at the intermediate-term moving average. While stop loss levels were violated on Monday, we will now use any subsequent rally to reduce equity risk by following the rules above. However, with the market holding support currently, negative hedges will remain on hold for now. Where the market finishes on Friday will determine the next set of actions.

Lastly, and importantly, it is worth noting that price momentum has turned decisively negative against a backdrop of negative divergences from the index itself. Historically, when momentum declines as prices rise, the outcome for investors have been less than favorable. The chart below shows several variations of price momentum and the previous outcome of the negative divergence.

While the markets are bouncing today, caution is highly warranted. This is likely NOT a “buy the dip” opportunity as bond yields are currently unchanged.

The next few days will begin to “tell the tale.” Importantly, however, the ongoing disregard for underlying fundamentals is something that has only been witnessed at major market peaks historically.  

Furthermore, it is virtually assured the Federal Reserve will not hike rates now. In fact, the Fed will likely not hike rates at any point in 2016.

Here are the big risks I am watching going forward as money shifts from the instability of Europe to the “safety” of the U.S.

• International and Emerging Market performance will suffer relative to domestic markets.
• USD will strengthen from currency inflows.
• Bond prices will rise (interest rates will fall further)
• Oil prices will decline towards $30/bbl.
• Utilities, REIT’s, Healthcare, and Staples should outperform the S&P 500. (This just means they won’t decline as much as the index)
• Financials, Technology, Discretionary will lag as recessionary forces pick up steam.
• Imports / Exports will continue to suffer weighing on corporate profits (fuggeta’bout hockey stick earnings recovery.)

This is just some initial outlooks. I will continue to monitor and report on these specific areas each week from a price trend basis and make adjustments/recommendations accordingly.

Caution is highly advised.

“Better to preserve capital on the downside than outperform on the upside.” – William Lippman

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In

“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 commentary, I discussed the failure of the market to hold its breakout above 2100 and the upcoming negative revisions to GDP. As of Friday, the market was flirting with breaking below important support at 2040.

However, Monday morning, that all changed. Over the weekend, the “Brexit” polls showed a surprising reversal as the “Leave” vote fell back to a neck-and-neck race with “Remain.” Of course, the primary concern for the markets over the last couple of weeks has been the impact of exit by Britain from the EU. (Which is arguably the best thing for them to do.) It all reminded me of the scene from “Breakfast at Tiffany’s:”

“Paul Varjak: Well, uh, [holds up ring from Cracker Jack box] We could have this engraved, couldn’t we? I think it would be very smart.

Tiffany’s salesman: [taking ring and examining it] This, I take it, was not purchased at Tiffany’s?

Paul Varjak: No, actually it was purchased concurrent with, uh, well, actually, came inside of… well, a box of Cracker Jack.

Tiffany’s salesman: I see…[continuing to look at ring] Do they still really have prizes in Cracker Jack boxes?

Paul Varjak: Oh yes.

Tiffany’s salesman: That’s nice to know… It gives one a feeling of solidarity, almost of continuity with the past, that sort of thing.”

Like the “ring in the cracker jack box,” the EU needs Britain much more than Britain needs the EU. For the EU, which is on the verge of self-destruction due to ongoing failed monetary policies, the need to maintain an image of “continuity” is critical.  A recent Bloomberg Brief with billionaire Peter Hargreaves, the largest U.K. retail broker, with more than $84.1 billion equivalent in assets, crystallized this point.  

“Every year in the EU it gets more political, it gets more legislative, more regulative; we don’t seem to get very much benefit from it. We will be far better out. The EU as an economic mark is declining in the world, when there were only nine countries in, it was 30 percent of the world’s GDP, now there are 28 it is only 17 percent. That’s some serious decline.

There’s a huge amount of vested interest, a lot people making these comments are politically motivated and also work for big banks that aren’t British. They’ve built these enormous dealing rooms and offices in the City of London and Canary Wharf and their bosses are saying we don’t want to endanger this huge investment of ours. I don’t think it will endanger that huge investment. You can’t move the City of London to anywhere else in Europe. It’s madness to suggest it. Frankfurt, the place everybody keeps talking about, only has a population of 700,000, it could not accommodate anything like the City of London.The City of London is absolutely guaranteed, it is bound to survive. The only center that could take over would be Zurich and that’s not in the EU either. It’s absolute drivel that the City of London will be affected. The City of London will go out and it will deal with these emerging economies in the Pacific Basin, Southeast Asia, Africa —  they’re all going to want finance for different things. You can’t set up the City of London anywhere else. It takes years, and during that time the City of London will have grown.

The EU will disintegrate when we leave. They will realize there is nothing left. The political union is going to be a disaster and they’ll want a free-trade area. Do you know who’ll be the first country invited to that free trade area? The U.K.”

2100 Or Bust!

So, as I said, with the odds of “Brexit” swinging back strongly to the “Stay” camp, shares across the globe rallied Monday as the risk of an EU disruption seemingly fades.

The immediate reaction for US stocks was to rally +1.4% out of the gate to retest 2100. Resistance proved formidable as hour by hour stocks handed back half of the gains to end the day at 2083.

The greater battle is still at the all-time highs at 2135, but we will deal with that resistance level when, and IF, we get there.

Of course, with Janet Yellen strolling up to Capitol Hill today for the beginning of the semi-annual Humphrey-Hawkins testimony, the markets will be glued to her comments for hints at continued “dovishness” with respect to monetary policy. As has been the case since the beginning of the year, the markets have migrated investment strategies to follow “Fed Speak” rather than fundamentals.

Of course, the market ignoring fundamentals and focusing on “Fed Speak” is not a new innovation but something seen at the peak of the last two major bull markets.

As I pointed out in this past weekend’s newsletter (subscribe for Free E-Delivery)

“As has been repeatedly been the case, with risk outweighing reward at the moment, a more cautious stance to portfolio management should be considered.

The next chart shows the now 13-month long sideways trading range of the market. However, most importantly, the downward trending price pattern remains in place. The recent failure at the downtrend resistance line remains a concern.

The vertical blue-dashed lines denote market sell signals where subsequent price action has been poor, to say the least. While a “sell signal” is NOT CURRENTLY in place, it will not require much further deterioration in price to trigger one.”

What is important to note is the compression that is building between the short-term moving average (blue dashed line) and the current “downtrend resistance.”  That compression will resolve itself it soon and will lead to a breakout that will retest highs of 2135, or a break below support at 2040.

There are times in portfolio management where “doing nothing” is better than “doing something.” This is one of those times.

With portfolios already running at just 50% of total recommended equity exposure, portfolio risk is already substantially mitigated. This leaves us is the best place to be for the moment as we await the outcome of the “Brexit” vote on Thursday and the culmination of Yellen’s testimony on the “Hill.”

From that vantage point, we can then assess the markets and make a reasonable assumption about what to do next. Could we miss a bit of upside? Absolutely. But such a small lag is a much better outcome than trying to recoup a substantial loss if things go wrong. 

Importantly, whatever the vote on Thursday turns out to be, the focus of the markets will once again turn back global economic realities which remain wanting at best. As Andrew Lapthorne noted from SocGen (via ZeroHedge):

“Whatever the outcome of the Brexit vote this week investors will still be facing the prospect of negative rates and negative yields on a huge range of bonds, massive corporate leverage with worryingly rising delinquencies and of course expensive equity markets and falling profits. To that extent these political events are a distraction from the main event, weak global economic growth and perverse asset markets. So whilst the market preference for the status quo might be celebrated in the short-term, actually when the fog clears all of the problems will still be there.“

Lance Roberts

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report”. Follow Lance on Facebook, Twitter, and Linked-In