Tag Archives: technology

Beware Of Those Selling “Technology”

“3. And they said to one another, ‘Come, let us make bricks, and burn them thoroughly.’ And they had brick for stone, and bitumen for mortar. 4. Then they said, ‘Come, let us build ourselves a city, and a tower with its top in the heavens, and let us make a name for ourselves; otherwise we shall be scattered abroad upon the face of the whole earth.’” Genesis 11:3-4 (NRSV)

Technology

Technology can be thought of as the development of new tools. New tools enhance productivity and profits, and productivity improvements afford a rising standard of living for the people of a nation. Put to proper uses, technological advancement is a good thing; indeed, it is a necessary thing. Like the invention of bricks and mortar as documented in the book of Genesis, the term technology has historically been applied to advancements in tangible instruments and machinery like those used in manufacturing. Additional examples include the printing press, the cotton gin, and the internal combustion engine. These were truly remarkable technological achievements that changed the world.

Although the identity of a technology company began to emerge in the late 1930s as IBM developed tabulation equipment capable of processing large amounts of data, the modern-day distinction did not take shape until 1956 when IBM developed the first example of artificial intelligence and machine learning. At that time, a computer was programmed to play checkers and learn from its experience. About one year later, IBM developed the FORTRAN computer programming language. Until the early 1980s, IBM was the dominant tech company in the world and largely stood as the singular representative of the burgeoning technology investment sector.

The springboard for the modern tech era came in 1980 when the U.S. Congress expanded the definition list of copyright law to include the term “computer program.” With that change, software developers and companies like IBM involved in programming computers (mostly mainframes at that time) had a legal means of preventing unauthorized copying of their software. This development led to the proliferation of software licensing.

As further described by Ben Thompson of stratechery.com –

This highlighted another critical factor that makes tech companies unique: the zero marginal cost nature of software. To be sure, this wasn’t a new concept: Silicon Valley received its name because silicon-based chips have similar characteristics; there are massive up-front costs to develop and build a working chip, but once built additional chips can be manufactured for basically nothing. It was this economic reality that gave rise to venture capital, which is about providing money ahead of a viable product for the chance at effectively infinite returns should the product and associated company be successful.

To summarize: venture capitalists fund tech companies, which are characterized by a zero marginal cost component that allows for uncapped returns on investment.

Everybody is a Tech Company

Today, every company employs some form of software to run their organization, but that does not make every company a tech company. As such, it is important to differentiate real tech companies from those that wish to pose as one. If a publicly traded company can convince the investing public that they are a legitimate tech company with scalability at zero marginal cost, it could be worth a large increase in their price-to-earnings multiple. Investors should be discerning in evaluating this claim. Getting caught with a pretender almost certainly means you will have bought high and will be forced to sell low.

Pretenders in Detail

Ride share company Uber (Tkr: UBER) went public in May 2019 at a market capitalization of over $75 billion. Their formal name is Uber Technologies, but in reality, they are a cab company with a useful app and a business producing negative income.

Arlo Technologies (Tkr: ARLO) develops high-tech home security cameras and uses a cloud-based platform to “provide software solutions.” ARLO IPO’ed at $16 per share in August 2018. After trading as high as $23 per share within a couple of weeks of the initial offering, they currently trade at less than $4. Although the Arlo app is available to anyone, use of it requires an investment in the Arlo security equipment. Unlike a pure tech company, that is not a zero marginal cost platform.

Peloton (Tkr: PTON) makes exercise bikes with an interactive computer screen affording the rider the ability to tap in to live sessions with professional exercise instructors and exercise groups from around the world. Like Arlo, the Peloton app is available to anyone, but the experience requires an investment of over $2,000 for the stationary bike. PTON went public in September 2019 at the IPO price of $29 per share. It currently trades at roughly $23.

Recent Universe

From 2010 to the end of the third quarter of 2019, there have been 1,192 initial public offerings or IPOs. Of those, 19% or 226 have been labeled technology companies. Over the past two years, many of the companies brought to the IPO market have, for reasons discussed above, desperately tried to label themselves as a tech company. Using analysis from Michael Cembalest, Chief Strategist for JP Morgan Asset Management, we considered 32 “tech” stocks that have gone public over the past two years under that guise. We decided to look at how they have performed.

In an effort to capture the reality that most investors are not able to get in on an IPO before they are priced, the assumption for return calculations is that a normal investor may buy on the day after the IPO. We acknowledge that the one-day change radically alters the total return data, but we stand by it as an accurate reflection of reality for most non-institutional investors.

As shown in the table below, 23 of the 32 IPOs we analyzed, or 72%, have produced a negative total return through October 31, 2019. Additionally, those stocks as a group underperformed the S&P 500 from the day after their IPO date through October 31, 2019 by an average of over 35%.

Data Courtesy Bloomberg

Summary

Over the past several years, we have seen an unprecedented move among companies to characterize themselves as technology companies. The reason is that the “tech” label carries with it a hefty premium in valuation on a presumption of a steeper growth trajectory and the zero marginal cost benefit. A standard consumer lending company may employ technology to convince investors they are actually a new-age lender on a sophisticated and proprietary technology platform. If done convincingly, this serves to garner a large price-to-earnings multiple boost thereby significantly (and artificially) increasing the value of the company.

A new automaker that can convince investors they are more of a technology company than other automobile companies’ trades at many multiples above that of the traditional yet profitable car companies. Still, the core of the business is making cars and trying to sell them to a populace that already has three in the driveway.

Using the technology label falsely is a deceptive scheme. Those who fall for the artificial marketing jargon are doomed to sacrifice hard-earned wealth as has been the case with Lyft and Fiverr among many others. For those who are not discerning, the lessons learned will ultimately be harsh as were those described in the story of the tower of Babel.

It is not in the long-term best interest of the economic system or its stewards to chase high-flying pseudo-technology stocks. Frequently they are old school companies using software like every other company. Enron and Theranos offer stark lessons. Those were total loss outcomes, yet the allure of jumping aboard a speculative circus is as irresistible as ever, especially with interest rates at near-record lows. The investing herd continues to follow the celebrity of popular “momentum” investing, thereby they ignore the analytical rigor aimed at discovering what is reasonable and what allows one to, as Warren Buffett says, “avoid big mistakes.”

These Are The Headlines You See In A Bubble

The world has gone completely startup crazy over the last several years. Spurred by soaring tech stock prices (a byproduct of the U.S. stock market bubble) and the frothy Fed-driven economic environment, countless entrepreneurs and VCs are looking to launch the next Facebook or Google. Following in the footsteps of the dot-com companies in the late-1990s, startups that actually turn a profit are the rare exceptions. Unfortunately, today’s tech startup bubble is going to end just like the dot-com bubble did: scores of startups are going to fold and founders, VCs, and investors are going to lose their shirts. In this piece, I wanted to show a collection of recent news headlines (all from Business Insider) that capture the zeitgeist of the tech startup bubble – please remember these when the bubble bursts and everyone says “what were we thinking?!”

These Silicon Valley venture capitalist trading cards should tell you where we are in the cycle (close to the end) (link):

VC Cards

When trillions of dollars worth of central bank “Bubble Money” is sloshing all over the globe looking for a home, startups are a popular holding container (link):

5 startups

Since when did throwing “insane” amounts of cash into a hot industry ever end well? It never does and this time will be no exception. Masayoshi Son is definitely “Bubble Drunk.” (link):

Masayoshi Son

So, she started as a VC at age 17?! And the companies she invested in are worth billions? That’s what happens when central banks hold interest rates at record low levels for a record length of time and flood the economy and financial markets with trillions of dollars worth of liquidity. As the old saying goes, “a rising tide lifts all boats.” Also, “never mistake a bull market for brains.” (link)

24 Year Old VC

During a bubble, it is common to see fantastical stories about young wunderkinds getting hired for grown-up jobs, starting companies, making fortunes, etc. in the industry that is experiencing a bubble. (Undoubtedly, the parents play a very large role in opening doors for these kids and getting them media coverage – “it’ll look great when applying to Harvard!” ). Another example of this is the story of the 11 year-old “cryptocurrency guru” that was circulating during the crypto bubble earlier this year before the crypto price implosion. (link)

Coder

Pretty soon, you will see many more headlines like this (link):

25 Most Valuable

I believe that a very high percentage of today’s startups are actually malinvestments that only exist due to the false signal created when the Fed and other central banks distorted the financial markets and economy with their aggressive monetary stimulus programs after the global financial crisis. See this definition of malinvestment from the Mises Wiki:

Malinvestment is a mistaken investment in wrong lines of production, which inevitably lead to wasted capital and economic losses, subsequently requiring the reallocation of resources to more productive uses. “Wrong” in this sense means incorrect or mistaken from the point of view of the real long-term needs and demands of the economy, if those needs and demands were expressed with the correct price signals in the free market. Random, isolated entrepreneurial miscalculations and mistaken investments occur in any market (resulting in standard bankruptcies and business failures) but systematic, simultaneous and widespread investment mistakes can only occur through systematically distorted price signals, and these result in depressions or recessions. Austrians believe systemic malinvestments occur because of unnecessary and counterproductive intervention in the free market, distorting price signals and misleading investors and entrepreneurs. For Austrians, prices are an essential information channel through which market participants communicate their demands and cause resources to be allocated to satisfy those demands appropriately. If the government or banks distort, confuse or mislead investors and market participants by not permitting the price mechanism to work appropriately, unsustainable malinvestment will be the inevitable result.

As I’ve explained in a recent Forbes piece:

When central banks set interest rates and hold them at low levels in order to create an economic boom after a recession (as our Federal Reserve does), they interfere with the organic functioning of the economy and financial markets, which has serious consequences including the creation of distortions and imbalances. By holding interest rates at artificially low levels, the Fed creates “false signals” that encourage the undertaking of businesses and other endeavors that would not be profitable or viable in a normal interest rate environment.

The businesses or other investments that are made due to artificial credit conditions are known as “malinvestments” and typically fail once interest rates rise to normal levels again. Some examples of malinvestments are dot-com companies in the late-1990s tech bubble, failed housing developments during the mid-2000s U.S. housing bubble, and unfinished skyscrapers in Dubai and other emerging markets after the global financial crisis.

The chart below shows how recessions, financial crises, and bubble bursts have occurred after historic interest rate hike cycles:

Fed Funds Rate

I believe that rising interest rates and the overall tightening monetary environment will lead to the popping of today’s stock market bubble, which will then spill over into the tech startup bubble.

Please watch my recent presentation about the U.S. stock market bubble to learn more:

If you have any questions about anything I wrote in this piece or would like to learn how Clarity Financial can help you preserve and grow your wealth, please contact me here.

Technically Speaking: A Look At The A/D Line

By Lance Roberts and Michael Lebowitz, CFA

In yesterday’s post on investor psychology, we discussed the issue of confirmation bias. To wit:

“As individuals, we tend to seek out information that conforms to our current beliefs. For instance, if one believes that the stock market is going to rise, they tend to heavily rely on news and information from sources that support that position. Confirmation bias is a primary driver of the psychological investing cycle.

To confront this bias, investors must seek data and research that they may not agree with. Confirming your bias may be comforting, but challenging your bias with different points of view will potentially have two valuable outcomes.

First, it may get you to rethink some key aspects of your bias, which in turn may result in modification, or even a complete change, of your view. Or, it may actually increase the confidence level in your view.”

A good example of this was a recent tweet, shown below, which stated the cumulative advance/decline (A/D) line of the NYSE Composite Index “bodes quite well for continued equity strength.” The argument is based on the lower graph which shows that the upward momentum in the cumulative A/D line has not shown any retreat despite the price consolidation of the S&P 500 (upper graph) since late January. The Tweet also points out, using red shaded bars, that the current behavior of the A/D line is not similar to how it behaved before the last three major drawdowns.

Before we analyze the tweet and graph, we think it may be helpful to provide a brief explanation of the A/D line.

“The A/D line is simply the number of advancing stocks less the number of declining stocks for a given day. The daily A/D is typically positive on up days and negative on down days. The graph above showing the cumulative A/D is simply each daily A/D figure added to the net sum of the A/D’s that preceded it. Importantly, there are occasions when the A/D line falls (more stocks down than up) but the market continues to rise. This kind of divergence can serve as a warning of a potential market correction. Conversely, when the market is trending lower and the A/D line begins to rise, it can signal a bottom and eventual turn higher.”

Here is the chart of the Cumulative Advance/Decline Line versus the S&P 500 index for a bit clearer understanding.

While technical analysis is a great way for investors to gauge market sentiment, and hopefully make more informed investment decisions, there are thousands of technical studies which can easily be turned to promote a bullish or bearish narrative to support one’s market view.

However, this is where technical studies should be carefully analyzed to ensure we are not “feeding” our own “confirmation bias.”

Before crunching numbers and looking at historical instances, we must first ask a basic question; what stocks does the NYSE Composite Index (NYA) measure? The NYA is comprised of securities that trade on the NYSE. With a little research, you will find this is not just the equity of corporations such as IBM, Google or McDonalds.

Per Paul Desmond, President of the Lowry Research Corporation:

“Since about 1990 the NYSE has allowed securities other than domestic common stocks to the trade on the NYSE. These include closed-end funds (that match the trends of bonds, not stocks) plus a proliferation of interest (rate) sensitive non-convertible preferred stocks and REITs (which mimic the movements of the bond market, rather than the stock market) plus ADRs of foreign stocks (that do not necessarily follow the trends of domestic common stocks).”

Based on his research, as of 2013, non-operating companies account for 52% of the issues trading on the NYA.

Simply put, the index, and by default, the daily or cumulative A/D of the index, does not provide a clear picture of the breadth of equities. In fact, one could argue it is every bit as much an indicator of the breadth of the fixed income markets.

Because of this composition problem we chose to analyze A/D data for the S&P 500. While the S&P 500 does include some REITs and possibly other non-operating companies, we believe that percentage to be significantly smaller than the NYA and therefore provides a clearer picture of equity breadth.

We take a different approach than the graph shown above. We plotted daily instances of the change in the S&P 500 and the associated net A/D for that day. Further, we only included instances when the S&P 500 was higher on the day. In a strong bull market, one would expect a larger than normal Net A/D on up days.

The graphs below isolate the daily instances occurring four months prior to the market peaks of 2000 and 2007 to the longer term trend occurring four years prior to each peak. Given the large number of data points, we make trend spotting easier by adding darker trend lines. The steeper the slope of the trend line, the higher the net A/D figure per percentage gain, and therefore the better the breadth. Conversely, a flatter line denotes not as many net stocks advanced on days the market rose and subsequently breadth is worse.

In the four months leading the market peaks of 2007 and 2000 the recent A/D trend line (orange) flattened versus the slope of the prior four years.

The graph below showing current data tells a similar story.

Here is another take on similar data. The chart below is the S&P 1500 Advance-Decline percent. The difference here is that instead of just the 500-largest capitalization companies in the S&P 500, it also includes 600 small-capitalization and 400 mid-capitalization companies as well. This analysis provides a much broader sense of the markets true underlying strength.

Again, we see that with roughly an equal split in participation, the overall strength of the market heading into the last half of the year may not be as robust as currently perceived.

While the “bulls” tend to take the data at face value, and extrapolate current trends into the future, investors should also consider the opposing view which suggests the outlook for the next few months is inconclusive at best. 

Battling “confirmation bias” is a difficult challenge because it forces us to consider views we absolutely disagree with. However, it also leads us into making much better decisions, not only in our portfolios, but in life.

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather

Click here to download our investment manifesto.

Technically Speaking: FOMO Overrides FOLM

In this past weekend’s missive, I stated:

“The good news is the break above the 61.8% retracement level, as we noted last week, keeps the markets intact (Pathway #1) for now. And, as suggested above, a retest of recent June highs seems very likely. However, Monday will be key to see if we get some follow through from Friday’s close.”

Well, on Monday, the markets did indeed follow through and rose towards a retest of June highs.

With the markets now back to a short-term overbought extreme, the June highs may be a challenge for the bulls in the short-term. Also, it is worth noting that since the beginning of this year, “gap up” openings for the market have tended to be within a couple of days of a short-term peak. In other words, yesterday’s “gap up” opening was likely a good opportunity to trim positions that have become overweight in portfolios. For us, those were the technology and discretionary sectors, which we have now reduced back to target portfolio allocations.

However, on a positive note, if the bulls can indeed muster a rally above the June highs, and can hold it, it will likely be an easy stretch back to the highs of the year. With the market climbing an advancing trend (higher bottoms and higher highs), our portfolios remain weighted towards equities, although we do remain underweight from target goals. If the “bull market” reasserts itself and shows stronger breadth, then further increases in allocations may be justified.

But that point is not now. Over the last month, the bullish backdrop has become markedly less clear as the list of economic and market concerns persists. This great graphic came from Mark Raepczynski on Friday:

Liz Ann Sonders also took a stab at the list of headwinds facing the bulls currently:

“More broadly, at the midpoint of the year, there continue to be both headwinds and tailwinds for the economy and the market. Trade uncertainty clearly falls in the former. As you can see in the graphic below, I have loosely connected many of these, along the lines of an ‘on the one hand…on the other hand…’ analysis.” 

With concerns rising, it is not surprising to see that investor “optimism” has dwindled in recent weeks, particularly as price volatility has risen sharply this year. The chart below shows the daily price movements of the S&P 500 from 2017 to present.

The chart below is a composite “investor sentiment” index or rather how investors “feel” about the current investing environment.

Clearly, the “exuberance” of the market has given way to more “concern” since the beginning of the year, but given sentiment remains elevated, there is little to suggest real “fear” is present.

In other words, as I discussed this past weekend, despite the rise in “fear,” investors are not willing to “do” anything about. Or rather, F.O.M.O. (fear of missing out) still trumps F.O.L.M. (fear of losing money.)

“With valuations elevated and earnings expectations extremely lofty, the risk of disappointment in corporate outlooks is elevated. Furthermore, despite those who refuse to actually analyze investor complacency measures, both individual and institutional investors remain heavily weighted towards equity risk. In other words, while investors may be “worried” about the market, they aren’t doing anything about due to the ‘fear of missing out.’”  

“This is the perfect setup for an eventual ‘capitulation’ by investors when a larger correction occurs as overexposure to equities leads to ‘panic selling’ when losses eventually mount.”

Overall, the market continues to quickly discount the various risks facing the market. But almost as quickly as one is “priced in,” another emerges. With “trade wars” now live, “Brexit” running into trouble and the November elections in the U.S. quickly approaching, there are plenty of concerns which still lay ahead.

Also, we continue to be concerned about the lack of overall “breadth” of the rally, which was also noted by Jim Bianco, on Monday.

“The next chart shows the impact the so-called FAANMG stocks — Facebook Inc., Apple Inc., Amazon, Netflix Inc., Microsoft Corp., and Google parent Alphabet Inc. — have had on the S&P 500 Index since November 2017. These six stocks alone pushed the S&P 500 up 2.66 percent. The other 494 stocks were collectively down 0.40 percent. Overall, the S&P 500 was up 2.26 percent.”

We have seen this in our own data. Each week in the newsletter, I provide the relative performance of various sectors in our portfolio model to the S&P 500 index. When sectors are above trending positively, and the short-term moving average is above the long-term moving average, the sectors are on “buy” signals.  When the majority of sectors are on “buy signals” and the market is rising, it suggests the overall “breadth” of the rally is strong and the market should be bought. 

This is what the relative performance of the model was one year ago at the beginning of July, 2017.

Here is what it looks like today.

The deterioration in sector performance is indicative of a late stage market cycle, rising risks, and declines in risk/reward backdrop.

Combine the weakening performance backdrop with a market back to overbought conditions, following an abbreviated rally, and you can understand why we remain more cautionary on the intermediate-term outlook. 

As Helene Meisler noted Monday:

“Friday’s breadth continued the strength we’ve been seeing. This makes it six consecutive green days for breadth.

Since prior to this string of positive breadth readings we had seen breadth alternate positive and negative every other day for two weeks, it’s not going to be easy to pinpoint the day we get overbought. However, I can note that we will be maximum overbought Friday, July 13.”

“Last week we used the Nasdaq Momentum Indicator to pinpoint Tuesday as the day we got oversold. If I use this same method to find the overbought time frame it’s far too wide to be of use. For example, it shows an overbought reading sometime between this Tuesday and next Tuesday.

Then if we use the “what if” for the McClellan Summation Index we discover that it will currently take a net differential of -1,900 (advancers minus decliners) to turn the Summation Index from up to down. In 2017 this indicator was of no help but in 2018 once this gets to the point it needs -2,000 we have been overbought. It’s hard to pinpoint the day using this method but it’s likely that if the market’s breadth is strong on Monday this will go down under -2,000.”

“Thus the conclusion is that in the latter part of this week we should reach an overbought condition.

The number of stocks making new highs on the NYSE increased. It’s nothing to write home about but at least it increased.

Finally, I would note that while anecdotally sentiment seems to have turned bullish, it is not yet evident in the indicators. The put/call ratio was 100% on Friday and while that may have been “weekend” related, long-time readers will know I prefer not to rationalize an indicator.”

We remain cautious for now until the investing risk/reward scenario improves enough to warrant additional equity exposure.

Could we miss some of the rally before that occurs? Sure.

We have no problem with that. Opportunities to take on additional market risk come along about as often as a taxi cab in New York City. However, for us, the “fear of missing out” is much less important than the “fear of losing money.” Spending our time working to recoup losses is a process we prefer to avoid.

“When it comes to investing, it is important to remember that no investment strategy works all the time, but having some strategy to manage risk and minimize loss is better than no strategy at all.”

Click here to download our investment manifesto.

Technically Speaking: 2nd Half Starts With A Fumble Recovery

On Monday, the market opened the 2nd half of the year with a fumble as Wall Street continues to wrestle with the uncertainty stemming from the White House with regards to tariffs, geopolitical risks, and economic growth. After a sloppy open with the S&P 500 down 14 points, investors managed to grab the ball and run it back for an 8-point gain. However, the participation and volume left much to be desired.

Stepping back to the beginning of the year, Barron’s penned an outlook for 2018 suggesting the markets would climb 7% in 2018 fueled by strong earnings growth. While it certainly seemed that way coming out of the gate in January, the markets have since struggled to maintain breakeven with the market only rising 1.67% for the 6-month period ending in June.

Bonds have had a rough go of it this year as well. While bonds have lost roughly 3% in price so far this year, bonds have continued to be the “go to” asset class during market sell-offs. Despite predictions of surging interest rates this year, which has been the case for the last several years, rates have remained mired below 3% as economic growth struggles to gain traction.

For investors, performance so far this year has fallen well short of expectations. Year-to-date, a typical 60/40 stock bond portfolio, on a capital appreciation basis only, has returned:

(1.67% * .60) + (-3.07% * .40) = 1% – 1.2% = -0.2% YTD.

Throw in dividends and interest income and basically, you only performed slightly better than a money market account with a whole lot more price volatility and implied risks.

The big winner so far this year has been oil prices. Oil prices are up more than 20% since the beginning of the year due to concerns over supply disruption, Iran, and OPEC. Optimism has led commodity traders to run up net long positioning on oil to some of the highest levels ever on record.

Importantly, as I recently discussed in “Bulls Keep It Together,”

The chart below shows oil prices as compared to a composite index of real GDP, interest rates and the consumer price index (CPI). As shown, the recent uptick in economic growth, inflation, etc. coincides with the recent surge in energy prices.”

“There is also a very high correlation between the direction of oil prices and the S&P 500 index. This is particularly the case since the 2016 lows as oil prices have made up a bulk of the surge in corporate earnings during that time.”

“There are four threats to oil prices in the near term:

  1. A surge in the U.S. Dollar which would likely coincide with a “trade war.” 
  2. A reversal by OPEC countries to start sharply increasing production.
  3. A continued surge in supply (shale) in the midst of global economic weakness.
  4. More rhetoric from the current Administration that “oil prices are too damn high.”

With commodities traders, all crowded on the ‘same side of the boat’ a reversal could be sharp. All that is really needed is a technical breakdown that spooks oil traders to flee for the exits. The last few times ‘sell signals’ have been registered in combination with extreme overbought and overly exuberant positioning, the outcomes have not been good.”

While there is a decent correlation between the direction of energy prices and the markets, it is something to follow as we move into the last half of the year. Higher energy prices, in the short-term, push inflation, retail sales, and other economic data higher. However, in the longer-term, higher energy prices are a tax on the consumer and contributes to a drag on corporate earnings, economic growth and ultimately the market.

Earnings

Speaking of earnings, earnings have come in short of expectations as well. In January, analysts expected the S&P 500 to show reported earnings of $114.45 for Q4 of 2017 and $119.05 for Q1 of 2018. Reality proved a bit disappointing as results came in at $109.88 and $115.23 respectively. You should expect these numbers to revised substantially lower as we progress into the back half of the year.

As I discussed in “The Risk To Estimates:”

“Since then, analysts have gotten a bit of religion about the impact of higher rates, tighter monetary accommodation, and trade wars. As I wrote yesterday, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the ‘beat the estimate game’).  For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.”

“However, the onset of a ‘trade war’ could reduce earnings growth by 11% which would effectively wipe out all of the benefits from the recent tax reform legislation.

As you can see, the erosion of forward estimates is quite clear and has gained momentum in the last month.” 

While analysts continually push estimates lower, so companies can beat them, valuations remain extremely elevated. As of the end of June, the S&P 500, based on Shiller’s CAPE ratio, was trading at 31.68 times. Despite sharply rising earnings, valuations remain extremely elevated relative to long-term historical norms.

Trend Review

As I have discussed many times in the past, we are long-term investors. However, we do manage the risk in the short-term to avoid more important market reversions that could negatively impact long-term capital appreciation. “Getting back to even” is not an investment strategy we wish to employ – neither should you.

Daily

As I noted in this past weekend’s missive:

“The market failed twice in trying to climb back above the 61.8% Fibonacci retracement level which kept the market confined to the same tight trading range we saw in May. Because of the breakdown on Monday, we DID NOT increase equity exposure in portfolios as of yet. With 50% of portfolios currently in cash and fixed income, the damage from last week’s sell-off was mostly mitigated. (This is the advantage of cash and fixed income in a volatile market.)”

On Monday, the market maintained support at the 50% retracement level and was also able to climb back above the 50-dma. With a “sell signal” currently firmly in place, the pressure on asset prices in the short-term is negative. Going into the last half of the year, I have laid out the potential trading range of the market based on current levels.

Improving earnings, a resolution to the current “trade war,” and some relaxation of geopolitical risks could certainly give the bulls what they need in the short-term to rally the markets higher. Currently, despite the volatility of the first half of the year, “bullish optimism” remains well intact. However, a confirmed break of major support will reflect a “changing of attitudes” which will likely coincide with some unexpected exogenous event.

My partner, Michael Lebowitz has a slightly more bearish short-term opinion but in the longer run, which I will discuss, we are on the same page. He believes direction will be determined when the market breaks out of the yellow shaded area below. A break above the box accompanied by new record highs would likely signal a resumption of the bull market. Unfortunately, Michael fears the market will break out to the downside over the course of the next six months and provide confirmation that a topping process for the ten-year bull market is in place. In the meantime, the market will likely use 2700 as a line of support and then resistance.

Weekly

For portfolio management purposes, we prefer weekly data as it smooths out the daily volatility of the markets. Subsequently, the reduced volatility removes some of the “head fakes” and “whipsaws” which can occur during mid-week due to the increased speed at which information, and trading activity, flows through the market.

More importantly, weekly data tends to reveal the trend of the market. As portfolio managers, our job is to participate with the trend as long as that trend is moving in a positive direction. Breaks of the trend, and changes in the trend, are the drivers which lead to more significant changes in overall portfolio allocation models.

As we have repeatedly addressed in our reports, we remain weighted towards equity risk in portfolios currently as the overall trend remains positive. However, the markets are currently testing the accelerated bullish trend from the 2016 lows. A confirmed break will likely lead to roughly a 21.5% correction from this year’s highs to the bullish trend line from the 2009 lows. Such a break will trigger further reductions of equity risk in portfolios, an increase of cash and addition of portfolio hedges.

Monthly

Monthly data is good for understanding major turning points and overall market risk. However, in our opinion, monthly data moves too slowly to minimize portfolio risk properly. While we focus on the weekly data to manage portfolio and allocation risk, we certainly watch the monthly data to look for early warning signs of potential trend changes. The chart below shows the S&P 500 with a variety of indicators attached. When the majority of the indicators align, they have previously provided the “weight of evidence” needed to support more major changes to allocation models. 

Currently, there are several indicators aligning to confirm more “risk” to the market over the next several months. However, since this is monthly data, we won’t know for sure until the data updates at the end of July.

Conclusion

With the first 6-months of the year behind us, performance has been markedly less than Wall Street was expecting. If the market is going to churn out 7-10% by the end of this year, the march higher needs to get underway soon.

I am reminded of a great quote by Axel Merk:

Prepare yourself for volatility. It is the norm of the market. Focus on what you can control – margin of safety. By doing that you will be ready for most of the vicissitudes of the market, which stem from companies taking too much credit or operating risk.

Finally, don’t give up. Most people who give up do so at a time where stock investments are about to turn. It’s one of those informal indicators to me, when I hear people giving up on an asset class. It makes me want to look at the despised asset class, and see what bargains might be available.

Remember, valid strategies work on average, but they don’t work every month or year. Drawdowns shake out the weak-minded, and boost the performance of value investors willing to buy stocks when times are pessimistic.”

When it comes to investing it is important to remember that no investment strategy works all the time, but having some strategy to manage risk and minimize loss is better than no strategy at all.

Click here to download our investment manifesto.

Technically Speaking: The Beer Bet

In this past weekend’s newsletter, I laid out my positioning for a short-term rally back to recent highs and why we were looking to “modestly” increase exposure. To wit:

“That is what we got this past week as the market retested the most recent breakout above the Fibonacci 61.8% retracement level twice.

While the weekly ‘buy signal’ did NOT trigger this week, keeping our allocation model at 75%, we have been adding exposure over the last few weeks as the market continued to break out of consolidations. As we stated previously, we were looking for the following setup to add equity exposure to portfolios.

  • A retracement back to previous support that did not violate it
  • An oversold condition on a short-term basis.
  • An opportunistic setup for a continuation of our investment pathway #2a

As shown in the chart below, all three requirements were fulfilled this week. Therefore, on Thursday and Friday, we did increase equity exposure and will look to add more on any weakness in the markets early next week.”

Over the weekend, my friend Doug Kass disagreed with my view:

In yesterday’s post, he clarified his reasoning behind his view of more trouble ahead for the market.

“Meanwhile, the partisanship in Washington, D.C. – on both sides of the pew – has never been more pronounced and a disquieting backdrop of animus and hostility reins. The impact of this condition on consumer and business confidence remain unknown.

Valuations are contracting, stocks are beginning to ignore good results (e.g., Micron Technology (MU) ) and the risks of policy (both fiscal and monetary) miscues are rising — at a time in which monetary policy around the world is pivoting towards tightening.

Meanwhile, the benefits of the corporate tax reduction is trickling up and not trickling down.

I was long as the S&P Index rose in early June. but I moved back into a net short exposure (via defined risk (SPY) puts and with a short (QQQ) ) at mid-month as signs of global economic ambiguities multiplied, investor optimism grew and the threat of policy mistakes increased — and the downside risks were heightened as measured against upside reward.

  • Market Downside: 2400 to 2450
  • ‘Fair Market Value’: 2500
  • Trading Range: 2550-2750 to 2800
  • Current S&P Cash (Adjusted for this morning’s future drop): 2735 

Here are the current reward versus risk parameters (based upon the -15 handle drop in S&P futures, 2735 S&P equivalent):

  1. There are 310 points of downside risk against only 65 points of upside reward (compared to the top of the expected trading range) in my new pessimistic case (2400-2450). This is an overwhelmingly negative reward vs risk ratio (5:1). 
  2. Compared to ‘fair market value,’ (2500) there are 235 points of downside risk versus only 65 points of upside reward. That’s a negative 4:1 ratio. 
  3. Against the expected trading range, there are 185 handles of downside risk and only 65 points of upside reward (to the top end of the anticipated trading range). That’s a 3:1 adverse ratio. 

There are more Shades of 1999 and signposts that FAANG may have peaked, while we face a new regime of volatility reflecting a host of factors and the possibility of increased economic and market outcomes (many of which are adverse).

A changing market complexion is occurring coincident with global monetary tightening – making equities and other long-dated assets less attractive as the risk-free rate of return expands.”

I don’t disagree with Doug’s outlook at all. Although, we did place a friendly wager on a very short-term outcome.

While I have indeed maintained a bit more bullish stance as of late due to a confluence of factors, I have also consistently recognized the risks which remain. As I wrote this weekend:

“There is risk to the outlook, however. With the short-term sell signal triggered last week, it does keep us cautious. However, as we have seen previously, such a signal can be reversed quickly. Also, with the 50-dma crossing above 100-dma, further support for a continued bullish advance is back in place.

Importantly, while we are indeed more ‘bullishly inclined’ at the moment, and are willing to give the bulls a bit of ‘running room,’ we have moved stops up. We are also keeping our tolerance for losses restricted as downside risk continues to outweigh reward over the intermediate term.

We still remain slightly overweight in cash, and underweight equities, as the late-cycle risk and trade issues remain heavily prevalent.”

Doug won the bet yesterday as the market cracked the 100-dma and certainly raises the risk profile of market currently. However, while the breakdown yesterday is certainly concerning, there is a confluence of support at the 100-dma which coincides with the 50- and 75-dma as well. Also, there is a rising trend line from the March lows which provides additional support at current levels. With the market oversold, the bulls must make a stand here and defend these levels. 

Because of the breakdown on Monday, we DID NOT increase equity exposure in portfolios as of yet. With 50% of portfolios currently in cash and fixed income, the damage from yesterdays sell-off was mostly mitigated. (This is the advantage of cash and fixed income in a volatile market.)

The good news, if you want to call it that, is the cluster of support, as noted above, is now critically important. A break below these levels brings Doug’s lower ranges into view very quickly with the first real test coming at the 200-dma.

With this idea in mind, I updated the pathway chart above to take into account these potential outcomes.

Pathway #1: Given the recent tendency for bulls to rush in to “buy the dips,” the current oversold condition on a short-term basis provides enough “fuel” to support a rally back to recent highs. (30%)

Pathway #2a: Given both the short-term oversold condition AND the confluence of support at the 100-dma, the market is able to rally back to 2740 remains confined to a tight trading range between the 100-dma and 2740. (30%)

Pathway #2b: follows the path of #2a but fails to hold support at the 100-dma and quickly falls to test support at the 200-dma. The market will be deeply oversold at that point, so a rally back to the 100-dma is probable. If the market fails to move above 100-dma then a break below the 200-dma becomes probable and brings Pathway #3 into focus.  (40%)

And just like the first rule of “Fight Club” – we do not talk about “Pathway #3.” 

Actually, we will, we just aren’t there yet.

Should a break of the 200-dma occur we will be discussing much more about the onset of a cyclical bear market, risk reduction, and hedging. While I remain “hopeful” the market can regain its stability and continue to quickly compensate for Trump’s trade rhetoric, “hope” is not an investment strategy.

As I stated previously, these “pathways” are how we assess the risk of potential outcomes in a market that is experiencing much higher levels of price volatility than what we have seen previously. As longer-term investors, we “hope” to invest capital that will grow over time, but given the rising risks of a late stage market cycle, reductions in market liquidity, and tighter monetary policy we maintain a focus on capital preservation.

There is a strong rising bullish trendline from the 2016 lows which coincides with both the short and long-term moving averages. This provides fairly strong support for the market on an intermediate-term basis which keeps us allocated to equities currently.

Any confirmed break below 2710 on a weekly basis, a break which fails to recover, will most likely signal the onset of a protracted bear market. With no real support, until you reach the long-term bullish trendline from 2009, there is roughly 500-points of downside risk. I certainly don’t plan to “hold” equities “long” during such an event.

For now, I continue to allow excess cash and bonds to continue to offset the short-term volatility.

One thing is for sure, things are starting to get much more interesting. As I stated a couple of weeks ago, we are still giving the “bulls the benefit of the doubt” momentarily, however:

“…we do so with a risk-management process in place. We encourage you to do the same. If you don’t have one, it might be time to develop one.”

Or find someone to do it for you.

Now, I just have to figure out how to get a case of beer across state lines.

Technically Speaking: The Drums Of “Trade” War

In last week’s Technical Update, I discussed the risks to our short-term bullish view. To wit:

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

With global economic growth slowing, trade war risks rising, and liquidity being extracted, there is a rising possibility that tighter global monetary policy will lead to a credit-driven event. This is particularly the case given the rate at which corporations have been gorging themselves on cheap debt to take cash out of their balance sheets for the benefit of their executives and shareholders.”

On Monday, we woke to the “sound of distant drums” beating out the warning of a pending trade war as China vowed to retaliate to the $50 billion in tariffs imposed by the Administration on Friday. To wit:

“Global stocks and US index futures are a sea of red this morning amid growing concerns over the escalating trade war between China and the U.S., which on Friday launched tit-for-tat $50BN in tariffs, coupled with the growing risk that Merkel’s government is on the edge of collapse.

Global trade is (once again) back at the top of the wall of worry, with investors afraid that the confrontation between the U.S. and China can escalate out of control, hitting both the global economy and corporate earnings. On Friday, China immediately responded after President Donald Trump slapped tariffs on $50 billion of imports, putting an additional 25 percent levy on $34 billion of U.S. agricultural and auto exports starting July 6.

Analysts expect the U.S.- China confrontation to be a war of attrition: while China has shown a willingness to make a deal on shrinking its trade surplus with the U.S., it has made clear it won’t bow to demands to abandon its industrial policy aimed at dominating the technology of the future.

Looking ahead, Reuters reported the US may impose higher tariffs on an additional $100bn of Chinese imports. If this triggers another round of actions from China, then this second round of trade war will likely be much more damaging for both sides. According to DB, this could reduce China’s GDP growth by 0.3% of GDP, but importantly, the US tariff list will likely include big item consumer goods such as phones, computers, TVs etc, which could mean a lot more workers in China and US consumers would be negatively affected.”

This morning, U.S. futures plunged lower after President Trump called for $200 Billion more in Chinese tariffs and China vowed to “hit back.” 

Further action must be taken to encourage China to change its unfair practices, open its market to United States goods and accept a more balanced trade relationship with the United States,” – President Trump

Bloomberg reported:

  • CHINA SAYS TO HIT BACK IF U.S. ROLLS OUT NEW TARIFF LIST
  • CHINA MOFCOM SAYS U.S. TARIFF DECISION AGAINST MARKET RULES
  • CHINA WILL TAKE STRONG COUNTERMEASURES IF U.S. ISSUES NEW LIST
  • CHINA COMMERCE MINISTRY SAYS IF U.S. PUBLISHES ADDITIONAL IMPORTS TARIFF LIST, CHINA WILL HAVE TO ADOPT COMPREHENSIVE MEASURES TO FIGHT BACK FIRMLY: RTRS

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

While many have believed a “trade war” will be resolved without consequence, there are two very important points that most of mainstream analysis is overlooking. For investors, a trade war would likely negatively impact earnings and profitability while slowing economic growth through higher costs. The following table shows the current and proposed tariffs in play.

Playing The Trade

While the markets have indeed been more bullishly biased in recent weeks, we have couched our short-term optimism with an ongoing view of the “risks” which remain. An escalation of a “trade war” is one of those risks, the other is a policy error by the Federal Reserve which could be caused by the onset of a “trade war.” 

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

However, the red dashed line denotes an 11% reduction to those estimates due to a “trade war” as noted by Barclays Bank yesterday:

“As a result of escalating trade war concerns, Barclays recently estimated the impact in the worst-case scenario of an all-out trade war for US companies across sectors and US trading partners.

In a nutshell, the bank calculated that an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies by ~11% and, thus, completely offset the positive fiscal stimulus from tax reform.”

Combine a “trade war” with a Federal Reserve intent on removing monetary accommodation, both through higher rates and reduction in liquidity, and the market becomes much more exposed to an unexpected exogenous event which sparks a credit-related event. (Of course, it isn’t just the Fed, but also the BOJ and ECB.)

While our longer-term analysis remains more negative, due to both price extension and valuation issues, on a short-term basis, the markets remain confined to the uptrend that began back in April. Our “pathways” currently remain intact as #2a now seems to be the probable outcome currently. (I have cleaned up the chart to only show the two most probable paths currently.)

With the market weakness yesterday, we are holding off adding to our equity “long positions” until we see where the market finds support. Currently, there is a cluster of support coalescing at the 100-dma. The 50-dma is set to cross back above the 100-dma this week, and the downtrend line from the March highs also resides at that juncture.

If the markets retrace to that cluster of support, we suspect the market will be sufficiently oversold enough for a reflexive bounce by the end of the month. Again, going back to the pathway chart above, the most probable outcome currently remains a continued sideways and choppy market.

For now.

However, longer-term there is little indication the markets have a substantial amount of upside from current levels. As shown in the chart below, the parabolic advance from the 2015-2016 lows have pushed indicators to extremes on many levels. More importantly, we are very close to registering a “sell signal” (bottom panel) at a level higher than previously witnessed at the “dot.com” peak.

The warning from the chart above also coincides with the deterioration in the breadth of participation of stocks as well.

I want to be exceedingly clear that while our outlook on a short-term basis is more optimistic due to recent market action, the longer-term setup remains very bearish for long-term investors.

Simply, this is no longer a “buy and hold” market environment.

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

As a portfolio manager, I must manage short-term opportunities as well as long-term outcomes. If I don’t, I suffer career risk, plain and simple.

However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns from the second longest bull-market in history.

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

If you went to cash now, the odds are EXTREMELY high that you will far outpace investors who remain invested in the years ahead. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,”  but when the next “mean reverting event” occurs the decline will destroy most, if not all, of the returns accumulated over the last 9-years.

All I am suggesting, is that if you continue to ride this particular “bull,” do so carefully. Keep stop losses in place, and be prepared to sell when things go wrong.

For now, things do indeed remain weighted towards the bullish camp, however, such will not always be the case, and that could be sooner than most expect.

Technically Speaking: The Risks To Our Bullish View

As we detailed in this past weekend’s newsletter:

“…[the expected] breakout did occur and pushed prices to the first level of resistance which resides at the late February highs.”

“…there is a significant amount of overhead resistance between 2780 and 2800 which may present a challenge in the short-term to a further advance. However, I suspect any weakness next week will likely provide a decent opportunity to increase equity exposure modestly. 

This idea aligns with the updated ‘pathway analysis’ from last week.”

“We had previously given pathway #1, #2a and #2b a 70% probability of coming to fruition. The tracking of pathway #1 also negates pathway #3 entirely for now. 

More importantly, the market is sitting at the critical juncture of either a continuation of pathway #1 toward all-time highs or a correction of some sort to retest support and confirm this past week’s breakout. A corrective retest that provides a better entry point to increase exposure is the most preferable of outcomes.”

While we will increase our equity exposure in portfolios, cautiously and moderately, it does not mean we no longer appreciate the risk in the markets, or to investment capital.

Risks To Our View

As we discussed this past weekend, the risks to our view, both in the short and intermediate-term, remain.

  1. The Fed will hike rates next week, however, their press conference will be closely watched for more “hawkish” undertones.
  2. Next week, the Trump Administration will announce $50 billion in “tariffs” on Chinese products. The ongoing trade war remains a risk to the markets in the short-term. 
  3. Any unexpected “back-of-the-napkin” policy the White House takes which surprises the market.
  4. Ongoing liquidity concerns with respect to Italy or Deutsche Bank.

On Monday, the market shrugged off the “back-of-the-napkin” trade policy and backlash by the Administration towards Canada’s Prime Minister Justin Trudeau following the G-7 Summit. However, there is still a growing risk that “trade policy” will have a more detrimental impact to U.S. companies in the months ahead.

There is also risk in the optimism over Trump’s “mano-a-mano” meeting with Kim Jung Un on the issue of a “nuclear-free North Korea.” While the pair signed an agreement yesterday “committing” to denuclearization, it was actually little more than an agreement to have more summits.

The markets had already priced in much of the current events with the recent run up, so an agreement to have more summits left markets a bit “underwhelmed” this morning.

The biggest risk to our more optimistic market view remains the Fed, global Central Bank liquidity support, and monetary policy. Bank of America, via ZeroHedge, provided additional support to our view of the “end of liquidity” which will become more aggressive this year.

“In our view, the ECB has decided to announce in June how QE will end for three reasons. The QE program will end for sure this year, because of technical constraints, so there is no reason to keep the uncertainty and give a false impression that extending QE to 2019 remains an option.

Following the market turmoil from Italy last week, the ECB has strong incentives to make it clear that QE is about to end, also sending a message to the new government in Italy that they should not count on QE support if they want to loosen fiscal policies. And recent headlines on the ECB drop of BTP purchases in May makes the QE program politically more controversial. This suggests that the end of QE has nothing to do with the intended ECB monetary policy stance or the latest economic developments and outlook ahead. We would expect the ECB to emphasize that rate hikes ahead will be strictly data dependent.”

With the FOMC hiking rates this coming week, and accelerating its “balance sheet normalization” by increasing its roll-offs from $30 to $40 billion a month, the proverbial “global liquidity punch bowl” is now being more aggressively removed. This is akin to removing the trampoline with the jumper currently at their apex.

With global economic growth slowing, trade war risks rising, and liquidity being extracted, there is a rising possibility that tighter global monetary policy will lead to a credit-driven event. This is particularly the case given the rate at which corporations have been gorging themselves on cheap debt to take cash out of their balance sheets for the benefit of their executives and shareholders. Steven Pearlstein via the Washington Post:

“Now, 12 years later, it’s happening again. This time, however, it’s not households using cheap debt to take cash out of their overvalued homes. Rather, it is giant corporations using cheap debt — and a one-time tax windfall — to take cash from their balance sheets and send it to shareholders in the form of increased dividends and, in particular, stock buybacks. As before, the cash-outs are helping to drive debt — corporate debt — to record levels. As before, they are adding a short-term sugar high to an already booming economy. And once again, they are diverting capital from productive long-term investment to further inflate a financial bubble — this one in corporate stocks and bonds — that, when it bursts, will send the economy into another recession.

Welcome to the Buyback Economy. Today’s economic boom is driven not by any great burst of innovation or growth in productivity. Rather, it is driven by another round of financial engineering that converts equity into debt. It sacrifices future growth for present consumption. And it redistributes even more of the nation’s wealth to corporate executives, wealthy investors and Wall Street financiers.”

“As the accompanying chart indicates, over the past decade, net issuance of public stock — new issues minus buybacks — has been a negative $3 trillion. This reduction in the supply of public shares in American companies, coupled with an increased global demand for them, goes a long way toward explaining why stocks are now priced at 25 times earnings, well above their historical average.”

This is a problem that provides our biggest concern currently. As I noted last week:

“Rising interest rates are a ‘tax.’ When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.

The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events. Of course, it is during those events which loan default rates rise, and leverage is reduced, generally not in the most ‘market-friendly’ way.

This is THE story we will most likely be discussing in the future even while the mainstream media suggests “no one could have seen it coming.” 

It’s Confusing

This is where it gets confusing.

“Why are you increasing equity risk in portfolios, if you are certain the markets are going to break?”

It’s a great question from a reader over the weekend.

As portfolio managers we face two great challenges – making investments in the short-term to capitalize are market movements (or suffer career risk from underperformance) and managing long-term capital destruction risks which will occur from overvalued and extended bull markets.

Our investment discipline is designed to manage both ends of the spectrum. Our technical analysis, as we discuss each week, drives shorter-term portfolio actions (weeks to months), with fundamental analysis driving asset allocation and portfolio weighting decisions (months to years.)

Are we certain the markets are going to experience a severe “mean reverting event?” 

Absolutely.

When? 

We have no idea.

This is specifically why we don’t make absolute predictions about where markets are headed. We are not psychics, fortune-tellers, or imbibed with any prescient gifts. As such, we must we focus, and rely, on our assessment of the current possibilities versus probabilities based on an accumulation of evidence (hence our pathway analysis as shown above.)

We will make right “calls” and wrong ones. Such is the nature of investing. We just focus on trying to right more often than we are wrong.

This is why we share our analysis with you each week.

Writing forces us to consolidate our views, have an opinion, and make informed decisions. Having a record of our decision-making process forces us to be accountable to ourselves and our clients. 

Even if you don’t publish your own views and ideas, we encourage you to write them down, review them on a regular basis, and compare them to your portfolio actions. A written record informs you of what you have done right, and wrong. It also keeps you honest about your assessment of risk, reduce emotional responses to short-term market volatility, and focus your investing behavior toward your goals.

You will be a better investor for it.

“Consensus is something everyone agrees to, but no one believes in.” – Margret Thatcher

Technically Speaking: Bulls Charge Into “Trade War”

On Monday, stocks opened higher as the bulls pushed the market above overhead resistance. In this past weekend’s missive, I updated our ongoing “pathway” analysis which continues to drive our overall portfolio positioning currently. To wit:

“As shown by the reddish triangle, the ongoing consolidation process continues. Eventually, this will end with either a bullish or bearish conclusion. There is no ‘middle ground’ to be had here.

  • Pathway #1 – a breakout to the upside on heavy volume that pushes the market through resistance at 2780 and back to old highs. (Probability 20%)
  • Pathway #2a and #2b – a breakout to the upside which fails resistance at 2780. The market then either a) retests the 100-dma and then is able to push to old highs, or, b) fails at 2780 a second time and continues the consolidation process through the summer. (Probability 50%)
  • Pathway #3 – the market breaks down next week on continued geopolitical worries, economic data or some unexpected catalyst and retests the 200-dma. (Probability 30%)

I have increased the more “bearish” probability from 20% last week to 30% this week given the triggering of a short-term ‘sell-signal.’ (Lower panel)

With the higher open on Monday, the market broke above the downtrend resistance and is set up to test resistance at 2780. With the market back to overbought currently, it is likely that 2780 may well be a challenge to the bulls in the near term. Pathway #2a and #2b continue to be the highest probability outcomes currently.

However, a “one-day” move is not necessarily the start of a new trend.

As we discussed previously, from a portfolio management perspective we rely much more heavily on “weekly” data as it smooths out the “volatility” of daily price movements. Given that we are “longer-term” investors, seeking to deploy capital for extended periods of time, using weekly data helps reduce the issues of “head fakes” or “false breaks” which lead to a variety of bad investing outcomes and behaviors. Also, weekly data reduces the emotional “wear and tear” on investors over time by keeping the primary focus on the “trend” of the data.

If we take a look at the weekly chart, a slightly clearer picture emerges.

As shown in the chart above, the consolidation process continues as in the daily chart above. While the market is appearing to bullishly “break out” of the current consolidation pattern, such will not be “confirmed” until the end of the trading week. On Friday, if prices have reversed, then the “break out” will NOT have occurred and portfolio allocations will remain flat.

Furthermore, on a “weekly basis,” the intermediate-term “sell signal” remains which suggests continued pressure on stock prices in the short-term. While the signal is improving, it has not confirmed an increase in equity allocations just yet. The market is also wrestling with a 61.8% Fibonacci retracement from the February lows which is providing some resistance.

We want to give the “benefit of the doubt” to the “bulls” currently. The action on Monday was indeed bullish, and sets us up to add further equity exposure to portfolios, but we will wait for confirmation of the weekly data.

Our worry is the “bulls” seem to charging directly into a potential “trade war.”

A “Trade War” Cometh

As discussed this past weekend, there are a litany of issues which currently concern us particularly has we meander further into the “seasonally weak” period of the year.

  • Italian “debt” is a problem. While it was quickly dismissed by the markets, the potential impact to the global financial system is magnitudes larger than Greece was.
  • The elected officials in both Spain and Italy are not particularly “EU” friendly with both recent appointments primarily anti-establishment officials. 
  • Deutsche Bank is a major issue of concern.
  • The Fed is raising interest rates and reducing their balance sheet.
  • Short-term interest rates are rising rapidly.
  • The yield curve continues to flatten and risks inverting.
  • Credit growth continues to slow suggesting weaker consumption and leads recessions
  • The ECB has started tapering its QE program.
  • Global growth, especially in Europe, is showing signs of stalling.
  • Domestic growth has weakened.
  • While EPS growth has been strong, year-over-year comparisons will become challenging.
  • Rising interest rates are beginning to challenge the equity valuation story. 

However, the biggest immediate concern is the implementation by the current Administration of “tariffs” not only on China but the EU, Mexico, and Canada.

On June 1st, the Administration announced tariffs on steel and aluminum products. On June 15th, the Administration will announce further tariffs on roughly $50 billion of imported products from China.

While “tariffs” sounds like a rather benign issue, it is simply another word for “tax.” In this case, it is a 25% tax increase on the goods and services being penalized. But it is not just those specific goods and services that rise in price, but all related and affected goods and services.

When tariffs are applied, the cost of steel, aluminum, and everything comprised of those commodities, will rise in price. Products, like automobiles, which use imported parts will also rise in price if the imported component increases in cost. As Doug Kass noted previously:

“What I believe they don’t understand is how interconnected the global economy is today compared to the past. As each year progresses, the role of world trade increases and the role of non-US operations in our largest multinationals multiply. Just look at the ever-expanding role of exports (and non-US sales) in the S&P Index – it’s increased as a percentage of total revenues by 2.5x in the last few decades.”

Throw into the mix a stronger dollar, and the risks increase further. As Garfield Reynolds blogged for Bloomberg:

“The law of unintended consequences is striking again. This time it’s the surge in the U.S. dollar that’s being fueled by decisions from President Donald Trump -who seems to prefer a weaker currency – to intensify his attacks on the current ‘unfair’ global trade regime.

The U.S.’s insistence on using tariffs as a weapon came as the White House dropped any effort to seek trade rebalancing through a weaker USD and decided against naming any nations as FX manipulators.

As Trump’s trade stance became more truculent, the dollar just kept climbing. That was puzzling because classic havens such as JPY, CHF, and gold were seeing little benefit as market fears heightened.

It’s become clear that the dollar gained because the impact of Trump’s stance was seen benefiting U.S. assets on a relative basis.”

“Yes, a major trade war is likely to cause damage to the U.S. economy, but a lot of that will be in the longer term. It’s going to cause significantly more pain, especially in the short term, to all those exporters Trump is targeting; and the U.S. is far and away the world’s largest net importer.

This issue is helping to leach investment out of EM in particular, with major developing economies among those most at risk from a U.S.-initiated trade war. Developing Asia, for example, sends 18% of its exports to the U.S., almost three times what it sends to Japan, the next- biggest single-country destination.

With the 10-year treasury rate now extremely overbought on a monthly basis, combined with a stronger dollar, the impact historically has not been kind to stock market investors. While it doesn’t mean the market will “crash” today, or even next week, historically rising interest rates combined with a rising dollar has previously led to unexpected and unintended consequences previously.

As I have stated previously:

“We remain keenly aware of the intermediate-term “risks” and we continue to take actions to hedge risks and protect capital until those signals are reversed.”

We also remain acutely aware of the longer-term capital risks due to elevated valuation levels, the length of the economic cycle, and weakening annualized comparisons going forward. While it is not yet time to be exceedingly “bearish” on equities, it is no longer advantageous to be exceedingly “bullish” either.

Technically Speaking: How Far Can Stocks Fall?

With the markets closed for Memorial Day yesterday, our analysis remains. In case you missed it, we updated our potential pathways following last week’s stagnation as follows:

“As shown by the reddish triangle, the ongoing consolidation process continues. Eventually, this will end with either a bullish or bearish conclusion. There is no ‘middle ground’ to be had here.

  • Pathway #1 – a breakout to the upside on heavy volume that pushes the market through resistance at 2780 and back to old highs. (Probability 20%)
  • Pathway #2a and #2b – a breakout to the upside which fails resistance at 2780. The market then either a) retests the 100-dma and then is able to push to old highs, or, b) fails at 2780 a second time and continues the consolidation process through the summer. (Probability 50%)
  • Pathway #3 – the market breaks down next week on continued geopolitical worries, economic data or some unexpected catalyst and retests the 200-dma. (Probability 30%)

I have increased the more ‘bearish’ probability from 20% last week to 30% this week given the potential triggering of a short-term ‘sell-signal.’ (Lower panel)  If the market struggles next week, a triggering of that signal will increase the downward pressure on equity prices.

We will continue to hold our cash position until the market makes some determination as to its direction.”

Importantly, while we are still assigning a 70% possibility to more constructive market action, the 30% possibility of more “bearish” action should not be dismissed.

But what does that mean? How big of a correction are we talking about?

Just recently, Jesus Aldana took a shot at answering that very question.

As he showed in his chart below, heading into 2018 the market pushed an unprecedented string of monthly gains not seen since heading into the peak of the market in 2008. Such market exuberance is not uncommon at the peaks of bull markets as remaining “holdouts” are finally sucked in.

The question which must be answered is what needs to happen to start a more significant correction process? Mr. Aldana suggests:

“First signs of a recession are the lack of new highs in the stock market. At this stage, it will be highlighted as a correction, investors aren’t willing to raise their open positions no matter how good the quarterly report is, it’s just not safe to keep pouring money in the market. This stage is already cleared as the S&P 500 hasn’t posted new highs since January.

Technical reversal patterns start to appear like double top, triangles, head and shoulders and others. A reversal pattern gives a good approach as to when a correction could start.”

As he shows in his chart below, the first reversal pattern was already broken and failed to reverse. As I showed this past week, which concurs with Mr. Aldana’s analysis, a second pattern has started to develop which potentially suggests a more important “double top” is in the process of forming. If this is indeed the case, it would likely complete over the next couple of months and could push the S&P 500 to toward new highs at 2950.

As shown in the chart above, a rally to “all-time highs” does not negate a more significant “topping process.” As I showed recently, such action is common at market peaks.

“While the markets have indeed gone through a correction over the last couple of months there is no evidence as of yet that central banks are on the verge of ramping up liquidity. Furthermore, the “synchronized global economic growth” cycle has begun to show “globally synchronized weakness.” This is particularly the case in the U.S. as the boost from the slate of natural disasters last year is fading.

More importantly, on a longer-term basis, the recent corrective process is the same as what has been witnessed during previous market topping processes.”

“In each previous case, the market experienced a parabolic advance to the initial peak. A correction ensued which was dismissed by the mainstream media, and investors alike, as just a ‘pause that refreshes.’ They were seemingly proved correct as the markets rebounded shortly thereafter and even set all-time highs. Investors, complacent in the belief that ‘this time was different’ (1999 – new paradigm, 2007 – Goldilocks economy), continued to hold out hopes the bull market was set to continue.

That was a mistake.”

There are a couple of important factors the Mr. Aldana discusses to support the idea of a deeper correction if the market does indeed begin a more important corrective process.

“First, let’s look at the VIX, it’s an Index most investors use when markets start to enter a correction phase. We can see that 10.00 is a multi-year support and normally when it reaches that price things don’t get better. In 1993, and 1995, it reached that level and started to rise until 2003 (Dot-Com Crisis). In 2006 and 2007, that level was reached again and then rallied until 2009 (Sub-Prime Crisis). Once again, in 2017 it touched 10.00 before reaching almost 30.00 in 2018.

Just looking at the VIX one can deduce there is plenty of room for another rally, which suggests another crisis is likely to happen and we are potentially not too far from it.”

Mr. Aldana goes on to suggest the Treasury market is also sending some important warnings.

“The Treasury market normally predicts when a crisis is near. When short-term yields are far lower than a long-term yield, things are ‘okay.’ However, when the yield curve flattens, heading towards inversion, you should start worrying as investors aren’t comfortable with the current economy.

Looking at the charts below, one can see how brutally short-term yields have risen compared to longer-term rates in 2012. The 1-year rose +2400% while 5-year climbed +160%. A 2000% increase in only 6-years is not stable, and if we add the fact the 10-year has only risen +40% and 30-year just +4%, one can see the magnitude of the problem. It won’t be long for the 1-year yield to approach, or even cross, the 30-year.”

As he concludes:

“Under these circumstances, one can conclude that a market crash is more probable than just a market correction. Analyzing the S&P 500, VIX and Treasuries all point to a further downtrend. The question, of course, is just how deep will a correction be?

One of the best tools to determine a reversal is a Fibonacci Retracement. I have also added multi-year, month and week trend lines. The first support is located at 2600 where it has been consolidating since January. Second support is located at the multi-year support which nearly matches Fib 23.6% (healthy support.) The third support is located at the 2016 resistance level (major setback) with the fourth support located at Fib 50% (a complete meltdown.)”

Whether you agree with the analysis, or not, is largely irrelevant. The important point is to consider the possibility of a more sustained correction process. While we have no idea exactly “when” a correction of magnitude will occur, we do know it will.

Ignoring the “risk,” and failing to take some action to mitigate the potential destruction of capital in the near-term, has historically had irreparable long-term consequences.

This “time is not different,” and there will be few investors that truly have the fortitude to “ride out” the next decline.

Everyone eventually sells. The only difference is “selling when you want to,” versus “selling when you have to.”

But then again, if you do “ride it out,” the mathematical reality is that getting back to even is not a successful investment strategy to begin with.

Technically Speaking: Riding The Bull

One of the most dangerous sports in America lasts a total of eight seconds – bull riding. In bull riding, a rider must stay on top of the bucking bull while holding onto the bull rope with one hand for eight seconds and not touching the bull or himself with his free hand. If he does that, it is a qualified ride. If he gets bucked off before eight seconds, it is a no score.

For investors, the difference between success and failure in “riding the bull,” often comes down to knowing when “hang on” and when to “dismount” the bull market. The worst outcome is getting “bucked off” and facing a really “p*ssed off” bull looking to stomp or gore whoever is closest to it.

In this past weekend’s missive, “Consolidating The Breakout,” I updated the projected pathways for the market given the recent break above the cluster of resistance surrounding the 100-day moving average. To wit:

“As shown, in the chart above, this ‘pause’ sets the market up for a continuation of pathway #2a to the next level of resistance. However, there is a reasonable possibility that has opened up of a new path (#2c) which could lead to another retest of the 200-dma if the market breaks the current support.

Pathway #2c is currently a binary outcome and will only exist next week. Either the market will move higher next week and continue following pathway #2a or it won’t. Monday will likely ‘tell the tale’ and I will update this analysis in Tuesday’s report.”

I can now update that analysis with yesterday’s move higher on reports the “trade war” with China has been put on hold to negotiate a reduction in the “trade deficit.”

As I stated, pathway #2c was binary. Given our analysis is based on the “end-of-week” close, if the market breaks above last week’s highs, we will remove pathway #2c.

Where does that leave us now in terms of our portfolio models?

When the market broke above the 100-dma, we used some of the cash we had raised on previous rallies to increase the allocation to equities in our portfolios. However, we still maintain an overweight position on cash currently as a hedge against potential market risk.

This week, we are looking to add further exposure. However, before we do that, we need some confirmation from the market of a push higher. While the markets moved higher yesterday, it remains contained in a short-term trading range. We are looking to add further exposure to equities if the market can close above last week’s closing high. 

Importantly, while we are increasing equity exposure, we do so under the following guidelines:

  • We are still overweight cash in portfolios as the “risk” of a failure has not been absolved as of yet,
  • Positions are carrying a “tighter than normal” stop-loss level, and;
  • We will quickly add negative hedges as necessary on any failure of support. 

Earnings Remain The Biggest Concern

While market performance has certainly improved over the last couple of weeks, it remains overall quite disappointing relative to the jump in Q1 earnings. As noted by Upfina last week:

“Earnings growth has been solid even as stocks have been restless. It makes you wonder if earnings results matter in the near term. The chart below reinforces the notion that earnings beats haven’t mattered. 

As you can see, the average price change from 2 days before the report to 2 days after the report shows earnings beats have led to a 0.3% decline instead of a 1.1% increase which is the 5-year average. The stocks meeting and missing results have also fallen more than average. The beat portion of this chart is the most important because most firms beat results. It’s obviously important to figure out if stocks are actually selling off when bad results come out. “

There are two important things to remember about earnings:

  • The first is that earnings consistently beat estimates as analysts reduce estimates heading into the earnings to ensure a high “beat” rate. 
  • The second is that today, more than ever before, earnings are heavily manipulated through accounting gimmicks and share repurchases. 

But more importantly, the market may be sniffing out the specific problem I discussed recently – estimates have gone parabolic.

“Despite a recent surge in market volatility, combined with the drop in equity prices, analysts have “sharpened their pencils” and ratcheted UP their estimates for the end of 2018 and 2019. Earnings are NOW expected to grow at 26.7% annually over the next two years.”

“The chart below shows the changes a bit more clearly. It compares where estimates were on January 1st versus March and April. ‘Optimism’ is, well, ‘exceedingly optimistic’ for the end of 2019.”

It is not just me that is scratching my head over the optimism. As my friend Doug Kass noted yesterday, so is Dr. Ed Yardeni who recently penned much of the same:

I would like to try some of whatever industry analysts are smoking. You can compare my earnings forecasts to their consensus estimates on a weekly basis in YRI S&P 500 Earnings Forecast on our website. I say “tomato.” They say “tomahto.”

My earnings-per-share estimate for 2018 is $155.00 (up 17.4% y/y). The analysts continue to up the ante and are currently at $160.40 (up 21.5%). My estimate for 2019 is $166.00 (up 7.1%). Theirs is $175.72 (up 9.6%). Perhaps the analysts are just high on life.

Their growth estimate for next year seems too high to me since I expect 2019 earnings growth to settle back down to the historical trend of 7%.”

“However, analysts tend to be too optimistic and often lower their estimates as earnings seasons approach.

While the surge in earnings estimates gives cover for Wall Street analysts to predict surging asset prices, the risk has historically been to the downside. This is because Wall Street has historically over-estimated earnings by about 33% on average.

Yes, while a vast majority of companies have beaten estimates in the first quarter, it is only the case because analysts are never held to their original estimates. If they were, 100% of companies would be missing estimates currently. 

At the beginning of January, analysts overestimated earnings by more than $6/share, reported, versus where they are currently. It’s not surprising volatility has picked up as markets try to reconcile valuations to actual earnings.

Economic Growth Is Set To Explode. Right?

Most likely not.

While there was a short-term boost to economic growth last year which was driven by a wave of natural disasters in the U.S., the boost from “rebuilding” is now beginning to fade.

As noted recently by Morgan Stanley (via Zerohedge):

While we are not yet seeing evidence of falling economic growth, we expect — with near- certainty — that we will have a peak rate of change in S&P 500 y/y earnings growth by 3Q thanks to the spike created by the tax cuts. This was something we cited in our 2018 outlook and one of the primary reasons why we thought P/Es would contract. The good news is that this has already occurred.

The risk for further P/E compression comes if markets start to worry that it’s not just a deceleration of growth on the backside of the peak, but an outright decline in growth. Consensus forecasts do not expect negative growth, but it’s worth considering the potential risk of ‘disappointment’ later this year and in 2019, for two reasons.

  • First, earnings growth expectations for 4Q and 2019 look high to us, given the extremely difficult comparisons created by the tax cuts.
  • Second, even in the absence of an economic recession or material slowdown, we do see growing risk to y/y growth of consumer spending due to the extraordinary one-time boosts that began late last year — hurricane relief, tax cuts and the interest in  cryptocurrency, not to mention the seeming euphoria in stock markets in January that looks unlikely to be repeated.

This suggests that the difficult comparisons are not only the result of tax cuts but perhaps better top-line growth that can’t be repeated. I think it’s too early to worry about this risk today, but it’s not too early to start thinking about it and watching for signs of consumer behavior becoming more tempered. I would also throw in the price of crude oil as an important consideration, given that our economics team estimates that close to one-third of the tax cut benefit to the US consumer may have already been removed by the rise in oil and gasoline prices.

The economy is sensitive to changes in interest rates. This is particularly the case when the consumer, which comprises about 70% of the GDP calculation, is already heavily leveraged. With corporations more highly levered than at any other point in history, and dependent on bond issuance for dividend payments and share buybacks, higher interest rates will quickly stem that source of liquidity. Notice that each previous peak was lower.

With economic growth running at lower levels of annualized growth rates, the “bang point” for the Fed’s rate hiking campaign is likely substantially lower as well. Currently, there are few, if any, Wall Street analysts expecting a recession at any point in the future. Unfortunately, it is just a function of time until a recession occurs and earnings fall in tandem.

More importantly, the expectation for a profits-driven surge in asset prices fails to conflate with the reality that valuations have been the most important driver of higher stock prices throughout history.

While we are increasing equity exposure from a “trading” perspective, we remain much more concerned by the in the longer-term from the underlying issues which have been unkind to forward returns:

  • Yields are rising which deflates equity risk premium analysis,
  • Valuations are not cheap,
  • The Fed is extracting liquidity, along with other Central Banks slowing bond purchases, and;
  • Further increases in interest rates will only act as a further brake on economic growth.

Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.

This time will likely be no different.

We remain “cautiously optimistic” and are happy just “riding the bull” for now.

As every good Texan knows, all “bull riders” get thrown if they stay in the saddle too long. The trick is to “hold on tight” with one hand and “dismount and run for safety” when the buzzer sounds.

The consequences of getting thrown have not been kind.

Technically Speaking: Return Of The Bull Or Bull Trap?

In this past weekend’s newsletter, I updated our previous analysis for the breakout of the consolidation process which has been dragging on for the last couple of months. To wit:

“From a bullish perspective there are several points to consider:

  1. The short-term ‘sell signal’ was quickly reversed with the breakout of the consolidation range.
  2. The break above the cluster of resistance (75 and 100-dma and closing high downtrend line) clears the way for an advance back to initial resistance at 2780.
  3. On an intermediate-term basis the “price compression” gives the market enough energy for a further advance. 

With the market close on Friday, we do indeed have a confirmed breakout of the recent consolidation process. Therefore, as stated previously, we reallocated some of our cash back into the equity side of our portfolios.”

It’s now time to make our next set of “guesstimates.”

With the market back to very short-term “overbought” territory, a bit of a pause is likely in order. We currently suspect, with complacency and bullish optimism quickly returning, a further short-term advance towards 2780 is likely.

  • Pathway #1 suggests a break above the next resistance level will quickly put January highs back in view. (20% probability)
  • Pathway #2a shows a rally to resistance, with a pullback to support at the 100-dma, which allows the market to work off some of the short-term overbought condition before making a push higher. (30% probability)
  • Pathway #2b suggests the market continues a consolidation process into the summer building a more protracted “pennant” formation. (30% probability)
  • Pathway #3 fails support at the 100-dma and retests the 200-dma. (20% probability)

Again, these are just “guesses” out of a multitude of potential variations in the future. The reality is that no one knows for sure where the market is heading next. These “pathways” are simply an “educated guess” upon which we can begin to make some portfolio management decisions related to allocations, risk controls, cash levels and positioning.

But while the short-term backdrop is bullish, there is also a rising probability this could be a “trap.” 

“But, while ‘everyone loves a good bullish thesis,’ let me restate the reduction in the markets previous pillars of support:

  • The Fed is raising interest rates and reducing their balance sheet.
  • The yield curve continues to flatten and risks inverting.
  • Credit growth continues to slow suggesting weaker consumption and leads recessions
  • The ECB has started tapering its QE program.
  • Global growth is showing signs of stalling.
  • Domestic growth has weakened.
  • While EPS growth has been strong, year-over-year comparisons will become challenging.
  • Rising energy prices are a tax on consumption
  • Rising interest rates are beginning to challenge the valuation story. 

“While there have been several significant corrective actions since the 2009 low, this is the first correction process where liquidity is being reduced by the Central Banks.”

In 2015-2016 we saw a similar rally off of support lows which failed and ultimately set new lows before central banks global sprung into action to inject liquidity. As I have stated previously, had it not been for those globally coordinated interventions, it is quite likely the market, and the economy, would have experienced a much deeper corrective process.

While the markets have indeed gone through a correction over the last couple of months there is no evidence as of yet that central banks are on the verge of ramping up liquidity. Furthermore, the “synchronized global economic growth” cycle has begun to show “globally synchronized weakness.” This is particularly the case in the U.S. as the boost from the slate of natural disasters last year is fading.

More importantly, on a longer-term basis, the recent corrective process is the same as what has been witnessed during previous market topping processes.

In each previous case, the market experienced a parabolic advance to the initial peak. A correction ensued which was dismissed by the mainstream media, and investors alike, as just a “pause that refreshes.” They were seemingly proved correct as the markets rebounded shortly thereafter and even set all-time highs. Investors, complacent in the belief that “this time was different” (1999 – new paradigm, 2007 – Goldilocks economy), continued to hold out hopes the bull market was set to continue.

That was a mistake.

The difference, in both previous cases, was the Federal Reserve had shifted its stance from accommodative monetary policy, to restrictive, by increasing interest rates to combat the fears of “inflation” and a potential for the economy to “overheat.”

As stated in our list of concerns above, the Federal Reserve remains our biggest “flashpoint” for the continuation of the “bull market.” 

Furthermore, the surge in stock buybacks to pay for “stock option grants” is also worrisome. While such activity will boost the markets in the short-term, there is a longer-term negative consequence. As noted by Barron’s:

“Standard & Poor’s 500 companies are on track to announce $650 billion worth of buybacks this year, according to a Goldman Sachs estimate, smashing the previous record of $589 billion set in 2007.”

But as noted by Societe’ General (via Zerohedge) those buybacks may boost stock prices temporarily but are not likely to show up in the economy longer-term.

“We recognize that calculating the stock option effect is an educated guess as we look at the amount repurchased versus the actual reduction in the share count and assume the difference is the option issuance effect (though issuance can be for other reasons).

It looks like the bulk of last quarter’s repurchases went on stock options (aka wages). But looking at the table below it appears as if buybacks have indeed gone to pay higher wages, but we suspect not in the way policymakers hand in mind.”

Such is a critical point considering that ultimately revenues are driven by economic growth of which 70% is derived from consumption. Boosting wages for the top 20% of wage earners, is not likely to lead to stronger rates of economic growth.

With year-over-year earnings comparisons set to fall beginning in the third quarter of this year, another support of the bull market thesis is being removed.

The biggest challenge of portfolio management is weaving short-term price dynamics (which is solely market psychology) into a long-term fundamentally and economically driven investment thesis.

Yes, with the breakout of the consolidation process last week, we did indeed add exposure to our portfolios as our investment discipline dictates. But such does not mean that we have dismissed our assessment of the risks that currently prevail.

There is a rising possibility the current rally is a “bull trap” rather than the start of a “new leg” in this aging bull market.

This is why we still maintain slightly higher levels of cash holdings in our accounts, remain focused on quality and liquidity, and keep very tight risk controls in place.

Technically Speaking: The “Coiled Spring” Market

In this past weekend’s missive, I discussed the market once again retesting support at the 200-dma.

“As stated, the market did defend its 200-dma and is very close to reversing its short-term ‘sell signal.’”

“That’s the good news.

The not so good news is that while the market did muster a rally on Friday, it still remains well-entrenched within the ongoing consolidation/correction process.”

As you can see in the “reddish triangle,” prices have been continually compressed into an ever smaller trading range. This “compression” is akin to coiling a spring. The more tightly the spring is wound, the more energy it has when it is released.

More importantly, these “compressions” can not go on indefinitely and will resolve themselves. It is a binary outcome. Currently, we have now reached the point where we will likely see a “conclusion” within the next several days to a couple of weeks at the most. So, exactly what does that mean?

When these compressions normally occur in a rising market trend, they historically resolve themselves to the upside. However, as discussed in a moment, there are many factors at work currently which makes “betting” on a positive outcome substantially riskier.

The chart below shows the total expected range, based on the initial decline, of a breakout of the consolidation range. As I discussed this past weekend, I am using a “weekly chart” to smooth out daily volatility which means the next update on the chart will be in this coming weekend’s newsletter.

If the market can break back above the current downtrend from the previous highs, a push to the top of the longer-term overhead bullish trend line is quite logical. That line has served as the peak of the current advance since the conclusion of the correction in early 2016.

A break downward, however, has substantially different connotations. Such a break will likely see the broader market step back to the 2400 level. Such a decline will definitely change the current “tone” of the market toward a more negative bias. If a breakdown does occur, the risk of being more aggressively invested in equities rises markedly.

I continue to “hope” for a more bullish conclusion to this corrective process. We remain invested in equities currently, although we are holding more cash than normal, and a more positive development would allow us to move equity exposure back towards full allocations.

As stated above, while we “hope” for a more bullish outcome, we will “wait” for it to occur before committing more capital towards “risk.”

Remember, “risk” is how much you lose when you are “wrong.” Waiting for the market to “tell us” where it is going next reduces that risk substantially.

We’ve Seen These Before

The rally on Friday and Monday, while certainly encouraging, has been little more than a short-covering, oversold, bounce currently. As noted above, the intermediate-term signals have been little changed as of yet and we have seen these rallies before.

During a corrective process, it is not uncommon to see sharp, reflexive rallies. Also, after two particularly rough months of trading, it would not be surprising to see a month of more positive price action. This is why we continue to give pathways #3a and #3b the most weight currently as noted in the first chart above.

On a longer-term basis, we remain focused on the potential triggering of our longer-term sell-signal. As shown below, these signals are rare and have previously coincided with more serious declines than what we have seen to date. Again, as stated above, the long-term weekly moving average (green line) current intersects at 2400.

More importantly, when long-term indicators turn lower, they tend to precede longer-term correction processes. We previously addressed the massive overbought condition represented by the monthly relative strength index. As shown below, it is not the rise in the RSI that becomes problematic for the market, but the decline. While the extreme extension of the RSI index has begun to decline, it still has a much more to fall before returning back to levels more normally associated with bull market advances. Also, notice that RSI has previously peaked and began to decline several months prior to the onset of a more important corrective period or outright bear market.

Valuations also have begun to decline which tends to lead more important corrective market actions. This is particularly something to watch as we have likely reached peak earnings for this current cycle. (Year-over-year comparisons will begin to become much more problematic as we head into 2019.) 

The chart below is a cyclically-adjusted price to earnings ratio based on a 5-year average of reported earnings. It is a bit more sensitive to market turns than use a 10-year average. (Read this)

The monthly advance-decline line has also started to flatten out and is close to registering a monthly “sell” signal. Again, as with all monthly signals, changes occur on a significantly slower basis and are much more important to pay attention to. Importantly, these signals are only updated AFTER the close of each monthly period so a very sharp rally between now and the end of the month could keep the signal from triggering. It is just something we are paying very close attention to currently.

Lastly, despite the recent corrective process, investors still remain primarily allocated to equities as shown by the Rydex allocation measures below. With the market below its bullish trendline from the 2016 lows, Rydex Bear and Cash allocations remain at low levels while bullish allocations have not fallen much from their recent highs.

If the market does break down out of the current consolidation process, the decline could well be fueled by a sudden shift out of long-asset exposure. In other words, investors haven’t “panicked” yet.

While “everyone loves a good bullish thesis,” the reality is that several changes are occurring simultaneously that have chipped away at the markets previous pillars of support:

  • The Fed is raising interest rates and reducing their balance sheet.
  • The yield curve continues to flatten and risks inverting.
  • Credit growth continues to slow suggesting weaker consumption and leads recessions
  • The ECB has started tapering its QE program.
  • Global growth is showing signs of stalling.
  • Domestic growth has weakened.
  • While EPS growth has been strong, year-over-year comparisons will become challenging.
  • Rising energy prices are a tax on consumption
  • Rising interest rates are beginning to challenge the valuation story. 

While there have been several significant corrective actions since the 2009 low, this is the first correction process where liquidity is being reduced by the Central Banks.

The current correction process is coming to an end, and soon. The only question is simply which way it breaks?

My suspicion is that even if the market breaks out to the upside, the advance may be somewhat limited as investors remain way too “complacent” currently.

Technically Speaking: Bullish Hopes Clash With Bearish Signals

In this past weekend’s missive, I quoted Jeffrey Hirsch, editor of the “StockTrader’s Almanac,” on the entrance of the market into the “seasonally weak” 6-month period for stocks.

“May officially marks the beginning of the ‘Worst Six Months’ for the DJIA and S&P. To wit: ‘Sell in May and go away.’ May has been a tricky month over the years, a well-deserved reputation following the May 6, 2010 ‘flash crash’ and the old ‘May/June disaster area’ from 1965 to 1984. Since 1950, midterm-year Mays rank poorly, #9 DJIA and NASDAQ, #10 S&P 500 and Russell 2000, #8 for Russell 1000. Losses range from 0.1% by Russell 1000 to 1.9% for Russell 2000.

For the near term over the next several weeks the rally may have some legs. But as we get into the summer doldrums and the midterm election campaign battlefront becomes more engaged, we expect the market to soften further during the weakest two-quarter stretch in the 4-year cycle.”

Here is the history of a $10,000 investment.

Despite the weight of evidence to the contrary, the “ever bullishly biased” commentators quickly point out there were many years where the “selling in May” would have left you behind in performance.

But again, the evidence is quite clear.

Nonetheless, as we kick off the month of May, the commentary remains optimistic as earnings have been coming in above already high expectations due to the reduction in corporate tax rates and outstanding float. With the economy still expanding, unemployment rates near lows and consumer confidence near highs – what’s not to love?

From portfolio management viewpoint, it is the disconnect between the “good news” and recent market action that has my full attention.

Warning Signs

While there are many suggesting the recent correction is just a healthy consolidation process within an ongoing “bull market,” which so far it has proved to be, there is a difference between today and previous corrections following the “financial crisis.”

First, The Federal Reserve was still reinvesting proceeds from the bloated $4 Trillion balance sheet, which provided for intermittent pops of liquidity into the financial market. The liquidity is now “running on empty” at a time where interest rates and inflationary pressures are rising.

Secondly, despite all of the good news from the earnings front, as I stated previously, the surge in the market from July of 2017 had already incorporated those expectations. With current prices expecting things to get even better, such may not be the case as the benefit from tax cuts will begin to fade in Q3 as noted next.

“But even if we give Wall Street the benefit of the doubt, and assume their predictions will be correct for the first time in human history, stock prices have already priced in twice the rate of EPS growth.”

Third, as Doug Kass quoted yesterday from Morgan Stanley:

“Our experience tells us that these leaderless periods typically occur during important transitions in the market. So what is that transition today and how can we harness it to make money? Sticking with our original thesis for 2018, we think the market is digesting the fact that the tax cut last year has created a lower quality increase in US earnings growth that almost guarantees a peak rate of change by 3Q. Furthermore, the second order effects of said tax cuts are not all positive.

Specifically, while an increase in capital spending and wages creates a revenue opportunity for some, it also creates higher costs for most. The net result is lower margins, particularly since the tax benefit is 100 percent ‘below the line.’ Now, with the pricing mechanism for every long duration asset- 10-year Treasury yields-rising beyond 3 percent, we have yet another headwind for risk assets.

Perhaps most importantly for US equity indices, these higher rates are calling into question the leadership of the big tech platform companies-the stocks that may have benefited from the QE era of negative real interest rates more than any area of the market. When capital is free, growth is scarce, and the discount rate is negative in real terms, market participants reward business models that can use that capital to grow. Dividends and returns on that capital today are less important with the discount rate so low. But, with real interest rates rising toward 1 percent, that reward structure may be getting challenged…2018 will mark an important cyclical top for US and global equities, led by a deterioration in credit. Narrowness of breadth and a lack of leadership suggest that this topping process is in the works and will ultimately lead to a fully defensive posture in the market later this year”.

Fourth, rising interest rates are a problem. While in the short-term the economy, and the markets (due to momentum), can SEEM TO DEFY the laws of gravity, ultimately they act as a “brake” on economic activity. This is particularly an issue when tax cuts have boosted bottom line earnings per share for corporations, but higher rates, oil prices, and tariffs will begin to lessen that benefit. This not only applies to corporations, but to already cash-strapped consumers which have seen their tax cut vanish through higher health care, food and energy costs.

Fifth, It is important to remember that US markets are not an “island.” What happens in global financial markets will ultimately impact the U.S. The chart below shows the S&P 500 as compared to the MSCI Emerging Markets and Developed International indices. I have highlighted previous peaks and subsequent bear markets as noted by the sell signals in the lower panel. Currently, the weakness in the international markets is being dismissed by investors, but it most likely should not be.

Lack Of Low Hanging Fruit

As we head into the “seasonally weak” period of the year, it may well provide an opportunity for more seasoned and tactical traders. However, for longer-term investors, like me, there is a lack of “low hanging fruit” to harvest particularly given the current backdrop.

The failure of the markets to rally on Monday continues to reinforce the overhead resistance. As shown below, with confirmed weekly “sell” signals in place, it has historically been a good idea to be a bit more “risk adverse.”  More importantly, the market currently remains below its previous bullish trend line, and moving averages, which keeps downward pressure on asset prices currently.

With price action still confirming relative weakness, and the recent rally primarily focused in the largest capitalization based companies, the action remains more reminiscent of a market topping process than the beginning of a new leg of the bull market. As shown in the last chart below, the current “topping process,” when combined with underlying “sell signals,” is very different than the action witnessed in 2011 or 2015. (I will argue the decline that began in 2015 would have likely been substantially larger had it not been for global coordinated Central Bank interventions.)

While I am not suggesting that the market is on the precipice of the next “financial crisis,” I am suggesting that the current market dynamics are not as stable as they were following the correction in 2011 or in 2015. This is particularly the case given the threat of a “tightening” of monetary policy.

The challenge for investors over the next several months will be the navigation of the “seasonally weak” period of the year against a backdrop of warning signals. Importantly, while the “always bullish” media tends to dismiss warning signs as “just being bearish,” historically such unheeded warnings have been detrimental. It is my suspicion this time will likely not be much different.

Technically Speaking: 5-Indicators To Watch

In this past weekend’s newsletter I discussed the market hitting “the wall” last week. This failure at the downtrend resistance keeps us on a defensive posture for now, but still allocated to the market as the longer-term bullish trend remains intact.

I know. It’s confusing.

However, this is the difficultly in navigating potential turning points in the market. It is also the juncture where the majority of investing mistakes are made.

This week, I want to review 5-indicators we are currently watching very closely. Importantly, these are NOT “market-timing” indicators as they are based on longer-term time frames and are slow to change. However, they do have a very strong record of determining important turning points in the market from “bull” to “bear.”

Since we are longer-term investors, our portfolio management process is driven less by short-term volatility, although we do hedge for such, and more towards changes in the trend of prices. While such analysis is “less predictive” and “more reactive” it is important to act accordingly within the portfolio management process when “signals” are issued.

The Stock-Bond Ratio

Something that should be of little surprise to anyone is the relationship between interest rates and equities. When interest rates rise, particularly sharply, it negatively impacts the costs of borrowing, the valuation of capital expenditures from the return on investment, and consumption. This eventually translates into slower rates of economic growth, not to mention recessions, which ultimately translates into a repricing of equity valuation.

The chart below shows that every time rates have reached the top of the long-term downtrend; the market has been impacted within the next 12-month period. Currently, that level on the 10-year Treasury is just a little above 3% on a log-scale.

One way to see this relationship more closely is by looking at the ratio between stocks and bonds. Again, we see that when the ratio, the difference between $SPY and $TLT, is at exceedingly high levels, it has been a good indication of more important inflection points in the market.

The next series of charts focuses on the S&P 500 index and related price indicators on various time scales. Again, as I stated above, we are looking at very long-term measures (quarterly, monthly and weekly) to determine potential changes in market dynamics. This analysis should NOT be used to make shorter-term trading decisions as these indications will take some time to develop. 

As noted, this is where the majority of mistakes are made by investors as in the short-term (days and weeks) the market can certainly seem to defy the analysis. It is at this point where much of the analysis is dismissed under a “this time is different” scenario. However, these signals have, more often than not, given investors “fair warning” to modify inherent portfolio risk.

Quarterly RSI

Quarterly analysis is only useful on an extremely long-term basis as it is extremely slow to change as the data is only valid as of the end of each quarter. However, since the first quarter of 2018 recently ended, we can take a look at the relative price measures for an update.

The top part of the chart is the 3-year relative strength indicator. Via Stockcharts.com:

“Developed by J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. Traditionally, and according to Wilder, RSI is considered overbought when above 70 and oversold when below 30. RSI can also be used to identify the general trend.”

Currently the RSI is registering levels of “overbought” conditions that have only been seen a few times in history. At every one of these points the market has experienced a correctionary period. What separated the price correction from just a “correction within an ongoing bull trend” and an outright a “full-blown mean reverting event” resides on valuation levels when signals were triggered. With valuations currently at the second highest level in history, one should be able to surmise the most likely outcome.

Monthly MACD

If we look at “monthly” price indications we can speed up the signals a bit. This chart looks at the Moving Average Convergence Divergence (MACD) of the 3-year moving average (bottom panel). Via Stockcharts.com

“Developed by Gerald Appel in the late seventies, the Moving Average Convergence/Divergence oscillator (MACD) is one of the simplest and most effective momentum indicators available. The MACD turns two trend-following indicators, moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter moving average. As a result, the MACD offers the best of both worlds: trend following and momentum. The MACD fluctuates above and below the zero line as the moving averages converge, cross and diverge. Traders can look for signal line crossovers, centerline crossovers and divergences to generate signals.”

Importantly, while the actual signal to occur provided sufficient warning to protect capital, the current signal combined with extreme overbought (top panel) conditions and deviations (3-standard deviations of 3-year average) has not previously been linked to “bull market” continuations. With both quarterly and monthly measures suggesting much higher levels of capital risk, the question of “timing” becomes more important.

Weekly Stochastics

The question of “timing” is where speeding up our measures to a “weekly” basis provides more beneficial analysis. In this analysis we look at the 1-year full Stochastic Oscillator.  Via Stockcharts.com

“Developed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. According to an interview with Lane, the Stochastic Oscillator ‘doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.’”

As shown by the vertical blue lines, “sell signals” from high levels, as we are at now, have been good predictors of both corrections and bear markets. The problem is that it doesn’t distinguish between the two. Therefore, as stated, it is best combined with the monthly and quarterly data above to confirm longer-term trends.

Putting It All Together

The chart below pulls all the measures above into a monthly chart. We also add two more confirming indicators – the Coppock Curve and the Ultimate Oscillator. Via Stockcharts.com

The Coppock Curve is a momentum indicator developed by Edwin ‘Sedge’ Coppock, who was an economist by training. Coppock introduced the indicator in Barron’s in October 1965. The goal of this indicator is to identify long-term buying opportunities in the S&P 500. The signal is very simple. Coppock used monthly data to identify buying opportunities when the indicator moved from negative territory to positive territory.”

The Ultimate Oscillator, developed by Larry Williams in 1976, is a momentum oscillator designed to capture momentum across three different time-frames. The multiple time-frame objective seeks to avoid the pitfalls of other oscillators. Many momentum oscillators surge at the beginning of a strong advance and then form a bearish divergence as the advance continues. This is because they are stuck with one time-frame. The Ultimate Oscillator attempts to correct this fault by incorporating longer time-frames into the basic formula.”

What is most important about technical analysis is not to rely solely on one indicator. Such can, and often does, lead to false signals that can impair performance over time though higher volatility, turnover, and emotional wear. This is especially the case with shorter-term signals (daily and weekly) which tends to lead to the assumption that price analysis doesn’t work. However, when several indicators begin to produce the same signals, that “confirmation” provides for a more reliable outcome. (Note that I said “more reliable” not “perfect.”)

Conclusion

With more and more signals on a longer-term basis all sending the same message, investors should be substantially more cautious. This is particularly the case when those longer-term signals are combined with excessively high valuations combined with weak economic growth and rising interest rates. Historically, the combination of these events has led to rather horrible outcomes for investors over the longer-term.

If the market is going to reverse these signals, and reinstate the longer-term bullish trend, the “bulls” need to re-engage immediately and push prices to new highs. However, the longer the market continues to languish, the risk of a deeper correction rises markedly.

Let me restate that we currently maintain short-term equity exposure to the markets as the bullish trend that begin in 2009 remains intact. However, we currently holding a higher level of cash than normal as a hedge against volatility and the lack of a positive risk/reward backdrop with which to deploy “risk” capital.

As I stated in “8-Reasons To Hold Cash:”

“I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity. With the fundamental and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a ‘hedge’ against loss becomes much more important. “

Just remember that while markets are typically irrational in the short-term, they often become rational quicker than you can “sell” in the long-term.

Technically Speaking: Selling The 200 Day Moving Average

This past weekend, I recommended taking action as the market approached our target zone of resistance. To wit:

Nearly a month later, and we are watching the “pathways” play out very close to our “guess.” 

Chart updated through Monday’s close

“More importantly, we continue to trace out the ‘reflexive rally’ path. However, my guess is we are not likely done with this correction process as of yet. From a very short-term perspective, the backdrop has improved to support a continued reflexive rally next week. 

The problem which now arises is the short-term oversold condition, which supported the idea of a “reflexive rally,” has largely been exhausted. Furthermore, the now declining 50-dma, which has also crossed below the 75 and 100-dma as well, suggests that some variation of ‘Option 2’ noted above is likely.

Given the recent rally, and overbought conditions, we are using this rally to follow our basic portfolio management rules. As the market approaches the “neighborhood” of the 100-dma we are:

  • Selling laggards and raising cash.
  • Rebalancing remaining long-equity exposure to comply with portfolio target weightings
  • Rebalancing the total allocation model to comply with target exposure levels.

Note that we are simply rebalancing risks at these levels – not selling everything and going to cash. There is an early “buy signal” combined with the potential for “earnings season” to support asset prices. The goal here is simply to rebalance risks and let the market “confirm” it has re-established its bullish bias.

A Simple Method Of Risk Management

Ben Carlson recently wrote an interesting piece on selling out of the market when it breaks the 200-day moving average (dma). To wit:

“As the legendary hedge fund manager Paul Tudor Jones said:

‘The whole trick to investing is: ‘How do I keep from losing everything?’ If you use the 200-day moving average rule, then you get out. You play defense, and you get out.’

Investors need to be careful about blindly following any indicator that gets them out of the market. There is no guarantee that markets are headed for a crash just because this trend was broken. There are no market timing signals that work every single time, so there’s no telling if the current correction will morph into an all-out bear market.

There are no silver bullets in the stock market. The 200-day moving average will be breached at some point during the next bear market. That’s a given. But it’s not a given that the most recent signal can assure investors a bear market is right around the corner. The majority of the time corrections don’t turn into crashes. History tells us that a false breakdown is a higher-probability event that further deterioration in the markets.”

While there is nothing “incorrect” contained in the article, in my opinion, Ben dismisses the two most important points about the investing and the portfolio management process – capital preservation and time.

The point of using any method of portfolio risk management is to have a strategy, process and discipline to avoid excessive levels of capital destruction over time. Ben is absolutely correct when he states there are no “silver bullets,” but “false positives” from time to time are a relatively small price to pay to avoid the probability of a major “mean reverting event.”

“In fact, the S&P 500 has crossed the 200-day moving average 150 times since 1997. If this were a perfect signal, that would imply 75 separate market corrections.

In reality, in that time, there were only 11 market corrections when stocks fell 10 percent or worse. That means the majority of the time when the S&P 500 went below the 200-day it was a head fake, when investors sold out of the market only to buy back higher.”

Let’s take a closer look.

The chart below is $1000 invested in the S&P 500 in 1997 on a capital appreciation basis only. The reddish line is just a “buy and hold” plot while the blue line is a “switch to cash” when the 200-dma is broken. Even with higher trading costs, the benefit of the strategy is readily apparent.

It’s Not The Method, It’s You

To Ben’s point, what happens to many investors is they get “whipsawed” by short-term volatility. While the signal gets them out, they “fail” to buy back when the signal reverses.

“I just sold out, now I’m supposed to jump back in? What if it crashes again?”

The answers are “yes” and “it doesn’t matter.” That is the just part of the investment strategy. 

But such is incredibly hard to do, which is why the majority of investors fail at investing over time. Adhering to a discipline, any discipline, is hard. Even “buy and hold,” fails when the “pain” exceeds an individuals tolerance for principal loss.

Investing isn’t easy. If it was, everyone would be rich. They aren’t because of the repeated emotional driven investment mistakes over time. This is why every great investor throughout history has had a basic philosophy of “buy low, sell high.”  Of course, you can’t buy low, if you didn’t sell high to begin with?

While there are many sophisticated methods of handling risk within a portfolio, even using a basic method of price analysis, such as a moving average, can be a valuable tool over longer-term holding periods.

Will such a method ALWAYS be right? Absolutely not.

Will such a method keep you from losing large amounts of capital? Absolutely.

Let’s go back further in time. The chart below is WEEKLY data to reduce price volatility and smooth out the signals over time. What becomes readily apparent is that using a basic form of price movement analysis can provide a useful identification of periods when portfolio risk should be REDUCED. Importantly, I did not say risk should be eliminated; just reduced.

Again, I am not implying, suggesting or stating that such signals mean going 100% to cash. What I am suggesting is that when “sell signals” are given it is the time when individuals should perform some basic portfolio risk management such as:

  • Trim back winning positions to original portfolio weights: Investment Rule: Let Winners Run
  • Sell positions that simply are not working (if the position was not working in a rising market, it likely won’t in a declining market.) Investment Rule: Cut Losers Short
  • Hold the cash raised from these activities until the next buying opportunity occurs. Investment Rule: Buy Low

By using some measures, fundamental or technical, to reduce portfolio risk by taking profits as prices/valuations rise, or vice versa, the long-term results of avoiding periods of severe capital loss will outweigh missed short-term gains. Small adjustments can have a significant impact over the long run.

This is shown in the chart below. There is always a big difference between market prices and the impact of losses on an actual dollar-based portfolio. By using a simple method to avoid losses, the differential over the long-term on $1000 is quite significant. (Chart below is capitalization only for example purposes.)

As shown in the chart above, this method doesn’t avoid every little twist and turn of the market, and yes, were many “head fakes” along the way. But what it did do was avoid a bulk of the major market reversions and inherent capital destruction.

Yet, despite two major bear market declines, it never ceases to amaze me that investors still believe that somehow they can invest in a portfolio that will capture all of the upside of the market but will protect them from the losses. Despite being a totally unrealistic objective this “fantasy” leads to excessive risk taking in portfolios which ultimately leads to catastrophic losses. Aligning expectations with reality is the key to building a successful portfolio. Implementing a strong investment discipline, and applying risk-management, is what leads to the achievement of those expectations.

Conclusion

Chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you realize. Two massive bear markets over the last decade have left many individuals further away from retirement than they ever imagined. Furthermore, all investors lost something far more valuable than money – TIME needed to achieve their goal.

While I have stated this many times before, it is worth reiterating that your portfolio should be built around the things that matter most to you.

  • Capital preservation
  • A rate of return sufficient to keep pace with the rate of inflation.
  • Expectations based on realistic objectives.  (The market does not compound at 8%, 6% or 4% every year, losses matter)
  • Higher rates of return require an exponential increase in the underlying risk profile. This tends to not work out well.
  • You can replace lost capital – but you can’t replace lost time. Time is a precious commodity that you cannot afford to waste.
  • Portfolios are time-frame specific. If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.

In hindsight, it is easy to see that investors should have been out of the market in 2001 and 2008. However, remember just prior to those two major market peaks the Wall Street mantra was the same then, as it is today:

“This time is different.” 

The problem, as always, is trying to determine the difference between a “false positive” and a “valid signal.” By the time you know for sure, it is often too late.

Technically Speaking: 10-Reasons The Bull Market Ended In 2018

“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 EmailFacebook or Twitter.


In this past weekend’s newsletter, “Bulls Hang On By A Thread,” I suggested a rally was likely due to the short-term oversold conditions that currently existed. To wit:

“For now, we want to give the bulls the benefit of the doubt, but that ‘bit of rope’ is awfully frayed at this juncture. If the market hits our target zone or breaks support, as shown below, we will reduce portfolio ‘risk’ further.”

“My best guess, at the moment, is that ‘someone’ may well try and talk ‘the Donald’ off his aggressive posture over the weekend. If the markets get some ‘relief,’ a rally back to resistance is likely.”

By Monday morning, the catalyst was in place as statements made by Trump over the weekend, which were described as conciliatory, sent the markets rallying early on the hopes a U.S./China trade war could be averted.

However, while the reflex rally was nice, most of the gains were lost by the close as concerns rose of the FBI’s raid of the office of Michael Cohen, Donald Trump’s attorney, searching for communications between Cohen and the President.

The market just can’t catch a break.

More importantly, the failure to break out of the current downtrend channel is rapidly pulling the 50-dma towards a cross of the 100-dma. Such a downside cross will be “just another brick in the wall” for the continuation of the bull market in the short-term. (My apologies to Pink Floyd.)

The good news is that futures are pointing sharply higher this morning and we should have another shot at a rally. If we can hang on to the rally, it should bring us very close to registering a “short-term buy signal.” Such a signal should theoretically provide enough “gas” to the market for a rally back to the 100-dma or even the previous downtrend line.

I highly suggest you use any substantial rally to reduce risk and rebalance portfolios accordingly. 

Why? Because I am going to out on a limb and making a call.

“I think the 9-year old bull market may have ended in February.” 

I could be wrong. Actually, I hope that I am because managing money is far easier when markets are rising.

However, as I was writing the newsletter, there was a moment of clarity as I penned a list of challenges weighing on the economy, and the markets, which are very different from where we were back in 2009 or even in 2016.

“In 2015, the market plunged as Fed Chair Janet Yellen brought QE3 to its conclusion and started hiking interest rates for the first time in 9-years. Again, this correction would likely have been substantially deeper as the Eurozone faced “Brexit” which sent shocks through the market. The well-timed phone calls to the Bank of England and the European Central Bank by then Fed Chairman Yellen, to take over liquidity operations stemmed the decline. Also as opposed to 2000 and 2007, the Fed had only just started its rate-hiking campaign.”

“Today’s market correction is more aligned with the end of a market cycle versus the beginning of one. The market is facing numerous headwinds that did not exist in 2011 or 2015.”

I want to expand and illustrate that list in today’s update.

1) The Federal Reserve continues to hike interest rates on the short-end pressuring the yield-curve flatter which has never ended well for investors.

2) The Federal Reserve, ECB, and other Central Banks are tapering their liquidity operations. While balance sheets globally continue to expand, the rate of growth is beginning to slow. 

3) Economic growth globally has begun to weaken as the boost to the U.S. economy from 3-hurricanes and 2-major wildfires have started to fade.

 

4) The current Administration is engaging in a “trade war” which potentially impacts various aspects of the economyAs noted by the Heisenberg this past weekend:

“The Trump administration decided to look into the possibility of proposing an additional $100 billion in tariffs on China in retaliation for Beijing’s retaliation”

“The major risk after Thursday evening is that the Trump administration ultimately backs China into a corner by proposing more in tariffs than China imports in U.S. goods. If the U.S. were to up the ante to $150 billion in total tariffs, that would exceed U.S. goods exports to China.

Do you see the problem with that? If not, allow me to quickly explain. It would corner Beijing into going the so-called ‘nuclear route’, and the thing investors need to understand is that China actually has several ‘nuclear’ options, two of which are devaluing the yuan and selling Treasuries.”

5) Valuations remain extremely extended as noted in John Hussman’s latest essay.

“The chart below presents several valuation measures we find most strongly correlated with actual subsequent S&P 500 total returns in market cycles across history. They are presented as percentage deviations from their historical norms. At the January peak, these measures extended about 200% above (three times) historical norms that we associate with average, run-of-the-mill prospects for long-term market returns. No market cycle in history – not even those of recent decades, nor those associated with low interest rates – has ended without taking our most reliable measures of valuation to less than half of their late-January levels.”

“Don’t imagine that a market advance “disproves” concerns about overvaluation. In a steeply overvalued market, further advances typically magnify the losses that follow, ultimately wiping out years, and sometimes more than a decade, of what the market has gained relative to risk-free cash.”

6) Despite the recent turmoil, high-yield spreads remain very compressed which suggests that “fear” has not entered back into the market yet.

7) Interest rates are rising in the areas of the economy that impact consumers directly through variable-rate debt like credit cards. Not surprisingly, rising rates on the short-end are already causing rising delinquency and charge-off rates and falling loan demand. 

8) Price volatility is rising.  Historically, significant increases in weekly point changes have occurred going into, and coming out of, more meaningful market corrections. 

9) Investors are still overly aggressive. Via Bloomberg:

“Perhaps the Markets Message Indicator peak in January will prove only temporary. However, its current warning comes when the indicator is near the peaks of 2000 and 2007,” Paulsen wrote in a note to clients Monday. “That is, it suggests investor confidence and aggressiveness ‘across all financial markets’ is nearly as pronounced today as it was at the last two major stock market tops.”

The same can be seen by investor actions. Via Decision Point

“Note that money has left and continues to trickle out of bear funds. Money market assets remain about the same, so we’re not seeing increased worry or cashing out. In fact, we are seeing money now flowing to bull funds.”

10) Earnings estimates are at a record which leaves plenty of room for disappointment. 

“In fact, Q1 of 2018 has marked the largest increase in the bottom-up EPS estimate during a quarter since FactSet began tracking the quarterly bottom-up EPS estimate in Q2 2002. The previous record for the largest increase in the bottom-up EPS estimate was 4.8%, which occurred in Q2 2004.

“Still, while on the surface, Q1 will be a clear upward outlier, the reality is that most of it (and according to Morgan Stanley, more than all) has already been priced in. Which is a risk because as Reuters reports, while in Q1 corporate America will post its biggest quarterly profit growth in seven years, rising by just over 18% Y/Y…even the smallest disappointments could add to further upset the fragile market.”

Conclusion

The backdrop of the market currently is vastly different than it was during the “taper tantrum” in 2015-2016, or during the corrections following the end of QE1 and QE2.  In those previous cases, the Federal Reserve was directly injecting liquidity and managing expectations of long-term accommodative support. Valuations had been through a fairly significant reversion, and expectations had been extinguished.

None of that support exists currently.

Let me conclude with this quote from John’s recent missive:

“At its core, investment is about valuation. It’s about purchasing a stream of expected future cash flows at a price that’s low enough to result in desirable total returns, at an acceptable level of risk, as those cash flows are delivered over time. The central tools of investment analysis include an understanding of market history, cash flow projection, the extent to which various measures of financial performance can be used as “sufficient statistics” for that very long-term stream of cash flows (which is crucial whenever valuation ratios are used as a shorthand for discounted cash flow analysis), and a command of the basic arithmetic that connects the current price, the future cash flows, and the long-term rate of return.

At its core, speculation is about psychology. It’s about waves of optimism and pessimism that drive fluctuations in price, regardless of valuation. Value investors tend to look down on speculation, particularly extended periods of it. Unfortunately, if a material portion of one’s life must be lived amid episodes of reckless speculation that repeatedly collapse into heaps of ash, one is forced to make a choice. One choice is to imagine that speculation is actually investment, which is what most investors inadvertently do. The other choice is to continue to distinguish speculation from investment, and develop ways to measure and navigate both.

At present, stock market investors are faced with offensively extreme valuations, particularly among the measures best-correlated with actual subsequent market returns across history. Investment merit is absent. Investors largely ignored extreme “overvalued, overbought, overbullish” syndromes through much of the recent half-cycle advance, yet even since 2009, the S&P 500 has lost value, on average, when these syndromes were joined by unfavorable market internals.”

There is a reasonably high possibility, the bull market that started in 2009 has ended. We may not know for a week, a month or even possibly a couple of quarters. Topping processes in markets can take a very long time.

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)

If I am wrong, and the bull market resumes, we simply remove hedges and reallocate equity exposure.

“There is little risk, in managing risk.” 

The end of bull markets can only be verified well after the fact, but therein lies the biggest problem. Waiting for verification requires a greater destruction of capital than we are willing to endure.

As my friend Doug Kass has often written:

“Risk is under-priced, and likely considerably so.” 

“Risk” is simply the function of how much you will lose when you are wrong in your assumptions.

Invest accordingly.

Technically Speaking: The Death Of Bull Markets

“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 EmailFacebook or Twitter.


The big question for investors at the moment is whether the 9-year old bull market has finally come to its inevitable conclusion or is it just a “pause that refreshes?” 

While the optimistic “hope” is that this is just a pause within a continuing “bull market” advance, from a money management standpoint getting the answer “right” is vastly more important to long-term investing outcomes.

The easiest way to approach this analysis is to start with the following basic premise:

“Bull markets are born on pessimism, grow on skepticism, and die on euphoria.” -Sir John Templeton

Take a look at the chart below which is Robert Shiller’s monthly data back to 1871. The “yellow” triangles show periods of extreme undervaluation while the “red” triangles denote periods of excess valuation.

Not surprisingly, 1901, 1929, 1965, 1999, and 2007 were periods of extreme “euphoria” where “this time is different” was a commonly uttered phrase.

What about today? Is this another period of “euphoria” or are investors still maintaining enough “skepticism” to fuel the bull market further? Unfortunately, there is little evidence investors are “skeptical” of much of anything right now.

“However, for now, there is little doubt the bullish bias exists as individuals continue to hold historically high levels of equity and leverage, chasing yield in the riskiest of areas, and maintaining relatively low levels of cash as shown in the charts below.”

But the “euphoria” of individuals is not just solely related to the stock market, but to the whole economy as well. (The chart below is a composite index of the University of Michigan and Census Bureau measures.)

So, why shouldn’t there be “euphoria?”

The stock market has been surging for the last 9-years, unemployment claims are at the lowest levels in more than 30-years and the housing market seems to be firing on all cylinders.

What’s not to love? But that’s the point.

Bull Markets Die Of Euphoria

The reason that bull markets die of euphoria is that market prices, particularly in the “momentum” stage of the investing cycle, are based on the assumption the current cycle will continue into perpetuity. Earnings, the economy, sales, etc. will continue to expand in a linear fashion…forever.

Since the economy, as well as virtually everything in life, is cyclical, it is only logical that eventually the disappointment of those assumptions sparks the beginning of the next bear market cycle.

Currently, the list of things that could disappoint the markets continues to grow:

  • The ongoing rhetoric from Washington over “trade wars” combined with complete fiscal irresponsibility, 
  • The reduction in support from Central Banks in terms of liquidity support.
  • The continued insistence of the Fed to hike rates which continues to reduce the “low rate supports higher valuations” argument.
  • The risk of further contagion from Facebook and other “big data” companies on the technology sector (which comprises roughly 25% of the S&P 500) as global threats of “internet taxes” or other data collection policies are considered.
  • Revenue growth continues to remain weak which is leading to downward revisions in earnings estimates.
  • Both domestic and international economic growth have peaked.
  • Inflationary pressures from wage growth remain non-existent while the cost of living continues to rise (this will be exacerbated by Trump’s “trade wars.”)
  • The yield curve continues to deteriorate and LIBOR has blown out which have typically been early warning signs of bad outcomes. 

From a fundamental perspective, the bulls are losing much of the argument there as well. As my friend David Rosenberg recently penned (via Mauldin Economics):

“Dave Rosenberg used four different S&P 500 valuation metrics:

  • Forward Price to Earnings Ratio
  • Price to Sales Ratio
  • Price to Book Value Ratio
  • Enterprise Value to EBITDA Ratio

He then calculated the percentage of time that each of these had been at its present level or below. Here’s the result for P/E ratio.

The S&P 500 forward P/E ratio has been below its present level 83% of the time since 1990. Repeating that exercise for the other three metrics and then averaging them, Dave found the index is presently at a 92nd percentile valuation event.

Here’s Dave, from the transcript, with my bold added:

In other words, only 8% of the time in the past has the stock market in the United States been as richly priced as it is today. And if you want to come up with reasons why that’s the case, that’s fine. But just understand that we are extremely pricey. We’re more than just a one standard deviation event versus the historical average.

Dave then showed this surprising table, comparing historic bull markets with GDP change during the same period.

The 2009–2018 bull market from trough to peak averaged 17.3% annually. Nominal GDP rose 3.6% annually during that time, and real GDP rose 2.1%. Go up the table to the 1982–1990 bull run. It reached a similar magnitude at 17.5%, but nominal GDP rose 7.6% and real GDP 4.2%.

Yes, GDP has its flaws. Today’s economy isn’t like the 1980s. Nonetheless, how is it that stocks rose the same amount on half as much economic growth? Dave said that if the stock-GDP ratio today had remained what it was back then, the S&P 500 would be around 1,550 today.

That’s how excessive valuations are now.”

Okay. you get the idea. There is little evidence to support the “bullish case” other than “sentiment based” data which can, and does, change very rapidly.

When that change in sentiment is combined with extremely elevated, extended and bullish prices, the subsequent “mean reverting” event has been exceptionally nasty. Even with the recent “pause,” the market remains extremely extended and overbought.

Just how big of a correction from these levels would it be? As I detailed this past weekend:

“The key levels from a price perspective are as follows:

  • 2600 – Market holds at current correction levels and resumes bullish trend (optimistic)
  • 2400 – Good support lies at 2400 but a 16% correction is painful. Long-term bullish trends remain intact.
  • 2200 – Strong support from previous correction breakout. Official “bear market” with near 24% decline.
  • 2050 – Economy likely in a recession at this point. Bear market grows with a 29% decline
  • 1800 – There is likely a lot going wrong at this juncture and a 37% decline has destroyed most portfolios.

The important lesson here is not to debate on why the bull market will likely resume. Such could very well be the outcome particularly if global Central Banks leap back into action. The lesson is to understand the varying degrees of portfolio risk and have a plan to react if things go wrong.

As I noted last week, missing out on a rally in the market is extremely easy to make up. Recouping lost capital is an entirely different matter.”

Managing Past The Noise

There are obviously many more arguments for both camps depending on your personal bias. But there is the rub. YOUR personal bias may be leading you astray as “cognitive biases” impair investor returns over time.

“Confirmation bias, also called my side bias, is the tendency to search for, interpret, and remember information in a way that confirms one’s preconceptions or working hypotheses. It is a systematic error of inductive reasoning.”

Therefore, it is important to consider both sides of the current debate in order to make logical, rather than emotional, decisions about current portfolio allocations and risk management.

Currently, the “bulls” are still in control of the market. The long-term running bull trend remains intact…for now. The chart below is a MONTHLY chart of the S&P 500 from 2008 to present. What you see is that the bullish trend that began in 2009 remains at the moment and a correction back to that trendline would encompass a nearly 20% decline from recent highs.

However, the real questions is whether this is simply a correction within the longer-trending bull market, or is the initiation of the monthly “sell signal” coincident with the previous late-2007 signal that developed into a major “mean reverting” event?  (As a side note, the monthly “sell signal” was also triggered in mid-1999 and no one paid attention then either.)

I am not willing to “ride this out” waiting to see what happens. As noted in the chart below, the market is oversold enough on a short-term basis for a reflexive rally to either the top of the current downtrend channel (2625ish) or the 100-dma (2675ish). In both cases, we will be further reducing equity exposure, rebalancing risks and adding hedges to portfolios.

If the market “heals up” and begins a stronger, fundamentally based recovery, we will redeploy capital accordingly. If not, and the market enters a bigger corrective process, the excess levels of cash will hedge portfolios against further destruction of capital.

Here are some basic guidelines we follow in our process.

  1. Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.
  2. Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.
  3. Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

These rules are hard to follow because:

  1. The bulk of financial advice only tells you to “buy”
  2. The vast majority of analysts ratings are “buy”
  3. And Wall Street needs you to “buy” so they have someone to sell their products to.

With everyone telling you to “buy” it is easy to understand why individuals have a such a difficult and poor track record of managing their money.

While “bearish” concerns are often dismissed when markets are rising, it does not mean they aren’t valid. Unfortunately, by the time the “herd” is alerted to a shift in overall sentiment, the stampede for the exits will already be well underway. Just remember, the process of “getting back to even” is not an investment strategy that will work over the long term.

Is the current bull market dead? I don’t know, and trying to predict the market is quite pointless. The risk for investors is the “willful blindness of change” until it is far too late to matter. Just remember, no one thought the “bull market was dead” in 1999 and 2007 either. 

I don’t need to remind you what happened next.

Technically Speaking: Predictions, Market Bounce & Risks

“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 EmailFacebook or Twitter.


I love trolls.

Seeking Alpha, which should be part of your daily reading process, has been graciously posting my articles for the last couple of years.

One of my favorite things to do is read the comments from readers. Most of the comments are generally insightful, well-intentioned, contribute to the community and inspire thought particularly when they disagree with my own views.

Then, there are the “trolls.”

“Trolls” are anonymous posters who have nothing better to do with their lives than try to degrade the dialog, and the intellectual commentary and community, by posting diatribe which shows their own lack of intellect, experience and, human decency.

Generally, I don’t waste my time responding to them but a comment to last weekend’s newsletter showed a clear lack of understanding about portfolio management and the investing process as whole. (Notice the anonymous handle)

5731311 – Every week I want to write an article crying wolf calling for a market crash, but actually stay fully invested. Then I will also offer 3 mutually exclusive scenarios for the near term. Then next week, I will say – see, I told you so, I was right on one of my predictions. I’m a genius.”

First, I have the “cojones” to analyze, write and publish on a very regular basis. “Trolls” hide behind anonymity as they don’t have the backbone to publish their own views and open themselves up for public scrutiny.

Secondly, if you actually read my articles you will already know that I have not been calling “for”a market crash, but rather pointing out that one is inevitable since such is part of the “boom/bust” cycle of the markets.

Lastly, yes, I absolutely offered 3-potential outcomes for the near term in this past weekend’s missive, to wit:

“Considering all those factors, I begin to layout the “possible” paths the market could take from here. I quickly ran into the problem of there being “too many” potential paths the market could take to make a legible chart for discussion purposes. However, the bulk of the paths took some form of the three I have listed below.”

  • Option 1: The market regains its bullish underpinnings, the correction concludes and the next leg of the current bull market cycle continues. It will not be a straight line higher of course, but the overall trajectory will be a pattern of rising bottoms as upper resistance levels are met and breached. (20%)
  • Option 2: The market, given the current oversold condition, provides for a reflexive bounce to the 100-dma and fails. This is where the majority of the possible paths open up. (50%)
  • The market fails at the 100-dma and then resumes the current path of decline violating the current bullish trend and officially starting the next bear market cycle. (40%)
  • The market fails at the 100-dma but maintains support at the 200-dma and begins to build a base of support to move higher. (Option 1 or 3) (20%)
  • The market fails at the 100-dma, finds support at the 200-dma, makes another rally attempt higher and then fails again resuming the current bearish path lower. (40%)
  • Option 3: The market struggles higher to the previous “double top” set in February, retraces back to the 100-dma and then moves higher. (30%)

Why all the options? Why not just draw a straight line down to zero, or up to 1 million, depending on your relative bullishness or bearishness?

Because that is not how portfolio management works.

The Best Forecasters On The Planet

A couple of years ago there was a study of a variety of forecasters – economists, financial experts, psychics, meteorologists, etc. The goal of the study was to determine the accuracy of forecasts that were given.

It turned out that meteorologists were the most accurate forecasters of the future.

How far into the future could the accurately forecast? 3-days.

“Even Punxsutawney Phil currently has an arrest warrant issued because ‘cold weather’ lasted longer than the six-weeks his shadow forecasted.”

So, for the “reading impaired,” or just the “investment illiterate,” it should already be readily apparent that no one can accurately predict the markets weeks, or months, in advance.

That is also not my job. Or yours.

In virtually every professional field there is “risk.” 

In any given profession, those who fail to focus on, and recognize, the inherent risk, more commonly known as ” being reckless,” tend not to be around very long. What has always separated the “winners” from “losers,” are those that can avoid the catastrophic damage over time.

Think about Tom Brady who is one of the greatest NFL quarterbacks to ever play the sport. Yes, he is indeed extremely skilled and talented, however, if he is injured he can not play. Therefore, he has become quite famous over the last couple of years with respect to his personal training and nutrition regimen. He controls, to the best of his ability, the “risk” of injury by focusing on the things he CAN control – his health and fitness.

The control of “risk: is also the very essence of portfolio management.

My job, as a portfolio manager, is simply to take all of the relevant data at my disposable and begin to weigh possibilities and probabilities about potential future outcomes. Without such a thought process, how can determinations on allocations, exposure, controls, etc. be made?

For investors, understanding risk is an important concept as it is a function of “loss”. The more risk that is taken within a portfolio, the greater the destruction of capital will be when reversions occur.

When investors lose money in the market it is possible to regain the lost principal given enough time, however, what can never be recovered is the lost “time” between today and the required financial goal. In other words, the destruction of “time” is a permanent impairment to the portfolio.

Making absolute predictions about the future, bullish or bearish, is not only useless, but inherently dangerous with respect to portfolio management. What can do is make educated “guesses” about potential outcomes based on history, statistics, trends, etc. in order to better control risk in portfolios and avoid permanent impairment of capital.

Decisions To Make

In the newsletter I stated:

“As I noted above, the market is 2-standard deviations oversold and testing the 200-dma on a very short-term basis. This is not surprising, as by the time ‘sell signals’ are triggered on a weekly basis, the market is generally ‘oversold’ enough to elicit a ‘reflexive’ bounce.

On Monday, the market did indeed bounce off of the 200-dma. However, that bounce does not change our stated objectives for rebalancing portfolios currently.

Currently, the market remains below the accelerated and bullish trend lines confirming both sets of “sell” signals currently registered.

“This week, the markets broke on several fronts which have triggered confirmed ‘sell signals’ on several levels requiring a reduction in equity risk exposure. In accordance with the model adjustments above, begin reducing portfolio equity weighting by 25% on any failed rally attempts.”

“IMPORTANTLY – this does NOT mean go ‘sell’ everything Monday morning. As noted above in the main analysis, we are slightly reducing equity exposure on a rally to hedge risks of a further decline until the current volatility phase passes. 

Importantly, as always, portfolio management is about making SMALL adjustments as evidence presents itself and should never be perceived as an ‘all or nothing’ issue.

Read that last part again.

With the market oversold, we are looking for a rally to the 100-dma to further rebalance portfolio risks. (We have been doing this already over the last several weeks and have been underweight equity and overweight cash.)

However, my guess is we are not likely done with this correctionary process as of yet.

That “feeling” was confirmed by the recent analysis from Decision Point:

“I am assuming that we are in a bear market. Not all of the technical signs have been triggered, but market behavior has me convinced. I want to emphasize that the parabolic advance and breakdown in January/February was the first and most convincing event pushing me into the bear camp. Now the IT Trend Model for SPY has changed from BUY to NEUTRAL (soft SELL), and price action is uninspiring, to say the least.

(A NEUTRAL signal is a ‘soft’ SELL signal because the position is cash or fully hedged, not short.)

“Obviously, the market is in the process of retesting the February lows. I can make a case for price finding support on the 200EMA and the bull market rising trend line, but, if I’m right about the bear market, that support won’t hold for long, if at all.”

Changing Facts

As I stated, portfolio management is about making small adjustments over time to “react” to what the market is doing.

So, what if I’m wrong?

What if the market just rockets immediately higher and reverses the current “sell signals?”

Well, then we simply invest capital back into the equity markets and take allocations back up to 100% of target.

What if the market breaks below the 200-dma?

Then we will reduce allocations further.

It’s not complicated.

It’s just a process.

There is an extremely high probability the market will not trace out any of my options listed above. But, as Nobel laureate, Dr. Paul Samuelson, once quipped:

Well, when events change, I change my mind. What do you do?”

Our job as investors is to navigate the waters within which we currently sail, not the waters we think we will sail in later. 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.

As I have stated before, as a portfolio manager, I am neither bullish or bearish. I simply view the world through the lens of statistics and probabilities. My job is to manage the inherent risk to investment capital. If I protect the investment capital in the short term – the long-term capital appreciation will take of itself.

For those that wish to remain “reading impaired,” there is always “hope” as an investment strategy.

Technically Speaking: The “Walking Dead” Market – 3000 or 1500?

“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 EmailFacebook or Twitter.


In May of last year, I wrote a blog post debating the likely path of the market through 2019. To wit:

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

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

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

Since that time, tax cuts/reform have been passed, earnings estimates have exploded higher, and corporate stock buybacks have surged to record levels while wage growth has remained non-existent for the bottom 80% of workers.

Not surprisingly, with those tailwinds, the market has pushed sharply higher towards our original target of 3000.

Currently, the pathway that target remains intact along with the longer-term bullish trend. However, the risk of a deeper correction, particularly given the signs of current economic weakness and weaker than anticipated revenue growth, continues to prevail.

Let me repeat, for those who may be “hard of reading,” the bullish trend remains intact and corrections should remain confined to the bullish trend for now which has been the case since 2009.

From the bullish perspective, a run to 3000, assuming the current consolidation completes successfully, is still a possibility as I detailed in last weekend’s missive:

“While I gave option (1) the greatest odds, it was option (2) that came to fruition as shown in the updated chart below.”

Chart updated through Monday

“The predicted path of decline, so far, has held at the 50-dma, which is bullish. However, the overbought condition, combined with the previous resistance level, proved too formidable for investors to push the market higher.”

On Monday the market broke back through the 50-dma and retested the top of the downtrend line which coincides with the 75-dma. Importantly, the short-term “buy signal” is threatening to reverse which could provide further selling pressure if it occurs.

This breakdown on Monday has not yet completely broken the “bullish case” for the market yet, however, a failed rally from current levels will bring “Option 3” into focus.

With the recent failure at the previous resistance level, we can now adjust our consolidation process for the market.

As long as the pattern of “higher lows” remains, a breakout above the current downtrend line and resistance should signal a move to old highs and the current 2018 target of 3000.

However, a break below the uptrend line will confirm a change to the current market and will require a shift in allocations to a more neutral stance.

We are potentially at a very critical juncture of this particular “bull market cycle,” and as Doug Kass noted yesterday:

“I expect a 2018 trading range of 2200-2850 – with a ‘fair market value’ (based on higher interest rates, disappointing economic and corporate profit growth, political and geopolitical uncertainties) of approximately 2400.

Compared to the expected trading range, downside risk relative to upside reward is approximately 5x.

Against ‘fair market value’ (based on my probability distribution of a host of independent variables – interest rates, inflation, corporate profits, economic growth, valuations, etc.) downside risk relative to upside reward is about 3x.”

I agree.

Risk/Reward Not Rewarding

My numbers are a little different than Doug’s but the premise is the same.

Given the length of the economic and market cycle, there is a significant bear case being built which entails a pullback towards the 2100 level. Such a decline, while well within historical norms, would wipe out all gains going back to 2015. 

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

  • 3000 – 2733 (as of Monday’s close) =  267 Points Of Potential Reward 
  • 2733 – 2100 = -633 Points Of Potential Loss

With a 2.37 to 1 risk/reward ratio, the potential for losses is far more damaging to your long-term investment goals than the gains available from here.

Moreover, the bearish case is also well supported by the technical dynamics of the market going back to the 1920’s. (The red lines denote levels that have marked previous bull market peaks.)

It is important to note that a full “mean-reverting event,” which has occurred numerous times throughout history will currently wipe out all stock market gains going back to 2000.

For investors planning on retirement, this eventual reality will devastate those goals. It will also correspond with the often repeated warnings of current stock market valuations (which are repeatedly scoffed out by the mainstream media.)

“What drives stock prices (long-term) is the value of what you pay today for a future share of the company’s earnings in the future. Simply put – ‘it’s valuations, stupid.’  

That’s banal, I know, but everyone seems to forget it. And it means equity returns depend on how much you pay for their future profits, not on how much price volatility you can endure.”

With valuations at levels that have historically been coincident with the end, rather than the beginning, of bull markets, the expectation of future returns should be adjusted lower. This expectation is supported in the chart below which compares valuations to forward 10-year market returns.”

“The function of math is pretty simple – the more you pay, the less you get.”

Whether Doug’s numbers are correct, or mine, it will make little difference. The simple fact is that all “bull markets” do end.

The difference is identifying and reacting to the change when, not if, it occurs which is what will separate “Survivors” from the “Walking Dead.”

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

However, without a sharp improvement in the underlying fundamental and economic backdrop, the risk of failure is rising sharply. Unfortunately, there is little evidence of such a rapid improvement is in the making.

There are two laws of physics worth remembering:

  1. What goes up…must come down, and;
  2. Gravity is a bitch.

Technically Speaking: Chart Of The Year?

Well, I jinxed it.

In this past weekend’s missive I wrote:

“There are generally two events that happen every year – somebody forgets their coat, goggles or some other article of clothing needed for skiing, and someone visits the emergency clinic with a minor injury.”

The tradition continues as my wife fell and tore her ACL. The good news is she tore the right one three years ago, and after surgery is stronger than ever. Now she will get to do the left one.

But, while I was sitting in the emergency clinic waiting for the x-rays to be completed, I was sent a chart of the technology sector with a simple note: “Chart Of The Year.”

Chart Of The Year

Yes, the technology sector has broken out to an all-time high. Yes, given the sector comprises roughly 25% of the S&P 500, it suggests that momentum is alive and well keeping the “bullish bias” intact. (We removed our hedges last week on the breakout of the market above the 50-dma on a weekly basis.)

This is why we are currently only slightly underweight technology within our portfolio allocation models as shown below.

But why “the chart of the year” now? As shown below the technology sector has broken out to all-time highs several times over the last 18-months. What makes this one so special?

The Last Breakout

As stated, breakouts are indeed bullish and suggest higher prices in the short-term. This time is likely no different. However, breakouts to new highs are not ALWAYS as bullish as they seem in the heat of the moment. A quick glance at history shows there is always a “last” break out of every advance.

1999-2000

2007-2008

As I discussed yesterday, the technology sector is once again the darling of “Wall Street” just as it was at the peak of the previous two bull-markets.

“When we compare the fund to Shiller’s CAPE ratio, not surprisingly, since Technology makes up a quarter of the S&P 500 index, there is a high correlation between Technology and overall market valuation expansion and contraction.”

“As was the case in 1998-2000, the fund exploded higher as exuberance over the transformation of the world was occurring before our eyes. Investors globally were willing to pay “any price” to “get in on the action.”  Currently, investors are once again chasing returns in the “FANG” stocks with little regard to underlying value. The near vertical ramp in the fund is reminiscent of the late 1990’s as valuations continue to escalate higher.”

I am not suggesting the current breakout is “THE” last breakout, and from a “trading perspective” the breakout is certainly bullish and should be bought.

However, from a long-term investing viewpoint, the problem is knowing the difference in a “breakout” and “the last breakout.”

In both previous instances, there were no warnings, no fanfare, or any glaring impediment to the technology sector, or the markets. Investors were bullishly optimistic, fully invested, margined, and willing to overlook fundamental valuation problems on the “hope” that “reality” would soon catch up with the price.

They were wrong on both previous occasions and suffered large losses of capital not soon thereafter.

Once again, we are witnessing the same mistakes being played out in “real time.”

But there is a “difference this time” as noted by the brilliant Harold Malmgren yesterday;

The importance of the point should not be overlooked as it has been the key source of liquidity pushing markets higher since 2009.

But that is now coming to an end via ZeroHedge:

“Yet the time of this unprecedented monetary experiment is coming to an end as we are finally nearing the point where due to a growing shortage of eligible collateral, the central bank support wheels will soon come off (the ECB and BOJ are still buying massive amounts of bonds and equities each month), resulting in gravity finally regaining control over the market’s surreal trendline.

It’s not just central banks, however: also add the one nation which 5 years ago we first showed has put the central bank complex to shame with the amount of debt it has injected in the global financial system: China.

Appropriately, this central bank handoff is also the topic of the latest presentation by Matt King, in which the Citi credit  strategist once again repeats that “it’s the flow, not the stock that matters“, a point we’ve made since 2012, and underscores it by warning – yet again – that “both the world’s leading marginal buyers are in retreat.” He is referring to central banks and China, the world’s two biggest market manipulators and sources of capital misallocations.”

With markets heavily leveraged, global growth beginning to show signs of deterioration, breakeven inflation rates falling, and liquidity support being removed – the markets have yet to recognize the change.

So, yes, the breakout in the Technology sector may indeed be the “Chart Of The Year” for 2018. But not for the reason as touted by the overly optimistic “hopefuls,” rather because this could very well mark the “last breakout” of this particular bull market cycle.

Just something to consider.