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Technically Speaking: Monthly “Buy Signal” Say Bull Is Back? But For How Long?

Just recently, there have been numerous “bullishly biased” analysts and bloggers discussing the turn up in the monthly MACD indicators as a “sure sign” the bull market rally is set to continue.

While “bullish buy signals” on any long-term indicator is indeed a positive sign, there are a few “warning labels” which must also be considered. For example:

  1. Since these are monthly indicators, the signal is only valid at the end of the month. Mid-month signals can be reversed by sharp price movements.
  2. No one signal provides any “certainty” about future market outcomes.
  3. Time frames of signals matter. Given monthly signals are long-term in nature, the signal time frames are important in providing actionable information.

So, is the bull market back?

That’s the answer we all want to know.

Each week on RIA PRO we provide an update on all of the major markets for trading purposes. You can view an unlocked version here. (We also do the same analysis for each S&P 500 sector, selected portfolio holdings, and commodities. You can try RIA PRO FREE for 30-days)

But as longer-term investors and portfolio managers, we are more interested in the overall trend of the market. While it is fundamental analysis derives “what” we buy, it is the long-term “price” analysis which determines the “when” of the buying and selling aspects of portfolio management over the long-term.

For us, the best measures of the TREND of the market is through longer-term weekly and monthly data. Importantly, as noted above, these longer-term data signals are only valid at the end of the period. It is not uncommon for signals to be triggered and reversed during the middle of the period, which creates “false” signals, and poor outcomes. Since we are more interested in discerning changes to the overall “trend” of the market, we find monthly indicators, which are slow-moving, tend to reveal this more clearly.

In April of 2018, I penned an article entitled 10-Reasons The Bull Market Ended,” in which we discussed the yield curve, slowing economic growth, valuations, volatility, and sentiment. Of course, 2018 turned out to be a tough year culminating in a 20% slide into the end of the year. Since then, we have daily reminders we are “close to a trade deal,” and the Fed has completely reversed course on hiking rates and extracting liquidity. In July, we published S&P 3300, The Bull Vs. Bear Case.

While volatility and sentiment have reverted back to levels of more extreme complacency, the fundamental and economic backdrop has deteriorated further.

The first chart shows the monthly buy/sell signals stretched back to 1995 (25 Years). As shown, these monthly “buy” and “sell” indications are fairly rare over that stretch. What is interesting, is that since 2015 there have been two-major sell signals, both of which were arrested by Central Bank interventions.

Importantly, while Central Bank interventions have been able to halt declines, the trade-off has been a negative divergence in overall momentum. This negative divergence in momentum suggests that the current monthly “buy signal,” if it is able to hold through the end of December, could quickly reverse if the Fed ceases, or reduces, its current monetary interventions.

With global economic growth continuing to drag, an unresolved “trade war,””Brexit,” and weaker earnings growth, the question is whether Central Banks can accommodate the markets long-enough for all of these more negative issues to be resolved?

Given that we are 10-years into a “cyclical” bull market, and have yet to complete the second half of the “full-market” cycle, there is risk to the bullish view.

I know…I know…

“But this time is different because of ‘_(fill in the blank__'”

Maybe, I certainly won’t argue the point of Central Bankers manipulating markets currently.

However, we can take those same monthly momentum indicator above back to 1950, and add two confirming monthly indicators as well. The vertical “red dashed lines” are when all three indicators have aligned which reduces false signals.

I can’t believe I have to write the next sentence, but if I don’t, I invariably get an email saying “but if you sold out, you missed the whole rally.”

What should be obvious is that while the monthly “sell” signals have gotten you out to avoid more substantial destruction of capital, the reversal of those signals were signs to “get back in.”

Investing, long-term, is about both deployment of capital and the preservation of it.

Currently, the monthly indicators have all aligned to “confirm” a “buy signal,” which since 1950 has been a good indication of rising markets. Yes, the bull market is back! However, when these signals have existed in a “negative tren,d,” and are diverging from the market, corrections have often followed. While the most current buy signal could indeed last for 6-months to one-year, which would conform to our cyclical indications, there are several things to consider:

  1. As was seen in the 1960s and 70s, “buy signals” in the negative trend led to repeated rallies and corrections until the cycle was completed at the bottom of the 1974 bear market.
  2. A rising trend in the “buy signals” was more aligned with a longer-term “secular” bull market cycle which consisted of very short-term sell signals.
  3. With markets very overbought on a longer-term basis, price advances could be somewhat limited.

Yes, the recent “buy” signal could turn out to be a “1995” scenario where the market rallied almost non-stop into the “Dot.com” crash, but the fundamental and technical backdrop doesn’t really support that thesis.

Furthermore, the QUARTERLY chart remain concerning given the massive extension above the long-term trend and continued overbought conditions. Historically, reversions from such extensions above the long-term trend line have not been kind to investors.

Let me be VERY clear. Both the MONTHLY and QUARTERLY signals confirm the “bull market” that began in 2009 remains intact currently.  This is why we are maintaining our long-biased exposure in portfolios. However, the current market cycle is extremely extended and is approaching a reversion within the next 12-24 months. That reversion will likely extract most of the gains of the previous bull market. As noted this past weekend, such an occurrence would be part of a normal full-market cycle.

One of the biggest reasons not to equate the current monthly “buy” signal to a “1995” type period is valuations. In 1987, valuations were low and rising at a time where interest rates and inflation were high and falling. Today, that economic and valuation backdrop are entirely reversed.

Currently, a correction from current price levels of the market to PE20 (20x current earnings) would be a 13.8% decline. However, a drop back to the long-term average of PE15 would entail a 34.8% fall, with a full-reversion to PE10, which would be required to “reset” the market, would wipe our 56.2% of the total market value.

Emotionally, the hardest thing for investors to do is to sit on their hands and avoid “risk” when the markets are rising. But this is the psychological issue which plagues all investors over time which is to “buy high” and “sell low.”

It happens to everyone.

David Rosenberg previously summed up investor sentiment very well.

“Well, the bulls certainly are emboldened, there isn’t any doubt about that. And this confidence, bordering on hubris, is proving very difficult to break. We are back to good news being good news, and bad news is also treated as good news.”

That is indeed the situation currently. “Bad news” means more Central Bank intervention, and “good news” is, well, just good news and is taken at face value with few questions. Don’t forget that “all good things do eventually end,” and being able to identify, and act, when the change comes is what separates winners from losers.

What This Means And Doesn’t Mean

At a poker table, if you have a “so so” hand, you bet less, or fold. It doesn’t mean you get up and leave the table altogether.

What this analysis DOES MEAN is we use this rally to take some actions to rebalance portfolios to align with some the “concerns” discussed above.

  • Trim Winning Positions back to their original portfolio weightings. (ie. Take profits)
  • Sell Those Positions That Aren’t Working. If they don’t rally with the market during a bounce, they are going to decline more when the market sells off again.
  • Move Trailing Stop Losses Up to new levels.
  • Review Your Portfolio Allocation Relative To Your Risk Tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

Here is the question you need to answer for yourself. What’s worse:

  1. Missing out temporarily on the initial stages of a longer-term advance, or;
  2. Spending time getting back to even, which is not the same as making money?

Currently, the monthly and quarterly indicators are indeed bullish. However, it is important to remember that it takes some time for these indicators to reverse, and issue clear signals to extract cash from the market. Currently, the risk of disappointment greatly outweighs the potential for upside surprises at this juncture.

What happens next may just surprise everyone.

Technically Speaking: Running On Empty

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Running On Empty

“Running On Empty” was an iconic song about life on the road as a traveling musician. The 1977 live recording, which became a 1978 hit for Jackson Browne, is considered one of true representatives of Heartland Rock, and a concert favorite.

When Jackson Browne was interviewed about the song by Rolling Stone Magazine, at the time he was recording the album “The Pretender” he said:

I was always driving around with no gas in the car. I just never bothered to fill up the tank because — how far was it anyway? Just a few blocks.

“Running on, running on empty
Running on, running blind
Running on, running into the sun
But I’m running behind”

Those lyrics are not so far and apart from where we are in the markets today.

As we discussed this past weekend, everyone is in the car driving along with no worries about how much “gas is in the tank.” 

Yes, since investors did sell the December lows, they are now buying the February-March highs. But to Doug’s point, investors are still heavily weighted towards equity.”

More importantly, they are getting long at a time where volatility has once again become extremely low which has historically led to negative outcomes.

“Lastly, market ‘complacency’ is back to levels which have denoted short-term corrections in the market previously with near record levels of short-volatility positioning.”

After four months on advances in the market, investors have once again been lured back into the belief that markets are a “one way trip higher.”

As noted by the Wall Street Journal on Monday:

“Sentiment is incredibly bullish. So many people are chasing performance now.” – Nancy Davis, CIO at Quadratic Capital Management.

She is right.

Currently, momentum and growth stocks are substantially outperforming value oriented stocks.

But investors are paying an excruciatingly high premium for that performance. Michael Lebowitz recently ran the analysis for our RIA PRO subscribers (Get A FREE 30-Day Trial)

Growth Stocks vs. Value Stocks

  • Price/Sales: 8x more
  • Price/Book: 16x more
  • Price/Cash Flow: 7x more
  • Dividend Yield: 5% less yield.

More importantly, our “Greed/Fear Gauge,” which is based on allocation exposure, is back to historically high levels.

Investors are current extremely optimistic that even with the fuel gauge warning light glaring red, that passing the “last chance” gas station won’t be a problem.

Maybe, they are right.

However, historically, and as shown in the chart below, when markets have previously been this overbought combined with negative divergences in momentum, short-term outcomes have been less than optimal.

Let me clear, this does not mean the markets are about to “crash.”

It simply suggests that after an incessant run higher, asset prices are likely going to correct which will provide a better “risk/reward” entry point for investors.

But it also doesn’t rule out a much deeper correction either.

As I noted on Friday:

“The overbought condition (top panel) is now back to where was the last time we were registering ‘all-time highs.’ Currently, that signal has flattened out to the point where it is dangerously close to crossing lower. Any additional weakness this week will likely trigger a sell signal.”

Importantly, it is where we close the week that matters. A break that is reversed by the end of the week doesn’t register as a valid signal.

I will update this chart this coming weekend and discuss the next set of actions as necessary.

Running On Hope

When you are “running on empty,” it requires a lot of “hope” you can make it to the next gas, or charging, station before the engine quits running.

The same is true with the markets. The current advance is not built on improving economic or fundamental data. It is built simply on “hope.”

  • Hope the economy will improve in the second half of the year.
  • Hope that earnings will improve in the second half of the year.
  • Hope that oil prices will trade higher even as supply remains elevated.
  • Hope the Fed will not raise interest rates this year.
  • Hope that global Central Banks will “keep on keepin’ on.” 
  • Hope that the US Dollar doesn’t rise.
  • Hope that China will keep stimulating.
  • Hope that a “trade deal” will be concluded soon.
  • Hope that high-yield credit markets remain stable

I am sure I forgot a few things, but you get the point.

“There’s a whole lotta’ hope goin’ on round here.”

However, with valuations expensive, markets overbought, volatility low, and sentiment pushing back into more extreme territory, there are a lot of things which can go wrong. While stocks above their 200-dma have surged from their recent nadir, the negative divergence, light trading volume, and narrowness of the rally leaves a lot to be wished for.

The overriding message is that fundamentals are not driving the current rally.

Prices are are dictating policy.

The sharp decline in prices in 2018 set the Fed against the White House.

You can deny it. You can rail against it. You can call it a conspiracy.

But in the “other” famous words of Bill Clinton: “What is…is.”

The markets are currently betting the economy will begin to accelerate later this year. The “hope” that Central Bank actions will spark inflationary pressures and economic growth is a tall order to fill considering it hasn’t worked anywhere previously. If Central Banks are indeed able to keep asset prices inflated long enough for the fundamentals to catch up with the “fantasy” – it will be a first in recorded human history. 

My logic suggests that sooner rather than later somebody will yell “fire” in a very crowded theater.

When that will be is anyone’s guess.

In other words, this is probably a “trap.”

But as I wrote previously:

“Over the next several weeks, or even months, the markets can certainly extend the current deviations from long-term mean even further. But that is the nature of every bull market peak, and bubble, throughout history as the seeming impervious advance lures the last of the stock market ‘holdouts’ back into the markets.”

Unfortunately, for most investors, they are likely stuck at the very back of the theater.

With sentiment currently at very high levels, combined with low volatility and excess margin debt, all the ingredients necessary for a sharp market reversion are currently present.

Just to clear, I am not calling for the “end of the known universe.”

I am simply suggesting that remaining fully invested in the financial markets without a thorough understanding of your “risk exposure” will likely not have the desired end result you have been promised.

As I stated often, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered “bearish” to point out the potential “risks” that could lead to rapid capital destruction; then I am unabashedly a “bear.”

But I have been through three previous bear markets and lived to tell about.

However, just to be very clear, I am still in “theater;” I am just moving much closer to the “exit.”

(Follow up read on how to approach the market: The 80/20 Rule Of Investing)


BONUS: For all you youngsters who have never seen a bear market or heard of Jackson Browne:

Technically Speaking: Drive For Show

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Drive For Show

In golf there is an old axiom:

“Drive for show. Putt for dough.” 

This past weekend, Tiger Woods completed a comeback on Sunday by capturing his fifth Master’s title and his 15th major tournament win. It was a victory that snapped a decade-long championship drought and instantly returned him to the top of the sports world.

While his drives were some of the best on display, it was his final two-putt, likely the greatest bogey of his career, which put him 13-under par clinching the title.

Yes, Tiger Woods is back at “all-time” highs.

Congratulations!

However, Tiger Woods’ journey back to the peak of the golfing world after being outside of the top 1000 in 2017 is not only a major accomplishment but a story of tragedy along the way.

Many wrote off Woods’ career as the injuries took their toll on his form, world ranking, and quality of life along with a high profile divorce, a bit of a scandal, and personal issues. However, despite the odds, Tiger Woods is back with a story that the world had resigned itself to never seeing again.

In many ways, investors over the last decade have endured much the same.

Investors were on top of the game in 1999, as the markets soared higher. There seemed to be nothing that could stop the advance despite high valuations and questionable accounting metrics. However, after 13-years in the “investment wasteland,” investors finally got back to even had they held onto their S&P index fund and religiously dollar cost averaged (DCA) into it.

Unfortunately, there were very few who did.

As repeated studies have shown, while “buy and hold” investing sounds like a workable plan, the fallacies of “being human” tend to deviate it from our goals. For Tiger Woods, it was his human frailties, both physically and emotionally, which deviated him from his dominance in golf. For investors, it is much the same as our emotions of “greed” and “fear” destroy the best laid of plans.

A recent study by DALBAR, a financial research firm, has shown how the general temptation for investors to buy and sell at the wrong times repeatedly results in the investor losses. (Chart courtesy of American Funds)

As we discussed in our recent weekly newsletterthis same behavior was on display during the December sell-off in the markets. To wit:

“Many investors are finally getting back to even, assuming you didn’t ‘sell the bottom’ in December, which by looking at allocation changes, certainly appears to be the case for many.”

“Not surprisingly, historically speaking, investors had their peak stock exposure before the market cycle peaks. As the market had its first stumble, investors sold. When the market bounces, investors are initially reluctant to chase it. However, as the rally continues, the ‘fear of missing out or F.O.M.O’ eventually forces them back into the market. This is how bear market rallies work; they inflict the most pain possible on investors both on the bounce and then on the way back down.”

As the markets near their all-time highs, investors are finally wading back into the markets. As Chris Matthews noted for MarketWatch:

“But individual investors are once again wading into the market, indicating renewed bullishness in surveys and flow data released in recent days. 

The latest E-Trade StreetWise survey, released Friday, showed 58% self-directed investors calling themselves ‘bullish’ on the stock market in the second quarter of this year, a 12 percentage-point increase from the first quarter, when a 54% majority indicated they were ‘bearish’ in their stock market outlook.”

Rising markets are exciting.

“Drive For Show”

The most exciting part of golf is watching the Pro’s “drive for show.” A hushed silence falls over the crowd as the golfer looks down the fairway at the distant flag. You can almost hear the breathing stop as the backswing begins. The camera chases the ball as it flies through the air as the excitement builds that it will land on the green.

It is the same with investors.

With all eyes focused on the market as it flies higher, it’s exhilarating.

Currently, with markets rising on hopes the Federal Reserve is returning to more “accommodative” ways and consistent headlines of a conclusion to “Trump’s Trade War,” there seems to be nothing that can stop the market’s advance. “Hope” is an incredibly virulent toxin that blocks the “logic pathways” of investor intellect. One of the clues of its presence is the belief that “this time is different.” 

However, it is when the “ball lands on the green” the real work begins.

The most challenging aspect of golf, and where it counts the most, is minimizing the number of strokes required to “putt” the ball into the cup. Those most skilled are the ones who win more often than not.

In investing it is much the same. As markets approach major important inflection points, it is the skill of mitigating risk and repositioning portfolios which reduces the number “strokes” in the investment game.

Since the December swoon, most investors have forgotten the pain they felt, and the “fear of losing” has once again been replaced with the “Fear of Missing Out.” However, while many investors spent their time “driving for show,” bond investors won by consistently “putting for dough.”

This is where we are today.

“Putting For Dough”

Currently, the market is as extended as it has been at other major points throughout history with a similar backdrop of slowing earnings and economic growth, higher interest rates, and geopolitical stresses. Also, complacency is back as volatility continues to subside as the “fear of a correction” has subsided substantially since the December lows.

Also, as shown in the next chart, the negative “cross over” is still intact AND it is doing so in conjunction with an extreme overbought weekly condition and a “negatively diverging” moving average divergence/convergence (MACD) indicator. This combined set of “signals” has only been seen in conjunction with the previous market peaks. (The corrections of 2012 and 2015-16 were offset by massive amounts of Central Bank interventions which are not present currently.)

Clearly, the “drive for show” is now behind us. 

As we prepare for the “putt,” it is time to focus on the “lay of the green.”

In the short-term the market remains bullishly biased and suggests, with a couple of months to go in the “seasonally strong” period of the year, that downside risk remains limited. Importantly, while downside risks are somewhat limited, this doesn’t mean there is a tremendous amount of upside reward either.

Currently, our portfolio allocations:

  • Remain long-biased towards equity risk
  • Have a balance between offensive and defensive sector positioning
  • Are tactically positioned for a trade resolution (which we will sell into the occurrence of.)

However, the analysis also keeps us cautious with respect to the longer-term outlook. With the recent inversion of the yield curve, deteriorating economic data, and weaker earnings prospects going forward, we are focused on risk management and capital controls. As such we are:

  • Continuing to carry slightly higher levels of cash
  • Overweight bonds 
  • Have some historically defensive positioning in portfolios. 
  • Continue to tighten-up stop-loss levels to protect gains, and;
  • Have outright hedges ready to implement when needed.

In your own portfolio, there are simple actions you can take to improve your chances of “sinking the putt.”

  1. Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits)
  2. Sell underperforming positions. If a position hasn’t performed during the rally over the last three months, it is weak for a reason and will likely lead the decline on the way down. 
  3. Positions that performed with the market should also be reduced back to original portfolio weights. Hang with the leaders.
  4. Move trailing stop losses up to new levels.
  5. Review your portfolio allocation relative to your risk tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.
  6. Look to reposition portfolio composition from “risk” toward “safety.” Look to reduce assets specifically tied to economic growth and increase holdings in assets which tend to be more defensive in nature. 
  7. If you just don’t know what to do – cash is the best alternative. With cash now yielding more than the S&P 500, holding cash IS an option until you figure out what to do. Remember, investing is about making a bet where the potential for reward outweighs the risk of loss. If you can’t find that opportunity right now, cash is the best alternative until you do.

How you personally manage your investments is up to you. I am only suggesting a few guidelines to rebalance portfolio risk accordingly. Therefore, use this information at your own discretion.

But if you need help click here.

Technically Speaking: Do You Really Want To Be Out?

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Do You Really Want To Be Out?

That was a comment made several times last week with respect to the markets stellar first quarter performance.

“The S&P 500 is on track for its best quarter in a decade, up roughly 12 percent. And if history is any indication, the index could be set for more gains for the rest of the year.

In nine of the 10 previous times since 1950 that the S&P returned more than 10 percent in the first quarter, it went on to post double-digit gains for the year, according to LPL Financial’s Ryan Detrick. The one exception was 1987, when the market crashed on Black Monday.”CNBC

As we noted in this past weekend’s newsletter:

“Friday wrapped up the first quarter of 2019, and it was the best quarterly performance since 2009. As shown in the chart below, if you bought the bottom, you are ‘killing it.’”

“Most likely, you didn’t.”

Despite all of the media ‘hoopla’ about the rally, the reality is that for most, they are simply getting back to even over the last year.”

“That is, assuming you didn’t ‘sell the bottom’ in December, which by looking at allocation changes, certainly appears to be the case for many.”

So, back to our question, why would you want to be out of the market?

Here is the problem with the Detrick’s analysis above:

  • 1986 – Reagan passes massive tax reform which boost stocks into 1987.
  • 1987 – The market crashes.
  • 1991 – The market rallies sharply coming out of recession.
  • 1998 – After Long-Term Capital Management is bailed out, and the “Asian Contagion” is resolved stocks rally as the “Dot.com” bubble inflates (2-year later, investors were wishing they hadn’t bought in)
  • 2012 – QE from the Fed boost stocks early in the year and Operation Twist supports asset prices through the end of the year. Balance sheet continues to expand with interest rates at ZERO.
  • 2013 – In the wake of the “Fiscal Cliff” the Fed launches QE-3 to offset the risk of a government contraction in spending which turns out not to be a problem. Stocks soar on a flood of liquidity.

As I have notated on the chart below, it is important to compare the context behind historical market actions rather than just making a blanket assumption.

Case in point was the huge January rally in 2018. Headlines rang out that the January “boom” pointed to bigger gains through the rest of the year. After all, “so goes January, so goes the year.”

The year finished lower by over 4%.

So, basing investment decisions solely on previous price action without the relevant context and can lead to poor outcomes.

While it is certainly hopeful that a strong first quarter will lead to further gains for the rest of the year, the current macro backdrop is not nearly as supportive as it was previously.

  • Rates are no longer zero.
  • Liquidity is still being extracted through September and will stabilize, not increase.
  • Economic growth is no longer-strengthening.
  • Confidence has peaked
  • Geopolitical tensions are rising
  • Earnings growth has peaked.
  • Valuations are no longer reasonable and rising, but excessively valued.
  • Inflation and interest rates are no longer falling.

Well, you get the idea.

Furthermore, leading economic indicators are also signaling some concern. The chart below shows the 3-month average percentage change relative to GDP. (Try RIAPRO for 30-days FREE with code PRO30)

Yes, this current test of the “recession” warning line could turn out to be another 2012 or 2015-16 event, but as noted above, the Fed is no longer directly engaged in supplying liquidity and the Fed Funds rate is no longer zero.

Of course, assuming there is “no recession in sight” is historically what has preceded previous recessions. Coincidently, it is also the subject of a recent Bloomberg article:

“In 1966, four years before securing the Nobel Prize for economics, Paul Samuelson quipped that declines in U.S. stock prices had correctly predicted nine of the last five American recessions. His profession would kill for such accuracy.”Simon Kennedy & Peter Coy, Bloomberg

While there are many suggesting that based on current economic data there is “no recession” in sight, therein lies the risk as noted previously:

“The problem with making an assessment about the state of the economy today, based on current data points, is that these numbers are ‘best guesses’ about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

‘The Federal Reserve is not currently forecasting a recession.’

In hindsight, the NBER called an official recession that began in December of 2007.”

For investors, while the first quarter of the year was a massively strong reflex rally from the lows, the risk of expecting asset prices to continue to rise unabated may prove disappointing. This is particularly the case as the factors which drove that first quarter performance are unlikely to repeat in the months ahead.

In December there was:

  • Deeply negative sentiment of the markets
  • Asset prices were stretched to the downside
  • The Fed surprised the markets with a very dovish reversal
  • The White House surprised the markets with statements a “Trade Deal” was near.
  • Oil prices had declined to lows, were oversold, and prime for a rally.

Today:

  • The markets are no longer fearful as shown our RIA PRO Technical Index
  • Asset prices are now stretched back to the upside
  • Economic data has bounced but remains weak
  • The Fed has more room to disappoint than not with future announcements. While many are expecting a rate ease later this year, such is unlikely to happen before data materially worsens.
  • There has been no “trade deal” completion
  • Oil prices are overbought and extended to the upside.

This was also the subject of a WSJ article by Ira Iosebashvili on Monday:

“Investors hoping for stocks’ rally to keep up the first quarter’s pace may be headed for a disappointment. Big climbs in the S&P 500 have tended to slow or even reverse in the three months following a first-quarter rally of 10% or more, according to Dow Jones Market Data.”

“Often, the gains pause as investors grow wary that prices have risen too high, or concerned that the expectations driving the rally won’t pan out. Some investors tend to lock in profits after a particularly good quarter, pushing markets lower.

Earnings are another factor that could pressure stocks. Some investors are worried that a slowing U.S. economy is already weighing on corporate bottom lines and clouding the case for share prices to keep rising. S&P 500 companies are expected to report a nearly 4% drop in first-quarter earnings from a year earlier, according to FactSet.”

“But if I did get out now, I might miss some of the upside.”

Such is really a personal choice, but as I stated earlier this year, there is a very high probability the bulk of the gains for this year have already been made.

However, the emotions of “greed” and “fear” are extremely powerful forces which consistently lead to poor outcomes over longer-term periods. As Michael Lebowitz and I discussed in our VideoCast last week, there is a time to be a contrarian and Howard Marks, the head of Oaktree Capital Management, just recently sold his entire firm. Howard is the ultimate contrarian investor and the message should not be readily dismissed.

This was the same message Sam Zell sent when he sold EQ Office to Blackstone Group in 2006 for $36 billion in the largest leveraged buyout in history at the time. Or, just as timely was when Bobby Shackouls, the CEO of Burlington Resources, sold to Conoco Phillips. Both occurred just prior to the “Financial Crisis” and the crash in oil prices.

Were they just lucky, or did they see something the rest of us didn’t? 

There was “no recession in sight” at the time. The economy was growing, stock market prices were rising, and it was a “Goldilocks economy.” 

But to this point was David Rosenberg’s missive yesterday which stated quite elegantly:

“I have to say, that from a contrarian perspective, when an article like ‘Investors Rush To Buy Up Stocks’ appears on the very front page of the Wall Street Journal, you know a whole lot of good news is in the price. It conjures up the image of two of Bob Farrell’s famous Ten Market Rules to Remember: #5 – the public buys the most at the top and the least at the bottom, and #9 – when all the experts agree something else is going to happen.”

While hindsight is pretty clear about what happens given the current environment of weak economic and profit growth, combined with high valuations, and deteriorating technical underpinnings, the ultimate outcome could take months to develop.

And because a warning doesn’t immediately translate into a negative consequence, it is quickly dismissed. It is akin to constantly running red lights and never getting into an accident. We begin to think we are skilled at running red lights, rather than just being lucky. Eventually, the luck will run out.

So do you want to be out? Most will say “no.” 

Just for the record, we aren’t “out” either.

But if you are waiting for someone to tell you the recession has officially started, it really won’t matter much anyway.


Technically Speaking: Are We Going To New Highs?

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Are We Going To New Highs?

I recently received the following email:

“Are we going to hit new highs you think, or is this a setup for the real correction?”

The answer is “yes” to both parts.

Thank you for reading. See you next week.

You still here?

Fine, let me explain then.

The “price” of the financial markets are ultimately driven by one thing and one thing only: “expectations.”

Yes, fundamentals, valuations, interest rates, etc. all play an important role, but it is ultimately “expectations” of “the herd” which moves prices. Currently, valuations on stocks are at the second highest level on record, but “expectations” are that a continued “low interest rate environment” can support economic growth allowing stocks to “grow” into their valuations.

This is why Wall Street begin using “forward operating earnings,” which are complete nonsense, to justify high valuations and, you guessed it, “expectations.” (Operating earnings are essentiallymade up” earnings without any of the “bad stuff” included.)

For more on this valuation read a recent article we wrote on the topic titled Price to Forecasted Hope.

The problem, historically speaking, is when those “expectations” are disappointing as shown below.  There are three important things worth pointing out:

  1. The top panel is GAAP earnings (what companies REALLY earn) and nominal GDP.
  2. The black vertical line is when the markets begin to “sniff out” something is not quite right.
  3. The red bars are when “expectations” are disappointed. 

While “expectations” were indeed disappointing in 2015-2016, the long-term rising trend line was never violated. Secondly, the current warning signal (black vertical line) is in place, but “expectations” have not yet been disappointed.

As I discussed yesterday, one of the biggest problems facing investors is that many have never recovered from the previous two bear markets. While “this time may seem different,” the reality is such is probably not the case.

Let’s review the periods just prior to the onset of the last two bear markets to see if there are any similarities to today’s environment.



1998-2000

Leading up to 2000, the Internet was changing the world. Companies like E*Trade brought investing to the mainstream public and now everybody was a “professional investor.” Despite silly little hiccups like Long-Term Capital Management and the “Asian Contagion,” the markets rocketed higher as expectations were that “clicks per page” had changed the investing dynamic forever. “Buy the dip,” and “Buy and hold” were the investing mantras of the day as retail investors loaded up on risk.

The economy was strong, employment was high, and corporate earnings were soaring as the advent of “operating, or proforma, earnings” established its place in the Wall Street lexicon. It’s was, for all intents and purposes, a “new era.”

The change came in late July of 2000 as stocks recovered from previous dips but failed to reach new highs. The deterioration in price momentum was signaling that something was changing as the Fed had been aggressively tightening monetary policy. By December of 2000, the “buy the dip” mantra and “buy and hold” investing were no more. 

The “all-time” high printed in 2000 would not be seen again for 7-years.

2006-2008

Fast forward to 2006. After the crushing of investors portfolios from 2000-2002, much of the damage had been corrected.

“See, if you had just bought and held, you would be fine.” 

“Buy and hold” and “dollar cost averaging” investment strategies had once again returned to the media headlines. With mortgage rates low and a litany of no cost/low-cost options for getting a mortgage, or using the mortgage as an A.T.M., Wall Street had found a new avenue for liquidity in the “real estate market.”

Once again it seemed as if nothing could go wrong as the flood of liquidity in the system allowed for asset prices to rise. As the market consistently rang out new highs through 2006 and 2007, it was believed once again this “time was different.” 

Even when small west coast banks and two Bear Stearn’s hedge funds collapsed due to their investments in risky “mortgage-backed” instruments, it was quickly ignored by investors as then Fed Reserve Chairman Ben Bernanke soothed the markets with docile tones of a “Goldilocks Economy.”

After a stumble in July of 2007, the market came roaring back, ignoring the growing mortgage and real-estate issues and surged back to hit all-time highs.

That was the last all-time high that would be seen for another 6-years. 

2017-Present

Of course, there are many investors, and more importantly financial advisors, who were not in the markets during those previous two periods. Many individuals simply sold out of the markets, or lost most everything, and never returned. Many financial advisors quit the business and started a different profession.

So, for many the bull market of the last decade seems to be “normal.” Once again, “buy the dip” and “buy and hold” are once again “a thing.” More importantly, “this time is different” because the “Central Banks have the market’s back.” 

But is it?

In reviewing the chart above, there are certainly many similarities between the current market backdrop and those previous bull market peaks. There are also an abundance of risks which Doug Kass noted on Monday:

“I continue to be of the view that 2018 marked the beginning of the end of the 10-year Bull Market and that an important top was in the process of being established last year.

‘Tops are a process, bottoms are an event.’

Consider the following fundamentally based issues and concerns I raised back then (and that still have value, and have been updated in boldface):

  • Downside Risk Dwarfs Upside Reward
  • Global Growth Is Less Synchronized .
  • FAANG’s Dominance Represents an Ever-Present Risk
  • Market Structure Is One-Sided and Worrisome. Machines and algorithms rule the day; they, too, are momentum-based on the same side of the boat. 
  • Higher Interest Rates Not Only Produce a More Attractive Risk-Free Rate of Return, They Also Make It Hard for the Private and Public Sectors to Service Debt.
  • Trade Tensions With China Are Intensifying and Mr. Market Is Improperly Looking Past Marginal Risks.
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window by Both Political Parties. This has very bad ramifications, which shortly may be discounted in lower stock prices, especially as it relates to the servicing of debt — a subject I have written about often. 
  • Peak Buybacks. Buybacks continue apace, but look who’s selling
  • China, Europe and the Emerging Market Economic Data All Signal a Slowdown. It’s in the early innings of such a slowdown based on any real-time analysis of the economic data. 

“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” – Benjamin Graham

He is correct.

However, while the “risks” are abundant, they don’t matter until they do. As I noted in last week’s Technical Update:

“The ‘animal spirits,’ which were awakened by consecutive rounds of financial stimulus on a global scale, has enticed investors into the belief that all risks of a market cycle completion have been removed. The problem, as I have discussed previously, is this optimism comes at a point in history diametrically opposed to when President Reagan instituted many of the same conservative policies.

It is this exuberance that reminded me of the following ‘investor psychology’ chart.”

“The third (current) full-market cycle is only 39-years in the making. Given the 2nd highest valuation levels in history, corporate, consumer and margin debt near historical highs, and average economic growth rates running at historical lows, it is worth questioning whether the current full-market cycle has been completed or not?”

As Doug concluded:

“The search for value and comparing it to risk taken is, at its core, the marriage of a contrarian streak and a calculator.

While it is important to gauge the possibility (based on fundamental and technical input) that the market may be making an important market top, it is even more important to distill, based on reasonable fundamental input, what the market’s reward versus risk is. This calculus and taking advantage of the discrepancy between price and intrinsic value trumps everything else that I do in determining market value.

My investment process points me to conclude that, at current prices, downside risk substantially eclipses upside reward.”

This was the case in 1999 and 2007 as well.

The “Goldilocks economy,” the “permanently high plateau,” and “buy and hold” all died at the altar of price reversions. 

And, the answer is “YES.” 

  • Yes, the markets could absolutely rally to, or near, all-time highs.
  • It could also well be the last “all-time” high you see for the next 6-10 years. 

Technically Speaking: A Different Way To Look At Market Cycles

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A Different Way To Look At Market Cycles

In this past weekend’s newsletter we noted the issues of similarities between the current market environment and previous market peaks in the past. To wit:

“It isn’t just the economy that is reminiscent of the 2007 landscape. As noted above, the markets also reflect the same. Here are a couple of charts worth reminding you of. 

Notice that at the peaks of both previous bull markets, the market corrected, broke important support levels and then rallied to new highs leading investors to believe the bull market was intact. However, the weekly ‘sell signal’ never confirmed that rally as the ‘unseen bear market’ had already started.”

“Currently, relative strength as measured by RSI on a weekly basis has continued to deteriorate. Not only was such deterioration a hallmark of the market topping process in 2007, but also in 2000.”

“The problem of suggesting that we have once again evolved into a “Goldilocks economy” is that such an environment of slower growth is not conducive to supporting corporate profit growth at a level to justify high valuations.”



My friend and colleague Doug Kass penned an important note about the current market backdrop on Monday:

“‘Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits-a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.’ – John Maynard Keynes

The markets, confounding many, have vaulted higher from the Christmas Eve lows with nary a selloff.

This morning, let’s briefly explore the catalysts to the advance and consider what might follow:

  1. Liquidity (and financial conditions) have improved, as Central Bankers, to some degree, have reversed their tightening policies. Interest rates and inflationary expectations have moved lower than expected, providing hope for an elongated economic cycle that has already been a decade in duration and appeared to be “long in the tooth.”
  2. Market structure (and the dominance of price following products and strategies like ETFs, CTAs and Risk Parity and Volatility Trending/Targeting) exacerbated the trend lower into late-December. The breadth thrust and reversal in price momentum contributed to the post-Christmas rally. As I have previously noted, in an investment world dominated by the aforementioned products that worship at the altar of price momentum – ‘buyers live higher and sellers live lower.’ This phenomenon has exaggerated market moves and has created an air of artificiality and absence of price discovery (on both the upside and the downside).
  3. Corporate buybacks – abetted by tax reform introduced 15 months ago – provided another reason for a strong backdrop for higher stock prices.
  4. As a result of the above factors (and others) animal spirits rose and valuations expanded.

These four conditions have offset the deceleration in the rate of global economic growth and U.S. corporate profit growth.”

He is correct, the “animal spirits,” which were awakened by consecutive rounds of financial stimulus on a global scale, has enticed investors into the belief that all risks of a market cycle completion have been removed. The problem, as I have discussed previously, is this optimism comes at a point in history diametrically opposed to when President Reagan instituted many of the same conservative policies.

It is this exuberance that reminded me of the following “investor psychology” chart.

This chart is not new, and there are many variations similar to it, but the importance should not be lost on individuals as it is repeated throughout history. At each delusional peak, it was always uttered, in some shape, form or variation, “this time is different.” 

Of course, to the detriment of those who fell prey to that belief, it was not.

As I was studying the chart, something struck me.

During my history of blogging and writing newsletters, I have often discussed the importance of full-market cycles.

“Long-term investment success depends more on the WHEN you start investing. This is clearly shown in the chart below of long-term secular full-market cycles.”

“Here is the critical point. The MAJORITY of the returns from investing came in just 4 of the 8 major market cycles since 1871. Every other period yielded a return that actually lost out to inflation during that time frame.”

By looking at each full-cycle period as two parts, bull and bear, I missed the importance of the “psychology” driven by the entirety of the cycle. In other words, what if instead of there being 8-cycles, we look at them as only three? 

This would, of course, suggest that based on the “psychological” cycle of the market, the bull market that began in 1980 is not yet complete. 

Notice in the chart above the CAPE (cyclically adjusted P/E ratio) reverted well below the long-term in both prior full-market cycles. While valuations did, very briefly, dip below the long-term trend in 2008-2009, they have not reverted to levels either low or long enough to form the fundamental and psychological underpinnings seen at the beginning of the last two full-market cycles.   

Long-Run Psychological Cycles

It is from that basis, and historical time frames, that I have created the following thought experiment of examining the psychological cycle overlaid on each of the three full-cycle periods in the market.

The first full-market cycle lasted 63-years from 1871 through 1934. This period ended with the crash of 1929 and the beginning of the “Great Depression.” 

The second full-market cycle lasted 45-years from 1935-1980. This cycle ended with the demise of the “Nifty-Fifty” stocks and the “Black Bear Market” of 1974. While not as economically devastating to the overall economy as the 1929-crash, it did greatly impair the investment psychology of those in the market.

The third (current) full-market cycle is only 39-years in the making. Given the 2nd highest valuation levels in history, corporate, consumer and margin debt near historical highs, and average economic growth rates running at historical lows, it is worth questioning whether the current full-market cycle has been completed or not?

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

  1. The long-term bullish trend line remains
  2. The cycle-oscillator is only half-way through a long-term cycle.
  3. On a Fibonacci-retracement basis, a 61.8% retracement would almost intersect with the long-term bullish trend-line around 1200 suggesting the next downturn could indeed be a nasty one.

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

It’s All Asymmetric

A second supporting theory of full market cycles was George Soros’ take on bubbles.

“First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, there is a lack of equilibrium conditions.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said:

‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’

Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.”

The chart below is an example of asymmetric bubbles.

Asymmetric-bubbles

Soros’ view on the pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view.  Prices reflect the psychology of the market which can create a feedback loop between the markets and fundamentals.  As Soros stated:

“Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.”

The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis.  I then took a look at the markets prior to each major market correction and overlaid the asymmetrical bubble shape as discussed by George Soros.

There is currently much debate about the health of financial markets. Have we indeed found the “Goldilocks economy?” Can prices can remain detached from the fundamental underpinnings long enough for an economy/earnings slowdown to catch back up with investor expectations?

The speculative appetite for “yield,” which has been fostered by the Fed’s ongoing interventions and suppressed interest rates, remains a powerful force in the short term. Furthermore, investors have now been successfully “trained” by the markets to “stay invested” for “fear of missing out.”

The increase in speculative risks, combined with excess leverage, leave the markets vulnerable to a sizable correction at some point in the future. The only missing ingredient for such a correction currently is simply a catalyst to put “fear” into an overly complacent marketplace.  

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

It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: “Stocks have now reached a permanently high plateau.” The clamoring of voices proclaiming the bull market still has plenty of room to run is telling much the same story.  History is replete with market crashes that occurred just as the mainstream belief made heretics out of anyone who dared to contradict the bullish bias.

It is critically important to remain as theoretically sound as possible as a large majority of investors have built their portfolios on a foundation of false ideologies.

The problem is when reality collides with widespread fantasy.

Technically Speaking: Will The Next Decade Be As Good As The Last?

In this past weekend’s newsletter we stated:

“This short-term oversold condition, and holding of minor support, does set the market up for a bounce next week which could get the market back above the 200-dma. The challenge, at least in the short-term remains the resistance level building at 2800.

That bounce occurred on Monday which allowed us to add some trading positions to our portfolios. We update all of portfolios regularly at RIA PRO (Try now for FREE for 30-days with Code: PRO30)

Our job as portfolio managers is simple:

  1. Protect investment capital, and; (Long-term view)
  2. Take advantage of opportunity when it presents itself. (Short-term view)

The blending of the short and long-term views is the difficult part for readers to understand.

“If you have a long-term bearish view on future market returns, how can you be increasing equity exposure?”

Because, as rule #2 states, our job is to make money when we can while avoiding the long-term risk of capital destruction. As such, we must marry the long-term views with short-term opportunities which don’t necessarily always align.

For example, the media was full of commentary over the weekend discussing the market’s 10th anniversary.

“The U.S. bull market turned 10-years old Saturday, underscoring the resilience of a rally that has persisted despite tepid global growth, anxieties about central bank policies, and mounting trade tensions.” – WSJ

Yes, March 9th marked the 10-year mark of a bull market that started on that same day in 2009. Although there have been a few bumps along the way, the long-term bullish trend has remained intact.

“So, why can’t it just continue for another 10-years?”

It’s a important question and investors should review the catalysts of the last decade.

In 2009, valuations had reverted to the long-term average, asset prices got extremely oversold, and investor sentiment was extremely negative. These are all the ingredients necessary for a cyclical bull market which David Rosenberg detailed on Monday:

“Yes, this was indeed the third strong run-up in the S&P 500 on record with a total return increase of 400%. But in inflation-adjusted dollars, the $30 trillion expansion was a record, taking out the $25 trillion surge in real terms from December 1987 to March 2000.

As David details, the supports for the ensuing rally were abnormal in many aspects.

The government bailed out insolvent banks.

  • There were two massive fiscal stimulus programs separated by 8-years.
  • The Fed funds rate was ZERO for eight years, and repeated intervention into the marketplace boosted the Fed’s assets six-fold. How could asset values not be influenced by the central bank taking $4.5 trillion of ‘safe’ securities out of the public market?
  • Because there were no investable opportunities, cloud computing and AI aside, there was no capital deepening cycle. Cash flows (from tax relief too) were diverted to stock buybacks and dividend payments. The share count of the S&P 500 hit two-decade lows alongside two crazes – buybacks and M&A.
  • The Fed’s policies ignited the mother of all leverage cycles in the corporate sector. And it’s not all just about BBB-rated bonds. It’s about private equity, which experienced a massive credit bubble this cycle as well.
  • The WSJ mentions ‘anxieties’ about central banks even though they have been the best friend to the investing class than they have ever been in modern history.
  • The article also posited that the 10-year bull run confronted “mounting trade tensions.” Well, in truth, by the time these tensions began, in early 2018, over 90% of the bull markets was behind us.
  • What sort of market has but 4-companies accounting for 9% of the total return of this 10-year cycle; and 20 of the S&P 500 representing 30% of the total return gain? Answer- a highly concentrated one.

Importantly, this is what happened.

The challenge for investors will be what happens next.

Currently, there is an overwhelming “hope” that what happened over the last 10-years will continue over the next ten. This is a psychological tendency known as “recency bias,” and is one of the biggest behavioral mistakes investors make when it comes to investing.

However, history suggests that the opposite is true more often than not. As I wrote previously:

“’Record levels’ of anything are ‘records for a reason.’

It should be remembered that when records are broken, that was the point where previous limits were reached.  Also, just as in horse racing, sprinting or car races, the difference between an old record and a new one are often measured in fractions of a second.

Therefore, when a ‘record level’ is reached it is NOT THE BEGINNING, but rather an indication of the PEAK of a cycle. Records, while they are often broken, are often only breached by a small amount, rather than a great stretch. While the media has focused on record low unemployment, record stock market levels, and record confidence as signs of an ongoing economic recovery, history suggests caution. For investors, everything is always at its best at the end of a cycle rather than the beginning.”

It isn’t just the stock market hitting record levels in terms of time, but also the economy. According to WSJ’s Alan Blinder:

“Only two economic expansions since 1854 have lasted longer than 100 months, and none have lasted more than 120 months. If the current expansion lasts into July, it will be the longest in history.”

While the old Wall Street axiom is that “bull markets don’t die of old age,” old age usually brings most things closer to the end. As I showed previously in “Is The Market Predicting A Recession?” stocks usually peak, and trough, ahead of the economy.

https://realinvestmentadvice.com/wp-content/uploads/2018/10/SP-500-Recessions-Dating-NBER-102418.png

As John Murphy noted last week for StockCharts:

  • The bull market that ended in March 2000 preceded an economic downturn by a year.
  • The October 2007 stock market peak preceded the December economic peak by two months.
  • The March 2009 stock upturn led the June economic upturn by three months.
  • Historically, stocks usually peak from six to nine months ahead of the economy. Which is why we look for possible stock market peaks to alert us to potential peaks in the economy that usually follow. And we may be looking at one.

The weekly chart below shows the S&P 500 hitting an all-time high last September before falling nearly 20% into the end of 2018. While the first two months of 2019 has seen an impressive surge back to its November highs, the market is starting to build a pattern of lower highs, and lower bottoms. More importantly, both relative strength and the MACD indicators are trending lower and negatively diverging from the markets price action.

Each week on RIA PRO we provide an update on all of the major markets for trading purposes. (See an unlocked version here. We also do the same analysis for each S&P 500 sector, selected portfolio holdings, and long-short ideas. You can try RIA PRO free for 30-days with code PRO30)

John continues by looking at the monthly chart of the S&P 500 going back 10-years to the start of the bull market.

“The uptrend is still intact. The sharp selloff that took place during the fourth quarter of 2018 stayed above the rising trendline drawn under its 2009, 2011, 2016 lows. That’s the good news. What may not be so good are signs that long-term momentum indicators are starting to weaken. The two lines in the upper box plot the monthly Percent Price Oscillator (PPO). [The PPO is a variation of MACD and measures percentage changes between two moving averages].

The PPO lines turned negative during the second half of last year when the faster red line fell below the slower blue line. And they remain negative. [The red histogram bars plotting the difference between the two PPO lines also remain in negative territory below their zero lines (red circle)]. Secondly, and maybe more importantly, the 2018 peak in PPO is lower than the earlier peak formed at the end of 2014. That’s the first time that’s happened since the bull market began. In technical terms, that creates a potential ‘negative divergence’ between the PPO lines and the S&P 500 which hit a new high last September.

This raises the possibility that the ten-year bull market may have peaked in the fourth quarter and is now going through a major topping process. If the bull market in stocks is nearing an end, that could start the clock ticking on the nearly ten-year expansion in the U.S. economy. That might not prevent it from setting a new record for longevity this July, but it might diminish its chances for celebrating the eleventh anniversary in the summer of 2020.”

These same negative divergences can be seen in the monthly chart below going back to 1995. Whenever the long-term bull trend lines have been broken from a topping process, with negative divergences, and monthly sell signals, it has been coincident with more major market topping processes.

Sure, this time could be different for a whole variety of reasons, but those generally fall into the category of “hope” rather than a systematic and disciplined approach to investing.

Even after the recent correction, long-term extensions and deviations remain at historically high levels which, historically speaking, have not been extremely kind to investors. But valuations, despite the recent correction, are still pushing 30x earnings as well.

As Brett Arends recently noted:

“From the viewpoint of long-term investment, major risks remain according to some long-term strategists. Yes, conventional wisdom on Wall Street tells you that stocks are likely to gain an average of around 9% a year. And yes, that’s based on the historical average going back at least to the 1920s. But, say some financial historians, that’s a misreading of the past. Stocks, they say, typically produced ‘average’ returns if you bought them at roughly ‘average’ valuations in relation to things like net assets and net income. And U.S. stock valuations today, they warn, are anything but average. According to price-to-earnings or ‘PE’ data tracked by Yale University finance professor and Nobel Prize winner Robert Shiller, the S&P 500 is about 75% above its historic average valuation. ‘

But it isn’t just the technical backdrop of the market that is completely reversed but also the fundamental and economic one. As I showed in “QE – Then, Now & Why It May Not Work:”

With the fundamental and technical backdrop no longer as supportive, valuations still near the most expensive 10% of starting valuations, and interest rates higher, the returns over the next decade will likely be disappointing.

However, that’s the long-term view and valuations are a “horrible” timing device. This is why we use a specific set of price indications over varied time frames to determine short-term risk versus reward.

Currently, the markets are rallying, so we need to participate.

As investors, we have to make money when “the cards are hot.” But just as important is knowing when it is time to “fold and step away from the table.”

I know it seems completely implausible today, but over the next decade there will be many who will have wished they had sold today.

Technically Speaking: Monthly Chart Review Yields Bearish Signals

With the month of February now officially in the books, we can take a look at our long-term monthly indicators to see what they are telling us now.

Is the bull market back?

That’s the answer we all want to know.

Each week on RIA PRO we provide an update on all of the major markets for trading purposes.

(See an unlocked version here. We also do the same analysis for each S&P 500 sector, selected portfolio holdings, and long-short ideas. You can try RIA PRO free for 30-days with code PRO30)

However, as longer-term investors and portfolio managers, we are more interested in the overall trend of the market. While it is fundamental analysis derives “what” we buy, it is the long-term “price” analysis which determines the “when” of the buying and selling aspects of portfolio management over the long-term.

For us, the best measures of the TREND of the market is through longer-term weekly and monthly data. Importantly, when using longer-term data these signals are only valid at the end of the period. It is not uncommon for signals to be triggered and reversed during the middle of the period which creates “false” signals and poor outcomes. Since we are more interested in discerning changes to the overall “trend” of the market, we find monthly indicators, which are slow moving, tend to reveal this more clearly.

In April of last year, I penned an article entitled “10-Reasons The Bull Market Ended” in which we discussed the yield curve, slowing economic growth, valuations, volatility, and sentiment. While volatility and sentiment have gone back into complacency, the fundamental and economic backdrop has deteriorated further. Had you heeded our warning then, you could have saved yourself some pain.

As of February’s end, despite the recent rally over the last two months, the market is still 4.8% lower than the previous peak. It also remains marginally lower than the January high. Despite the 12.5% rally over the last two months (open to close), the rally has only repaired the damage of the December decline.

(Fun with numbers: it took a 12.5% advance to repair a 10.2% decline. This is why measuring performance in percentage terms is deceiving.)

More importantly, note the MONTHLY SELL SIGNAL registered in the bottom panel of the chart above.

Given that monthly data is very slow moving, longer-term signals can uncover changes to trend which short-term market rallies tend to obfuscate.

The next chart shows the monthly buy/sell signals stretched back to 1999. As you will see, these monthly “buy” and “sell” indications are fairly rare over that period. During that period, only the 2015-2016 signal didn’t evolve into a deeper correction as Central Bank interventions flooded the markets with liquidity to stem the risk of a disorderly “Brexit” and slower economic growth.

Currently, we are once again facing slower global economic growth, the potential of a disorderly “Brexit” and Central Banks trying to reverse policy back to a more “accommodative” stance. Therefore, if Central Banks can support prices long-enough for economic data to trough and recover (data is cyclical) allowing earnings to rebound, the monthly signals will reverse putting the markets back into a “bullish” trend.

However, until those signals reverse, it tends to pay to “err to the side of caution.”

“But this time is different because of ‘_(fill in the blank__'”

Well, we can take those same monthly indicators and review them going back to 1950. I have added two confirming monthly indicators as well, so the vertical “red dashed lines” are when all three indicators have aligned which reduces false signals.


I can’t believe I actually have to write the next sentence, but if I don’t I invariably get an email saying “but if you sold out, you missed the whole rally.”

What should be obvious is that while the monthly “sell” signals have gotten you out to avoid more substantial destructions of capital, the reversal of those signals were signs to “get back in.” Investing, long-term is about both deployment of capital and the preservation of it.

Currently, the monthly indicators have all aligned to “confirm” a “sell signal” which since 1950 has been somewhat of a rarity. Yes, the recent signal could turn out to be a “1987” scenario where the market rallied immediately back and reversed the signals back to a “buy” a few months later. Or this could be the beginning of a more substantial corrective process over the course of many months.

The risk of ignoring the longer-term signal currently is the risk of a loss of what has been gained during the current reflexive rally. Yes, while waiting for the signal to reverse will equate to short-term underperformance, the long-term risk-adjusted returns have been more than enough to satisfy retirement planning goals which is why we started investing to begin with.

One of the biggest reasons not to equate the current monthly “sell” signal to a “1987” type period is valuations. In 1987, valuations were low and rising at a time where interest rates and inflation were high and falling. Today, that economic and valuation backdrop are entirely reversed. Currently, a correction from current price levels of the market to PE20 (20x current earnings) would be another 7.3% decline. However, a drop back to the long-term average of PE15 would entail a 30% decline and a reversion to PE10, which would be required to “reset” the market, would be a 53.9% fall.

Still not convinced?

I get it.

Emotionally, the hardest thing for investors to do is to sit on their hands and avoid “risk” when the markets are rising. But this is the psychological issue which plagues all investors over time which is to “buy high” and “sell low.”

It happens to everyone.

This is why we use technical signals to help reduce the “emotional” triggers which lead to poor investment decisions over the long-term. As I have noted before, the following chart is one of my favorites because it combines a litany of confirming signals all into one monthly chart.

Despite the recent rally, which has pushed prices back above their longer-term moving average, the longer-term trends of the signals remain “non-confirming” of the recent rally.

David Rosenberg summed up the current state of affairs very well yesterday:

“Well, the bulls certainly are emboldened, there isn’t any doubt about that. And this confidence, bordering on hubris, is proving very difficult to break. We are back to good news being good news and bad news is also treated as good news.”

He is right, but the technical signals, which do indeed lag short-term turns in the market, have not confirmed the bullish attitude. Rather, and as shown in the chart above, the negative divergence of the indicators from the market should actually raise some concerns over longer-term capital preservation.

What This Means And Doesn’t Mean

What this analysis DOES NOT mean is that you should “sell everything” and “hide in cash.”

As always, long-term portfolio management is about “tweaking” things over time.

At a poker table, if you have a “so so” hand, you bet less or fold. It doesn’t mean you get up and leave the table altogether.

What this analysis DOES MEAN is that we need to use this rally to take some actions to rebalance portfolios to align with some the “concerns” as discussed above.

1) Trim Winning Positions back to their original portfolio weightings. (ie. Take profits)

2) Sell Those Positions That Aren’t Working. If they don’t rally with the market during a bounce, they are going to decline more when the market sells off again.

3) Move Trailing Stop Losses Up to new levels.

4) Review Your Portfolio Allocation Relative To Your Risk Tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

Could I be wrong? Absolutely. But what if the indicators are warning us of something greater?

What’s worse:

  1. Missing out temporarily on the initial stages of a longer-term advance, or;
  2. Spending time getting back to even, which is not the same as making money.

For the majority of investors, the recent rally has simply been a recovery of what was lost last year. In other words, while investors have made no return over the last year, they have lost 1-year of their retirement saving time horizon.

The decline was small this time.

But what about next time?

Currently, the risk of disappointment greatly outweighs the potential for upside surprises at this juncture and the market may already be telling us such is the case.

Yes, if the market reverses back into a more bullish trend, we will miss some of the initial upside but portfolios can be quickly realigned to participate with a much higher reward to risk ratio than what currently exists.

If I am right, however, the preservation of capital during an ensuing market decline will provide a permanent portfolio advantage going forward. The true power of compounding is not found in “the winning,” but in the “not losing.”As I noted in yesterday’s trading rules:

Opportunities are made up far easier than lost capital.” – Todd Harrison



Technically Speaking: Sell Today? Risk Vs. FOMO

The market is downright bullish. 

There is little reason to argue the point given the bullish trend since the December 24th lows. Of course, such is not surprising given the Fed’s dovish turn from tightening monetary policy to quietly putting the “punch bowl” back on the table.

But yet, this rally is occurring at a time where Europe’s earnings growth rates for the just reported Q4-period stands at a -1% annualized, which is the lowest since Q2-2016, and the U.S. is on the verge of an earnings recession as well as declining economic data.

Something doesn’t quite jive. As Morgan Stanley’s Mike Wilson noted (via Zerohedge):

“The US is also about to enter an earnings recession, ironically after one of the strongest years for corporate profits on record, the picture of American companies is not much better. Not only is an above average number of companies issuing negative EPS guidance for Q1 2019 (of the 93 companies providing official guidance, 68 or 73%, have issued negative EPS guidance), but consensus EPS for Q1 is now deep in the red. According to Factset, the average Wall Street forecast now projects Q1 earnings per share to decline by 2.7% Y/Y, worse than a consensus -0.8% forecast drop three weeks ago, and starkly lower than the +3% EPS growth expected for Q1 at the start of the year.”

“In a troubling twist, this EPS drop is taking place even as companies continue to buyback record amounts of stock (according to BofA’s client tracker, corporate repurchases are running 98% YTD compared to the same period last year when as a reminder, total announce buybacks topped a record $1 trillion). More perplexing is that the EPS drop will take place even as S&P500 revenue is still expected to post a solid 5.2% Y/Y growth, suggesting that profit margins peaked some time in 2018 and are now declining, as the following chart from FactSet shows.”

As noted, the economic data is also deteriorating markedly in recent weeks as shown in the latest GDP NowCast from the Atlanta Fed.

Of course, if you have been reading our missives, this drop in the forecast was already evident by the sharp decline in our composite EOCI index.

(The index is comprised of the CFNAI, Chicago PMI, ISM Composite, All Fed Manufacturing Surveys, Markit Composite, PMI Composite, NFIB, and LEI)

As shown, over the last six months, the decline in the LEI has been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. The downturn in the LEI predicted the current economic weakness back in July of 2018 and suggests the data will likely continue to weaken in the months ahead. As of January, the 6-month percentage change was at ZERO and will likely go negative in the next quarter.

The next chart is the EOCI index versus GDP. As we have noted several times previously, the bump in economic growth was from 3-massive hurricanes and 2-devastating wildfires in late 2017. The effect of those natural disasters has quickly dissipated as expected and GDP growth, which is a lagged indicator, will quickly follow.

But despite the underlying economic and fundamental data, the markets have surged back to extremely overbought, extended, and deviated levels.

The chart table below is published weekly for our RIA PRO subscribers (use code PRO30 for a 30-day free trial)

You will note that with the exception of bond prices, every market and sector is more than 5% above its 50-day moving average and year-to-date performance is pushing more historic extremes both in price and in extreme overbought conditions.

Those overbought conditions are more prevalent in the chart below. On virtually every measure, markets are suggesting the fuel for an additional leg higher in assets prices is extremely limited.

The markets are not immune to the “laws of physics.” While the price action is indeed bullish in the short-term, the shorter-term moving averages act like “gravity” on prices. Given the current extension and deviation above the 50-dma the odds of a pullback, before a continued advance, is a high probability.

The same is shown in the chart below. Note the current overbought conditions are the same has they have been previously just prior to a corrective action.

Furthermore, investor complacency has quickly returned to the markets despite the fact investors just took a beating last year.

Importantly, record levels of complacency have been previously associated with short-term market peaks rather than the beginnings of bull markets. Unsurprisingly, VIX call buyers have gone on a shopping spree to lock in profits on recent gains as, despite hopes to the contrary, the risk of a price correction has risen markedly.

Here is the point to all of this.

As shown in the table below, it is very likely that if you sold everything today, and went to cash, that you would miss little over the balance of the year. In other words, the bulk of the gains have likely already been made for the year.

“What? I might miss out on a move higher?”

Yes, but at what risk?

Investing is alway about measuring risk versus reward. Currently, the risk to investors is a correction over the next couple of months followed by a rally into year end which culminates in a total return which is LESS than where you are today.

I know. That is a hard concept to grasp when the media is telling you to not only stay invested, but you better “buy more” now as the “bull market is back.”

I can’t disagree that the long-term trend of the market remains bullish, which is why we continue to have portfolios allocated toward equity risk. As shown below, the market has recently touched on the 3-year moving average confirming the longer-term bull trend of the market. The same occurred in 2015-2016 prior to global central banks leaping into action to flood the system with liquidity in advance of the “Brexit” referendum.

With the current advance already approaching historically high deviations from the long-term mean, again, the risk of a correction greatly outweighs the possibility of a continued advance.

While the intermediate-term market remains bullishly biased, the longer-term monthly dynamics are worrisome. From a purely technical perspective, the monthly backdrop for equities remains bearish and despite the sharp rally over the last two months, the market remains below its long-term bullish trend line. If the current rally fails beneath the long-term trend line, which is being tested now, such has been the hallmark of the change from a bullish to bearish market and suggests much more defensive positioning.

It is also worth noting that on a monthly basis the rally in the market has done little to reverse the declining relative strength of the market (top panel) or the monthly “sell signal” (bottom panel) which both suggest portfolios should remain hedged currently.

“History is replete with examples of major recoveries following big sell-offs, many of which turn out to be head fakes otherwise known as bear market rallies. At the end of the trading day, it’s still fundamentals that should drive investing decisions.”- Danielle DiMartino-Booth

As shown above, I agree with that view which is why, for now, we are holding a higher than normal level of cash. Slightly higher levels of cash in portfolios, not to mention hedges, certainly won’t detract significantly from portfolio performance in the short-term but provide an opportunity to take advantage of panicked sellers later.

Investing is ultimately about understanding the risk to invested capital at any given time. As noted previously, the risk currently outweighs the potential for reward by a significant margin. As Danielle concluded:

“This may be a bear market rally for the ages, but that shouldn’t imply investors should do anything other than rent it. Owning it promises to end in tears.”

Technically Speaking: You Carry An Umbrella In Case It Rains

With the markets closed yesterday, it gives us a chance to review the short, intermediate, and long-term signals the markets are currently sending.

Brett Arends recently wrote an excellent piece for MarketWatch with respect to investors feeling like they “missed out,” on the recent rally. To wit:

“Sure, if you’d bought and held you’d have been sitting in stocks during the boom since Jan. 1. But you’d also have been sitting in stocks when they tanked last quarter. The Dow has risen more than 2,000 points this year, but it fell more than 3,000 in the fourth quarter. Even after the rally, the Standard & Poor’s 500 is still 6% below last September’s peak. The average level on the S&P 500 during 2018 was 2,744, says FactSet. The level today: 2,745. It’s a wash. Meanwhile, the rest of the world has done even worse. The MSCI All Country ex-US index is still 12% below its 2018 average.”

This is an important point, because it is the “psychological” drivers, like the “Fear of Missing Out (F.O.M.O)” and “Get Me The F*** Out (G.M.T.F.O),” which are the primary cause of investing mistakes over time.

But, the recent rally sure “feels” like the worst is over as the Fed “Put” seems to be back on the table.

Or is it?

The following six charts are each identical in their design. The only difference is the time frame of the data being analyzed from Daily to Weekly, to Monthly. For our purposes, we use the three time frames for making different determinations:

  • Daily – “warning signals” – Like a “yellow light” at an intersection, it suggests whether an extra-layer of caution should be applied or not.
  • Weekly – portfolio allocation changes with respect to equity risk.
  • Monthly – understanding whether the overall “trend” of the market changed. (While a “rising tide lifts all boats,” the opposite is also true.)

As shown below, you can see that the daily indicator provides an abundance of signals. While many are timely in suggesting you should have less risk in the markets, there are also plenty of false signals along the way as well. Currently , the “sell signal” has been, and remains, in place since late September of 2018. But the recent rally suggests this signal could soon reverse if the rally persists.

The following series of charts come courtesy of RIA PRO. (Get a free 30-day trial with code PRO30)

Likewise, the secondary, or confirming indicator, is also suggesting “caution” with respect to chasing the market currently. But, as I stated above, these very short-term indicators are like “yellow lights at a busy intersection.” As investors we have a choice, “slow down” or “step on the gas.

But which action do you take? The recent rally certainly “feels” like you should “shove your foot in the carburetor” and “hang on for the ride.”

This is why we use confirming indicators. Like any good process, we want to have one signal “confirmed” by others which increase the probability of getting more accurate signals over time.

(Note: I said “probability” of “more accurate” signals over time. There are no “perfect” indicators or processes that work 100% of the time. It is the discipline of adhering to a process dogmatically over time, even when it seems broken, which has the highest probability of success.)

Even on a “weekly” basis, there can be a lot of signals, and as stated above, “false” signals are not uncommon. Currently, as the purple highlight shows, despite the recent rally, the signal suggests a higher level of caution currently.

But could it just be a “false signal?” Maybe. The signal in 2011 and 2012 were certainly false signals due to the interventions of massive rounds from “QE” from the Fed. However, given the Fed is only potentially pausing the reduction of, and not injecting, liquidity, the current “signal” is likely worth giving more weight to.

Stepping back to a monthly basis, we can “confirm” the daily, and weekly, signals further. Again, as with all signals, you can get some false indications, but those were small prices to pay for the “savings” when the signals were right as during 2018.

Currently, the ONLY signal which is NOT confirming the other five is the long-term month indicator which continues to confirm the current “bull market” trend from the 2009 lows remains intact.

This last indicator is why our portfolios remain primarily allocated to equity risk currently (although the first 5-signals have us running at reduced levels of equity risk, higher cash levels, and fixed income at targets.)

Currently, as Brett notes, the current rally has all of the “earmarks” of a “bull rally in a bear market.”

“Yes, certainly, the biggest “up” days on the market have historically accounted for a big chunk of long-term returns.

‘One of the most common rhetorical bulwarks in the defense of buy and hold investing is to demonstrate the effects of missing the best 10 days in the market, and how that would affect the compounded return to investors. This is perhaps one of the most misleading statistics in our profession.’ Meb Faber , Cambria Investments

The reasons? Most of the biggest ‘up’ days took place during bear markets, when the smart move was to be on the sidelines, he says. Oh, and missing the worst days was just as good for your wealth as catching the best ones, he found. From 1928 through 2010, he calculated, the 1% best days gained you, on average, 4.9% each. What about the worst 1% of days? They cost you about 4.9% each.'”

While we looked at daily, weekly, and monthly indications, taking a look at “quarterly” data can give us clues as to the “real risk” investors are taking on at any given time. Is this the beginning of a major bull market cycle? Or, are we nearing the end of one? How you answer that question, given the relatively short time frame of the majority of investors (hint – you don’t have 100-years to reach your goals), can have an important impact on your outcome.

As I wrote in “Investors Are Dealt A Losing Hand:”

“The problem for investors is that since fundamentals take an exceedingly long time to play out, as prices become detached “reality,” it becomes believed that somehow “this time is different.” 

Unfortunately, it never is.

The chart of the S&P 500 is derived from Dr. Robert Shiller’s inflation adjusted price data and is plotted on a QUARTERLY basis. From that quarterly data I have calculated:

  • The 12-period (3-year) Relative Strength Index (RSI),
  • Bollinger Bands (2 and 3 standard deviations of the 3-year average),
  • CAPE Ratio, and;
  • The percentage deviation above and below the 3-year moving average.
  • The vertical RED lines denote points where all measures have aligned”

Even after the recent correction, long-term extensions and deviations remain at historically high levels which, historically speaking, have not been extremely kind to investors. But valuations, despite the recent correction, as still pushing 30x earnings as well. As Brett noted:

“From the viewpoint of long-term investment, major risks remain according to some long-term strategists. Yes, conventional wisdom on Wall Street tells you that stocks are likely to gain an average of around 9% a year. And yes, that’s based on the historic average going back at least to the 1920s. But, say some financial historians, that’s a misreading of the past. Stocks, they say, typically produced ‘average’ returns if you bought them at roughly ‘average’ valuations in relation to things like net assets and net income. And U.S. stock valuations today, they warn, are anything but average.

According to price-to-earnings or ‘PE’ data tracked by Yale University finance professor and Nobel Prize winner Robert Shiller, the S&P 500 is about 75% above its historic average valuation. ‘

Today, with valuations still near the most expensive 10% of starting valuations, 10-year forward returns will likely be very disappointing.

But, valuations are a “horrible” investment timing device. Which is why we use a specific set of price indications over varied time frames to determine short-term risk versus reward.

Currently, the markets are rallying. so we have to pay attention to what is happening now. As investors, we have to make money when the “sun is shining.” But that doesn’t mean to do it with reckless abandon, and as Brett pointed out, the same things that caused the sell-off in 2018, still exist currently.

  • Economic slowdowns in China and Europe
  • Rising interest rates
  • Trade war fears
  • Looming conflicts between a Democratic Congress and President Trump
  • Weaker corporate earnings.

(You wouldn’t lay on the beach butt naked on a blistering summer day without any sunscreen would you? You could, but the consequences could be painful.)

The same is true for investing. Currently, the markets are rallying on a lot of “hope” and short-term “optimism.” However, longer-term fundamental and technical indicators are suggesting investors take some cautionary measures.

This doesn’t mean sell everything and hide in cash. But it does suggest adding some portfolio hedges, raising cash levels a bit, and holding fixed income.

You may appreciate having an umbrella if it begins to rain.

Technically Speaking: Stuck In The Middle With You

In this past weekend’s missive, we discussed the market stalling at the 200-dma. To wit:

“We said then the most likely target for the rally was the 200-dma. It was essentially the level at which the ‘irresistible force would meet the immovable object.'”

“What will be critically important now is for the markets to retest and hold support at the Oct-Nov lows which will coincide with the 50-dma. A failure of that level will likely see a retest of the 2018 lows.” 

“A retest of those lows, by the way, is not an “outside chance.” It is actually a fairly high possibility.  A look back at the 2015-2016 correction makes the case for that fairly clearly.”

“But even if a retest of lows doesn’t happen, you should be aware that sharp market rallies are not uncommon, but almost always have a subsequent retracement.”

Importantly, as I expanded to our RIA PRO subscribers:

We are likely going to have another couple of attempts next week as the bulls aren’t ready to give up the chase just yet. We are continuing to watch the risk carefully and have been working on repositioning portfolios over the last couple of weeks. 

As noted, we lifted profits at the 200-dma and added hedges to the Equity and Equity Long/Short portfolios.”

On Monday, the markets rallied a bit out of the gate over continuing hopes of a “trade deal” between the U.S. and China but fell back to even by the end of the day. With earnings season now largely behind us, the “bulls” are going to need improving economic data and relief from Washington to provide continued support for the rally.

This morning, futures are once again pointing higher on news that a proposal is ready to be sent to the President providing just $1.4 billion for border “security,” no wall, to avert another Government shut down. It is highly likely the bill will be rejected by the President and he will start talking about the use of a “national security” issue to fund the building of the wall. This will divide Congress even more than it is already almost ensuring NO legislation passes before the end of the President’s first term.

Also, talks are once again starting with China over trade. This is also buoying markets in the short-term in hopes of a resolution to reduce the impact of tariffs on businesses. Hopes for a noteworthy “deal” remain extremely slim at this point.

But those two issues are actually relatively minor as other issues, as noted on Saturday, will actually bear much more weight on the market going forward.

  • Earnings estimates for 2019 have sharply collapsed as I previously stated they would and still have more to go. In fact, as of now, the consensus estimates are suggesting the first year-over-year decline since 2016.
  • Stock market targets for 2019 are way too high as well.
  • Despite the Federal Reserve turning more dovish verbally, they DID NOT say they actually WOULD pause their rate hikes or stop reducing their balance sheet.
  • Larry Kudlow said the U.S. and China are still VERY far apart on trade.
  • Trump has postponed his meeting with President Xi which puts the market at risk of higher tariffs. 
  • There is a decent probability the U.S. Government winds up getting shut down again after next week over “border wall” funding. 
  • The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
  • Economic growth is slowing as previously stated.
  • Chinese economic has weakened further since our previous note.
  • European growth, already weak, will likely struggle as well. 
  • Valuations remain expensive

Of course, despite those more macro-concerns, the market has had a phenomenal run from the “Christmas Eve” lows and has moved above both the Oct-Nov lows and the 50-dma. This is clearly bullish in the short-term for investors. With those levels of previous resistance now turned support, there is a little cushion for the bulls to hold on to.

The biggest hurdle for a bullish advance from current levels is the cluster of resistance sitting just overhead. Sven Heinrich noted the market remains stuck below the collision of the 200-day, the 50-week, and the 15-month moving averages.

As shown, this set up previously existed back in late 2015 and early 2016. The initial challenge saw the market actually break back above the cluster of resistance, which “sucked the bulls” back into the market before setting new lows.

The correction, that was then in process, was cut short by massive infusions of global liquidity as I discussed yesterday:

“Global Central banks had stepped in to flood the system with liquidity. As you can see in the chart below, while the Fed had stopped expanding their balance sheet, everyone else went into over-drive.”

Another concern for a further rally is that investor allocations never got extremely bearish. The chart below compares the S&P 500 to various measures of Rydex ratios (bear market to bull market funds)

Note that during the recent sell-off, the move to bearish funds never achieved the levels seen during the 2015-2016 correction. More importantly, the snap-back to “complacency” has been quite astonishing. The next chart puts it into a longer-term perspective for comparison.

Despite the depth of the decline, and the belief that the “bear market” of 2018 is now complete, it is worth noting the reversion in investor positioning has not even begun to approach levels seen during an actual “bear market.”

But stepping back to the long-term trends, when managing money the most important part of the battle is getting the overall “trend” right. “Buy and hold” strategies work fine in rising price trends, and “not so much” during declines.

The reason why most “buy and hold” supporters suggest there is no alternative is because of two primary problems:

  1. Trend changes happen slowly and can be deceptive at times, and;
  2. Bear markets happen fast.

Since the primary messaging from the media is that “you can’t miss out” on a “bull market,” investors tend to dismiss the basic warning signs that markets issue. However, because “bear markets” happen fast, by the time one is realized, it is often too late to do anything about it.

So, you just have to ride it out. You don’t have any other option. Right?

The chart below is one of my favorites. It is a monthly chart of several combined indicators which are excellent at denoting changes to overall market trends. The indicators started ringing alarm bells in early 2018 which is when I begin talking about the end of the “bull market” advance.

Currently, every single monthly indicator, as of the end of January, is currently suggesting downward pressure on the market. The only signal which has yet to confirm is the cross of the 15-month and 21-month moving averages. The 21-month moving average has pretty much been both support and/or resistance, to the overall trend of the market for the past 25-years. At present, the market is “trapped in the middle” between those two monthly averages.

If the bull market is going to resume, the market needs to break above the 15-month moving average and rally enough to reverse the torrent of sell-signals running across the complex of price indications. With earnings and economic growth weakening, this could be a tough order to fill in the near term.

So, for now, with our portfolios underweight equity, over weight cash and fixed income, we remain “stuck in the middle with you.”

Technically Speaking: Too Fast, Too Furious

On December 25th, I penned “My Christmas Wish” where in I stated that is was “now or never” for the bulls to make a stand.

“If we take a look back at the markets over the last 20-years, we find that our weekly composite technical gauge has only reached this level of an oversold condition only a few times during the time frame studied. Such oversold conditions have always resulted in at least a corrective bounce even within the context of a larger mean-reverting process.”

“What this oversold condition implies is that ‘selling’ may have temporarily exhausted itself. Like a raging fire, at some point the ‘fuel’ is consumed and it burns itself out. In the market, it is much the same.

You have always heard that ‘for every buyer, there is a seller.’  

While this is a true statement, it is incomplete.

The real issue is that while there is indeed a ‘buyer for every seller,’ the question is ‘at what price?’ 

In bull markets, prices rise until ‘buyers’ are unwilling to pay a higher price for assets. Likewise, in a bear market, prices will decline until ‘sellers’ are no longer willing to sell at a lower price. It is always a question of price, otherwise, the market would be a flat line.”

We now know where the buyers were willing to start buying again.

Let’s take a look at that same technical indicator just one month later.

Now, let me remind you this is a WEEKLY indicator and is therefore typically very slow moving. The magnitude of the advance from the December 24th lows has been breathtaking.

Short-term technical indicators also show the violent reversion from extreme oversold conditions back to extreme overbought.

The McClellan Oscillator also swung from record low readings to record high readings in the same time frame as well.

But it isn’t just the technical change that has had a violent reversion but also the rush back into equities by investors.

Oh wait, that didn’t actually happen.

As noted by Deutsche Bank’s Parag Thatte noted recently:

“While the S&P 500 rallied +15% since late December, equity funds have continued to see large outflows. As Thatte elaborates, “US equity funds in particular have continued to see large outflows (-$40bn) since then, following massive outflows (-$77bn) through the sell-off from October to December.”

This confirms our concern the recent rally has primarily been a function of short-covering and repositioning in the markets rather than an “all-out” buying spree based on a “conviction” the “bull market” remains intact.

David Rosenberg recently confirmed the same:

“Let’s go back to December for a minute. This was the worst December since 1931, mind you, followed by the best January since 1987. This is nothing more than market that has gone completely manic.

To suggest that there is anything fundamental about this dead-cat bounce in equities is laughable. This is an economy, and a market, that couldn’t even sustain a 3% yield on the 10-year T-note. It sputtered at the thought of the Fed taking the funds rate marginally above zero on a ‘real’ basis, even as it feasted on unprecedented stimulus for a such a late-cycle economy.

Yes, Powell et al. helped trigger this latest up-leg, not just at last week’s meeting, but in the lead-up to the confab as well. The Fed has been crying uncle for weeks now.”

As I discussed previously, this also highlights the importance of long-term moving averages.

“Again, as noted above, given that prices rise and fall due to participant demand, long-term moving averages provide a good picture of where demand is likely to be found. When prices deviate too far above, or below, those long-term averages, prices have a history of reverting back to, or beyond, that mean.”

Well, as we now know, the market found support at the 200-week (4-year) moving average. As you will notice, with only a couple of exceptions, the 200-week moving average has acted as a long-term support line for the market. When the market has previously confirmed a break below the long-term average, more protracted mean-reverting events were already in process. Currently, the “bull case” remains intact as that long-term average has held…so far.

However, just because the initial test of the trend has held, it doesn’t mean the correction is over. As was seen in late 2015 and early 2016, the market held that trend during two sequential tests of the lows. While the bulls remain in charge for the moment, it will be whether the bulls can successfully manage a retest of lows without breaking the long-term trend.

The same goes for the 60-month (5-year) moving average. With the market currently sitting just above the long-term trend support line, the “bull market” remains intact for now.

Again, a monthly close below 2280 would suggest a more protracted “bear” market is underway.

The Bounce Hits Our Targets

As I noted in the Christmas report, we were looking for an oversold retracement rally to push stocks back toward the previous October-November closing lows of 2600-2650. The rally has hit, and slightly exceeded those original estimates.

But, we also said that on a monthly basis the rally could extend as high as 2700 which is roughly where January closed.

And, not surprisingly, it all turned out precisely as I stated:

“From yesterday’s closing levels that is a 12.7% to 14.8% rally. 

A rally of this magnitude will get the mainstream media very convinced the ‘bear market’ is now over.”

It is too early to suggest the “bear market of 2018” is officially over.

But, the rally has simply been “Too Fast, Too Furious,” completely discounting the deteriorating fundamental underpinnings:

  • Earnings estimates for 2019 have sharply collapsed as I previously stated they would and still have more to go.
  • Stock market targets for 2019 are way too high as well.
  • Despite the Federal Reserve turning more dovish verbally, they DID NOT say they actually WOULD pause their rate hikes or stop reducing their balance sheet.
  • Trade wars are set to continue as talks with China will likely be fruitless.
  • The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
  • Economic growth is slowing as previously stated.
  • Chinese economic has weakened further since our previous note.
  • European growth, already weak, will likely struggle as well. 
  • Valuations remain expensive

You get the idea.

But more importantly, as recently noted by Sven Henrich, it also resembles much of what was seen at the previous two bull market peaks.

“Note the common and concurrent elements of the previous two big market tops (2000, 2007) versus now:”

  • New market highs tagging the upper monthly Bollinger band on a monthly negative RSI (relative strength index) divergence — check.
  • A steep correction off the highs that breaks a multi-year trend line — check.
  • A turning of the monthly MACD (Moving Average Convergence Divergence) toward south and the histogram to negative — check.
  • A correction that transverses all the way from the upper monthly Bollinger band to the lower monthly Bollinger band before bouncing — check.
  • A counter rally that moves all the way from the lower Bollinger band to the middle Bollinger band, the 20MA — check.
  • A counter rally that produces a bump in the RSI around the middle zone, alleviating oversold conditions — check.
  • All these events occurring following an extended trend of lower unemployment, signaling the coming end of a business cycle — check.
  • All these events coinciding with a reversal in yields — check.
  • All these events coinciding with a Federal Reserve suddenly halting its rate hike cycle — check.

The rally we “wished” for on Christmas has come to fruition. However, it isn’t a rally to become overly complacent in as there remain significant challenges coming from weaker economic growth, rising debt levels, and slowing earnings growth.

But as I concluded in this past weekend’s missive:

“While markets can certainly remain extended for much longer than logic would predict, they can not, and ultimately will not, stay overly extended indefinitely. 

The important point here is simply this. While the Fed may have curtailed the 2018 bear market temporarily, the environment today is vastly different than it was in 2008-2009.  Here are a few more differences:

  • Unemployment is 4%, not 10+%
  • Jobless claims are at historic lows, rather than historic highs.
  • Consumer confidence is optimistic, not pessimistic.
  • Corporate debt is a record levels and the quality of that debt has deteriorated.
  • The government is already running a $1 trillion deficit in an expansion not half that rate as prior to the last recession.
  • The economy is extremely long is a growth cycle, not emerging from a recession.
  • Pent up demand for houses, cars, and other durables has been absorbed
  • Production and Services measures recently peaked, not bottomed.

In other words, the world is exactly the opposite of what it was when the Fed launched “monetary accommodation”previously. Logic suggests that such an environment will make further interventions by the Fed less effective.

The only question is how long will it take the markets to figure it out?”

I suspect not too much longer.

Technically Speaking: Can The Fed’s Reversal Save The Bull?

As we discussed in this past weekend’s missive:

A WSJ article suggesting that the Fed would not only stop hiking interest rates but also cease the balance sheet reduction which has been extracting liquidity from the market.

In mid-2018, the Federal Reserve was adamant that a strong economy and rising inflationary pressures required tighter monetary conditions. At that time they were discussing additional rate hikes and a continued reduction of their $4 Trillion balance sheet.

All it took was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.” 

This is a change for Jerome Powell, who was believed to be substantially against Fed interventions, shows his worst fear being realized – being held “hostage” by the markets. A look at Fed meeting minutes from 2013 was his recognition of that fear.

“I have one final point, which is to ask, what is the plan if the economy does not cooperate? We are at $4 trillion in expectation now. That is where the balance sheet stops in expectation now.  If we have two bad employment reports, the markets are going to move that number way out. We’re headed for $5 trillion, as others have mentioned.  And the idea that President Kocherlakota said and Governor Duke echoed— that we ’re now a captive of the market — is somewhat chilling to me.”

This week, the Fed meets to discuss their next policy moves. If the Fed announces a reduction/elimination of future rate hikes and/or a reduction/elimination of the balance sheet reduction, stocks will likely find a bid.

At least in the short-term.

Longer-term the markets are still dealing with an aging economic growth cycle, weakening rates of earnings growth, and rising political tensions. But from a technical basis, they are also dealing with a break of long-term trend lines and very major “sell” signals.

The problem for the Fed is that while ceasing rate hikes and balance sheet reductions may be a short-term positive, monetary policy is already substantially tighter than it was at the lows. In other words, “stopping” tightening is not the same as “easing.”

Back To The Future – 2015/2016

We have seen a similar period previously. During the 2015-2016 correction, the Fed had just announced it’s intent to start hiking rates and had stopped reinvesting liquidity into the markets. (Early tightening.)

The market plunged sharply prompting several Fed Presidents to make announcements reminding markets they still remained extremely “accommodative.”

The market rallied back closing in on previous highs. It certainly looked as if the bulls had regained control of the market. Headlines declared the “correction” was over. But, it wasn’t.

The retest of lows, and setting of new lows, happened over the next 60-days. With concerns over the impact of the upcoming “Brexit” vote, the Fed Chairman Janet Yellen coordinated with global Central Banks to provide liquidity to support global markets in the event of a disorderly “break up.”

In November of that same year, Donald Trump was elected to office with promises of deregulation, tax cuts, and massive infrastructure spending projects which provided an additional boost to equities into the end of the year.

Those promises combined with massive Central Bank stimulus led to one of the longest bull market runs in history with virtually no volatility.

So, here we are today.

The Trump Administration successfully passed tax cut legislation for corporations in December of 2017. Subsequently, stocks surged at the beginning of 2018 as bottom line earnings were expected to explode.

However, that surge also marked the “blow off” top of the rally.

As the Administration launched its “Trade War” with China. Stocks fell in February. However, the markets were able to regain their footing in April as the first look at earnings, post tax-cuts, had soared.

Then came October. The ongoing tariffs on goods being shipped, along with a stronger dollar, began to weigh on corporate outlooks. But it was the Fed, who was in the process of tightening monetary policy, uttered the words that spooked the markets.

“We are still a long-way from the ‘neutral rate.'” – Jerome Powell

Despite evidence of an already slowing economy, and the yield curve almost inverted, the idea the Fed would remain consistent in hiking interest rates and reducing their balance sheet further weighed on investor confidence.

The “Fed Put” was gone.

Market Dependent

Despite commentary from the Fed they were only “data dependent,” all it took was a 20% correction from the highs to change their minds. But not just the Fed’s.

While the WSJ is reporting a change in attitude from the Fed on the reduction of their balance sheet, the White House, which has pinned their measurement of success to stock prices, took prompt action.

The Secretary of the Treasury made announcements assuring the markets of stability and pushing for banks to put liquidity back into the markets. The Trump Administration has repeatedly assured the markets that “trade talks” are going well and “deal” is close to being done.

For now, the markets have bought into the “rhetoric” and have rallied sharply from the lows.

“Mr. Market” clearly has control over both fiscal and monetary policy. “Data dependency” has been relegated to the “dust bin of history.”

So, is the bull back?

Or, is the market, despite all of the support, set to retest lows as seen in early 2016?

Bryce Coward, CFA recently studied all the previous similar declines:

“We’ve cataloged all 20 uninterrupted 15% declines in the post-war period and documented what has happened afterward, as well as the type of market environment in which those declines have taken place. By uninterrupted decline, we mean a waterfall decline of at least 15% without an intermediate counter-trend rally of at least 5%. Some bullet points describing the rallies following those declines are below:

  • The average counter-trend rally following a 15% waterfall decline is 11.9% (11% median) and it takes place over 21 trading days on average (median 11 days).
  • The rallies end up retracing 57% of the decline on average (median 52%).
  • The average of those bear markets have a peak-to-trough decline of 33% (median 29%)
  • The duration of those bear markets is 284 trading days on average (median 139 days)
  • In 16 of 19 instances (excluding the decline we just witnessed), a recession was associated with the bear markets.
  • Waterfall declines of at least 15% have only taken place in bear markets.
  • 100% of the time the low resulting from the waterfall decline was retested, and in 15 of 19 cases a new lower lower was made.”

What do these data say about the current counter-trend rally?

  • First, this rally has already retraced 65% of the waterfall decline (greater than average and median) and has lasted about three weeks (less than average but greater than median). This suggests upside from here may be limited in both magnitude and duration.
  • Furthermore, these data strongly suggest the major index will retest the Christmas Eve low at the very least and most likely will make a new lower low in the weeks and months ahead.
  • While we are not forecasting a recession at this time, waterfall declines of the magnitude just witnessed tend to take place in recessionary market environments, so we need to at least be open to that possibility.
  • Finally, waterfall declines typically take place in bear markets lasting an average of 284 days (median 139 days). At just 81 days in duration, these data suggests we have bit further to run before we reach the bear market nadir. That said, there are four instances of waterfall declines taking place in short bear markets, so we don’t place much weight on this particular piece.

While the markets could certainly rally in the weeks ahead, there are significant challenges coming from both weaker economic growth, rising debt levels, and slowing earnings growth.

But most importantly, the biggest challenge in the months, and years, ahead will be the sustainability of the price deviation from long-term trends.

As Dana Lyons penned last week:

“Finally, even stock prices themselves can be considered excessive. In fact, when compared to a regression trend line on the S&P Composite going back to inception in 1871, the index price reached 122% above its long-term trend this past September. Another way of saying that is that the S&P 500 is 122% overbought. In other words, if stock prices were simply to revert to their long-term mean, the S&P 500 would be down closer to 1300 than recent highs near 2900.”

“There are certainly plenty more examples of excess in the stock market. But these few should give you an idea why, if we have entered a longer-term bear market, the oft-derided bears may end up getting the last laugh.”

Yes, this could certainly work out much like 2015-2016 if the Fed throws in the towel to appease the markets.

If they don’t, there are plenty of indications which suggest a more important mean reversion process has already begun.

Fundamentally Speaking: 2019 Estimates Are Still Too High

” So far in fourth quarter reporting season, with 11 percent of the results reported for the S&P 500, three-quarters of companies have actually surprised Wall Street’s forecasters. Earnings are shaping up to be better than people expected.” CNBC

While it is a correct statement, it is also shows the problem with the “earnings silly season.”

As I noted in this past weekend’s Real Investment Report:

With earnings season underway, there is support in the short-term for asset prices but remember that earnings are only beating sharply downgraded estimates. (This is the equivalent of companies scoring a 71 after the level for an “A” was reduced from 90 to 70)”



In other words, while the media is pounding the table screaming “buy, buy, buy,” investors should take a step back and remember that investing is ultimately a function of “actual” earnings, revenues, and cash flow. Or, as Warren Buffett once quipped:

“Price is what you pay. Value is what you get.”

To explain the issue, which ultimately becomes a major problem for investors, we have to jump into a DeLorean for a quick trip back to January 1, 2018.

At that point, Wall Street analysts were predicting earnings were going to rise to $156.75 per share by the end of 2019. With the S&P 500 trading at 2695.81 forward P/E’s were a “bargain” at just 17.19x earnings.

However, by May, analysts were chasing each other to be the highest estimate on Wall Street (bullish headlines get clicks) and pushed the 2019 number to a whopping 170.48 per share. With the market at 2734.62 at the end of May, it was time to “buy, buy, buy” as the market was “cheap, cheap, cheap” at just 16x earnings.

The only problem is that if you bought the market in June of 2018 based on its “cheapness,” it was a poor decision as forward earnings estimates turned out to be grossly wrong.

Over the last couple of years I have repeatedly produced the following chart which shows the problem with forward estimates. In just the last month, Wall Street earnings estimates fell by more than $3 per share pushing the total decline to more than $17 per share from the peak.

The red-dashed line is from an early 2018 where I discussed the fallacy of “tax cuts.” In reality estimates must eventually reflect real, organic, economic growth. Tax policy changes do not boost revenue growth at the top line.

Not surprisingly, such has been exactly the case, and despite a 20% correction from the peak of the market last year, consequently at a time when investors were told to “buy, buy, buy” because profits were exploding, investors are paying more today for each dollar in earnings today than they were in June, 2018.

To get a better sense of just how much those forecasts have been downwardly revised, the chart below compares where estimates were at the beginning of 2018 for the end of 2019.

In other words, equities have gotten MORE expensive over the last 6-months rather than less. However, given that bottom line earnings per share is grossly manipulated through share repurchases, accounting gimmicks, and outright “fudging,” more on this in a moment, top-line revenue gives us a much more accurate picture of the excessive prices being paid for stock ownership. Currently, investors are paying 2x sales which exceeds the peak paid in 2000.

However, investors quickly dismiss fundamental realities for the promise of future riches. Of course, this is the “modus operandi” of Wall Street to bring gamblers into the casino. As I discussed in The Problem With Wall Street Forecasts,:

“The biggest problem with Wall Street, both today and in the past, is the consistent disregard of the possibilities for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During the 25-year time frame, Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy.

This is why using forward earnings estimates as a valuation metric is so incredibly flawed – as the estimates are always overly optimistic roughly 33% on average.”

Yet, even while this data is readily apparent, Wall Street analysts continue to same game of starting with wildly exuberant estimates and then lowering estimates until companies can beat them.

Since investors don’t hold analysts accountable, it is a game which is played out each quarter so that Wall Street can sell their wares. The reality is that if analysts were held to their original estimates, instead of 70-80% of companies beating estimates every quarter, it would be exactly the opposite.

As noted above, the biggest drivers to bottom line earnings has been accounting gimmicks, share repurchases, and tax cuts. Revenue growth, as a percentage of the total, has shrunk to just 14% even though reported earnings per share surged by almost $3/share from repurchases.

However, even with the recent decline of forward estimates, they still remain far too lofty for 2019. Economic growth is slowing and, as I penned just recently (see article for composite index makeup), the domestic economy has already shown early signs of a more significant slowdown. Given that corporate profits are a function of economic activity, it should not be surprising that the rate of change of the S&P 500 is closely tied to annual changes in the Economic Output Composite Index.

The “sugar high” of economic growth seen in the first two quarters of 2018 was from a massive surge in deficit spending and the rush by companies to stockpile goods ahead of tariffs. While those activities create the “illusion” of growth by pulling forward “future” consumption, it isn’t sustainable and profit margins will follow suit very quickly.

The point here is simple, before falling victim to the “buy the market because it’s cheap based on forward estimates” line, make sure you understand the “what” you are actually paying for.

Wall Street analysts are always exuberant hoping for a continued surge in earnings in the months ahead. But such has always been the case.

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 the recession occurs and earnings fall in tandem.

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

2018 should have been a wake-up call. 2019 could well be the problem.

Technically Speaking: Bull Or Bear? Comparing Views

As the trumpets sound to signal the start of earnings season, the battle between fundamentals and “hope” begins. While earnings expectations have weakened markedly in recent months, the bulls remain steadfast in their belief the market correction is now over.

As I discussed in this past weekend’s missive :

“‘The stock market just got off to its best start in 13 years. The 7-session start to the year is the best for the Dow, S&P 500 and Nasdaq since 2006.’ – Mark DeCambre via MarketWatch

While headlines like this will certainly get ‘‘clicks’ and ‘likes,’ it is important to keep things is perspective. Despite the rally over the last several sessions, the markets are still roughly 3% lower than where we started 2018, much less the 11% from previous all-time highs.



Importantly, there has been a tremendous amount of ‘technical damage’ done to the market in recent months which will take some time to repair. Important trend lines have been broken, major sell-signals are in place, and major moving averages have crossed each other signaling downward pressure for stocks. 

“While the chart is a bit noisy, just note the vertical red lines. There have only been a total of 6-periods in the last 25-years where all the criteria for a deeper correction have been met. While the 2011 and 2015 markets did NOT fall into more protracted corrections due to massive interventions by Central Banks, the current decline has no such support currently. 

So, while there are many headlines circulating the ‘interweb’ currently suggesting the ‘Great Bear Market Of 2018’ is officially over, I would caution you against getting overly bullish too quickly.”

However, from a portfolio management perspective it is always a valuable exercise to analyze both sides of the argument to make a better investment decision. Therefore, let’s take a look at the technical case for the markets from both a bullish and bearish perspective.

THE BULL CASE

1) Big Rallies Happen Off Big Lows

It isn’t surprising. given the magnitude of the rally following the Christmas Eve low, the “bullish bias” would quickly return. There is precedent for such exuberance as well as recently noted by Bespoke.

As they showed in their table below, whenever there has previously been a sharp fall of more than 15% in a quarter, followed by a sharp rally of at least 10% in the following days, the markets were higher in the near future.

Such a combination of events has only occurred 12 times over the past 75 years, and the market was higher 75% of the time in 3-months and higher 83% of the time in 12-months.

But note that in some of these cases these were big rallies within the context of a bear market such as the rallies in 2001 and 2008.

2) The Fed Has Gone “Dovish”

In recent weeks, the previously “hawkish” Federal Reserve has become much more “dovish” suggesting a “pause” in monetary policy is possible if needed.

This change has not gone unnoticed by the bulls. Since Fed Chair Jerome Powell used the word “patient” when referring to the Fed’s approach to hiking interest rates, stocks went straight up. Given there had seemingly been a disconnect between the Fed, the markets, and the White House, the change was a welcome support for the bulls.

It is also believed the Fed will back off of their balance sheet reductions if needed, although Jerome Powell has not made any public indication such is an option currently.

While not really a “technical measurement,” such a change in monetary policy would certainly provide support for the bulls in the near term.

3) Advance-Decline Line Is Improving

The participation by stocks in the recent bullish advance has been strong enough to push the advance-decline line above the recent downtrend.

Such a rise in participation suggests the momentum behind stocks is supportive enough to push stocks to higher levels and should not be dismissed lightly.

Currently, as shown above, the short-term dynamics of the market have improved sufficiently enough to trigger an early “buy” signal. This suggests a moderate increase in equity exposure is warranted given a proper opportunity. However, to ensure that the current advance is not a “head-fake,” as repeated seen previously, the market will need to reduce the current overbought condition without violating near-term support levels OR reversing the current buy signal.

There is a good bit of work to do to satisfy those conditions, but things are indeed improving.

Let me be VERY CLEAR – this is VERY SHORT-TERM analysis. From a TRADING perspective, there is a tradeable opportunity. This DOES NOT mean the markets are about to begin the next great secular bull market. Caution is highly advised if you are the type of person who doesn’t pay close attention to your portfolio OR have an investment startegy based on “hoping things will get back to even” rather than selling.


THE BEAR CASE

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

1) Short-Term: Market Rally On Declining Volume

The recent market rally, while strong, occurred amidst declining volume suggesting more of a short-covering rally rather than a conviction to a “bull market” meme.

Furthermore, the rally which was one of the strongest seen in the last decade, barely retraced 38.2% of the previous decline. In order for the market to reverse the current “bearish” context, it will require a substantial move higher back above the 200-day moving average.

Given the economic and fundamental backdrop currently at play, such a rally will likely prove to be very challenging.

2) Longer-Term Dynamics Still Bearish

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

In both previous cases, the market peaked in a consolidation process, broke down through longer-term major trend lines, and did so on falling momentum combined with a long-term moving average convergence-divergence (MACD) “sell” signal.

3) Bonds Ain’t “Buyin’ It”

If a “bull market” were truly taking place we should see a flight from “safety” back into “risk.” As shown below, the declines in the stock-bond-ratio has been coincident with both short and long-term market corrections.

Currently, we are not seeing “risk taking” being a predominate factor at the moment. Could this change, absolutely. However, currently, despite the surge in the markets from the December lows, both Treasury yields and the stock/bond ratio have remained fairly firm.

Such continues to suggest the current market rally remains a “counter-trend rally” within the context of an ongoing correction.


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

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

Could the markets rocket higher as some analysts currently expect? It is quite possible particularly if the Federal Reserve reverses course and becomes much more accommodative.

For now the upside remains limited to roughly 80 points as compared to 230 points of downside.

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

Technically Speaking: Return Of The Bull Or Dead Cat Bounce

“No animals were harmed during the writing of this article.” 

If you listen to the media, the shocking and totally unexpected downturn last was unable to be foreseen by anyone. Thankfully, it’s now over and we can get back to the roaring bull market. 

Or can we?

Mark Hulbert wrote an interesting piece recently stating:

“The stock market’s recent correction has been more abrupt than you’d expect if the market were in the early stages of a major decline.

I say that because one of the hallmarks of a major market top is that the bear market that ensues is relatively mild at the beginning, only building up a head of steam over several months. Corrections, in contrast, tend to be far sharper and more precipitous.”

His view is a common pushed out in the mainstream narrative as of late, but is based on a potentially flawed assumption the bear market began in October of this past year as shown below. 

The decline from “all-time” highs took many of the persistently bullish commentators by surprise.

However, the topping process began long before October and, as shown in the chart below, the market was sending a clear warning that something was amiss.

As shown, the “blow-off rally” in January formed the left-shoulder of what would eventually become a “head and shoulder” topping process. For those not into the technical “mumbo jumbo,” this pattern of prices is similar to throwing a ball up in the air. Initially, the ball has a lot of momentum as it begins it rise. However, at a point, the force of gravity slows the momentum of the rise until, for a brief moment, the ball is motionless before falling back to earth.

Markets work much the same. Eventually, the momentum of the rise in prices becomes too far extended above long-term price trends, which act like gravity, and prices “fall back to earth.” The chart below shows the previous momentum driven rise and fall of the markets.

The yellow-shaded boxes denote the points where price momentum began to struggle to move higher. The lines in the bottom pane denote the change to price-momentum from positive to negative.

It is important to note that in late 2015, and early 2016, the market had begun a topping process that should have evolved into a deeper overall correction. However, just as longer-term trend lines were being violated, global Central Banks leapt into action with a flood of liquidity to offset the risk of a disorderly “Brexit” at a time the Federal Reserve was starting to hike overnight lending rates in the U.S.

While the “Brexit” issue is still ongoing, the risk to the market never actually matured. Therefore, the flood of global liquidity only had one place to go and drove asset prices skyward over the next 18-months.

However, today, that liquidity backdrop has changed dramatically. The Fed has hiked rates from near 0% to over 2%, and are slated to do more this year, and are extracted liquidity from the markets at a rate averaging $50 billion per month. I have shown the following chart before, but given the current environment, it is worth reviewing again.

But it isn’t just the extraction of liquidity from the markets which will likely weigh on the markets over the course of the next year. As I wrote back in April of 2018 there are 10-other reasons weighing on markets:

  • Global Central Banks are reducing liquidity flows
  • Global economic growth continues to weaken
  • “Trade Wars” and “Tariffs” are still a threat
  • Valuations remain elevated
  • High-yield spreads still remain compressed
  • Interest rates are still rising
  • Price volatility has picked up sharply
  • Investors remain aggressively allocated to equities
  • Earnings estimates are still too high and on the decline.
  • Debt loads remain extremely high and are vulnerable to exogenous events.

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, as I stated, 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 Hussman:

“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.”

As I discussed previously, there is a reasonably high possibility, the bull market that started in 2009 has ended. If that is indeed the case, the current bounce, which we have been anticipating, will likely not last for long. In other words, it currently looks, and feels, like a “dead cat bounce,” in technical terms.

With the market still oversold in the short-term BUT with a confirmed “weekly sell signal” in place, I want to reiterate that portfolio management processes have now been switched from “buying dips” to “selling rallies” until the technical backdrop changes.

Therefore, use rallies to:

  1. Re-evaluate overall portfolio exposures. We will look to initially reduce overall equity allocations.
  2. Use rallies to raise cash as needed. (Cash is a risk-free portfolio hedge)
  3. Review all positions (Sell losers/trim winners)
  4. Look for opportunities in other markets
  5. Add hedges to portfolios 
  6. Trade opportunistically (There are always rotations which can be taken advantage of)
  7. Drastically tighten up stop losses. (We  had previously given stop losses a bit of leeway as long as the bull market trend was intact. Such is no longer the case.)

There remains an ongoing bullish bias which continues to cling to belief this is “just a correction” in an ongoing bull market. However, there are ample indications, as stated, the decade long bull market has come to its inevitable conclusion.

If the bulls are right, then it is a simple process to remove hedges and reallocate back to equity risk accordingly.

However, if the bull market has indeed ended for now, a more conservative stance in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to make further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)

It also gives you the opportunity to buy at deeply discounted values.

For now, we continue to look sell into rallies.

Has “BTFD” Become “STFR”

Kevin Wilson recently penned a piece for Seeking Alpha that made a great point about where the markets are currently. To wit:

“Famous market observer Art Cashin mentioned a metaphor in October 2017 that resonated with me. He said (words to the effect that) at that moment, market players had only the protection provided by pictures of lifeboats, not the lifeboats themselves. This is just like the Titanic, whose measly 16 lifeboats looked nice, but left many hundreds on board with no means of escape when the ship sank. That is the current market situation in a nutshell. Players seem to believe that their positions are diversified enough to protect them in a downturn, and in any case, many appear to expect no major drawdown in spite of many months of extreme volatility. I would argue that the risk is far greater than perceived by many, and the protections most have in place are quite inadequate.”

Indeed, that is the case. As I noted in this past weekend’s newsletter, while the S&P 500 has declined only marginally for 2018, the devastation across markets has been dramatically worse.

In other words, traditional diversification, which is considered the “defacto” portfolio protection strategy by the mainstream media, has not worked.

Over the last several weeks, I have been discussing the transition of the market from “bullish” to “bearish.”

“The difference between a ‘bull market’ and a ‘bear market’ is when the deviations begin to occur BELOW the long-term moving average on a consistent basis.”

“For only the third time in the last decade, the market has now slipped below that longer-term trend.

The difference, this time, is there are no Central Banks talking about coming to the markets rescue – at least not yet.

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

  • Downside Risk Dwarfs Upside Reward. 
  • Global Growth Is Less Synchronized
  • Market Structure Is One-Sided and Worrisome. 
  • Higher Interest Rates Make It Hard for the Private and Public Sectors to Service Debt
  • Trade Tensions With China Are Intensifying
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
  • Peak Buybacks. 
  • China, Europe, and the Emerging Market Economic Data All Signal a Slowdown
  • The Democrats won control of the House in the Mid-term elections which will effectively nullify fiscal policy agenda moving forward.
  • The leadership of the market (FAANG) has faltered.

Here is the important point.

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

More importantly, as I have shown previously, the long-term technical backdrop has now substantially eroded. John Murphy at Stockcharts.com had an important note on this:

“There’s a reason why every short-term rally attempt over the past couple of months has failed. That’s because longer-range indicators have turned bearish and remain so. It’s more difficult for bounces on daily charts to get very far when the trends on weekly and monthly charts have turned down.”

He is absolutely correct and today we are going to go through some of the longer-term charts to show the risk currently at hand.

On a weekly basis, the market is clearly oversold and, historically speaking, such conditions have led to reflexive bounces.

However, it is important to note the difference between “bull” and “bear” markets.

During bull markets, markets trade above their longer-term moving averages and can remain overbought for extended periods of time. During “bear” markets, the opposite is true as markets tend to trade below their long-term means and remain oversold.

So, while it is very likely the current oversold condition will lead to a short-term bounce, it is likely an opportunity to reduce risk into.

John also highlighted similar concerns in his missive as well:

“Chart 1 plots weekly price bars for the SPX since the start of 2016 when the last ‘up-leg’ of its nearly ten-year bull market started. And the chart strongly suggests that the nearly three-year rally has ended. First of all, the rising trendline starting in early 2016 was broken during October. That previous support line has acted as a resistance line above short-term rallies since then. That’s a negative sign.

The SPX is now headed down for a retest of its early 2018 lows. That will be a major test of the market’s uptrend. Because a decisive close below that previous low would confirm that stocks are in the early stages of a bear market. In addition, the blue 10-week moving average crossed below the red 40-week average this month (called a “death cross”) which is another bearish sign. [A TV anchor on FOX Business this week referred to the death cross as “gobbledygook”, which says a lot about the quality of its reporting]. Even stronger bearish signals are clearly seen on the weekly RSI and MACD lines.”

Most importantly, the long-term weekly sell signals have turned negative as well. This combined signals are rare in nature and historically have been worth paying attention to.

The Bear Growls

On a monthly basis, the data is also suggesting that a “bear” may indeed be stalking investors.

IMPORTANT NOTE:  While we are discussing these technical issues today, monthly signals are ONLY VALID on the first day of the following month. So, if the markets were able to rally to all-time highs before the end of December, these signals would all be potentially reversed. 

Of the monthly signals we follow, the shorter-term signals have all recently crossed back into “alert” territory suggesting the pressure on stocks remains lower for now. However, as shown, given this is a short-term signal, it issues alerts which do not always indicate the beginning of a bear market.

However, once we move to the longer-term indicator, the picture becomes substantially clearer.

There are two very important points to take away from the chart above.

  1. The long-term monthly signal has been triggered which suggests risk should be substantially reduced, and;
  2. The market has violated the long-term moving average which has only occurred 3-times previously: 2000, 2007, and 2015.

As John concluded in his article as well:

“That’s because a bull market usually has three ‘up-legs,’ and it’s just completed the third one.”

The Biggest Threat To The Bull Market

Mike ‘Wags’ Wagner: ‘You studied the Flash Crash of 2010 and you know that Quant is another word for wild f***ing guess with math.’

Taylor Mason: ‘Quant is another word for systemized ordered thinking represented in an algorithmic approach to trading.’

Mike ‘Wags’ Wagner: ‘Just remember Billy Beane never won a World Series .’ 

– Billions, A Generation Too Late

While Billions is a hugely entertaining show, especially if you are in the business, the writers pull storylines straight from real life. As JP Morgan previously noted:

“Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets.

While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals. Fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago.

Herein lies the single biggest threat to the bull market.

As long as the algorithms are all trading in a positive direction, there is little to worry about. Algo’s were not a predominant part of the market prior to 2008 and, so far, they have behaved themselves by continually “buying the dips.” That support has kept investors complacent and has built the inherent belief “this time is different.”

But what happens when these algo’s reverse course and rather than “buying the f***ing dip,” they begin to “sell the f***ing rallies” instead?

It may have already started.

Technically Speaking: Has “BTFD” Become “STFR”

Kevin Wilson recently penned a piece for Seeking Alpha that made a great point about where the markets are currently. To wit:

“Famous market observer Art Cashin mentioned a metaphor in October 2017 that resonated with me. He said (words to the effect that) at that moment, market players had only the protection provided by pictures of lifeboats, not the lifeboats themselves. This is just like the Titanic, whose measly 16 lifeboats looked nice, but left many hundreds on board with no means of escape when the ship sank. That is the current market situation in a nutshell. Players seem to believe that their positions are diversified enough to protect them in a downturn, and in any case, many appear to expect no major drawdown in spite of many months of extreme volatility. I would argue that the risk is far greater than perceived by many, and the protections most have in place are quite inadequate.”

Indeed, that is the case. As I noted in this past weekend’s newsletter, while the S&P 500 has declined only marginally for 2018, the devastation across markets has been dramatically worse.

In other words, traditional diversification, which is considered the “defacto” portfolio protection strategy by the mainstream media, has not worked.

Over the last several weeks, I have been discussing the transition of the market from “bullish” to “bearish.”

“The difference between a ‘bull market’ and a ‘bear market’ is when the deviations begin to occur BELOW the long-term moving average on a consistent basis.”

“For only the third time in the last decade, the market has now slipped below that longer-term trend.

The difference, this time, is there are no Central Banks talking about coming to the markets rescue – at least not yet.

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

  • Downside Risk Dwarfs Upside Reward. 
  • Global Growth Is Less Synchronized
  • Market Structure Is One-Sided and Worrisome. 
  • Higher Interest Rates Make It Hard for the Private and Public Sectors to Service Debt
  • Trade Tensions With China Are Intensifying
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
  • Peak Buybacks. 
  • China, Europe, and the Emerging Market Economic Data All Signal a Slowdown
  • The Democrats won control of the House in the Mid-term elections which will effectively nullify fiscal policy agenda moving forward.
  • The leadership of the market (FAANG) has faltered.

Here is the important point.

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

More importantly, as I have shown previously, the long-term technical backdrop has now substantially eroded. John Murphy at Stockcharts.com had an important note on this:

“There’s a reason why every short-term rally attempt over the past couple of months has failed. That’s because longer-range indicators have turned bearish and remain so. It’s more difficult for bounces on daily charts to get very far when the trends on weekly and monthly charts have turned down.”

He is absolutely correct and today we are going to go through some of the longer-term charts to show the risk currently at hand.

On a weekly basis, the market is clearly oversold and, historically speaking, such conditions have led to reflexive bounces.

However, it is important to note the difference between “bull” and “bear” markets.

During bull markets, markets trade above their longer-term moving averages and can remain overbought for extended periods of time. During “bear” markets, the opposite is true as markets tend to trade below their long-term means and remain oversold.

So, while it is very likely the current oversold condition will lead to a short-term bounce, it is likely an opportunity to reduce risk into.

John also highlighted similar concerns in his missive as well:

“Chart 1 plots weekly price bars for the SPX since the start of 2016 when the last ‘up-leg’ of its nearly ten-year bull market started. And the chart strongly suggests that the nearly three-year rally has ended. First of all, the rising trendline starting in early 2016 was broken during October. That previous support line has acted as a resistance line above short-term rallies since then. That’s a negative sign.

The SPX is now headed down for a retest of its early 2018 lows. That will be a major test of the market’s uptrend. Because a decisive close below that previous low would confirm that stocks are in the early stages of a bear market. In addition, the blue 10-week moving average crossed below the red 40-week average this month (called a “death cross”) which is another bearish sign. [A TV anchor on FOX Business this week referred to the death cross as “gobbledygook”, which says a lot about the quality of its reporting]. Even stronger bearish signals are clearly seen on the weekly RSI and MACD lines.”

Most importantly, the long-term weekly sell signals have turned negative as well. This combined signals are rare in nature and historically have been worth paying attention to.

The Bear Growls

On a monthly basis, the data is also suggesting that a “bear” may indeed be stalking investors.

IMPORTANT NOTE:  While we are discussing these technical issues today, monthly signals are ONLY VALID on the first day of the following month. So, if the markets were able to rally to all-time highs before the end of December, these signals would all be potentially reversed. 

Of the monthly signals we follow, the shorter-term signals have all recently crossed back into “alert” territory suggesting the pressure on stocks remains lower for now. However, as shown, given this is a short-term signal, it issues alerts which do not always indicate the beginning of a bear market.

However, once we move to the longer-term indicator, the picture becomes substantially clearer.

There are two very important points to take away from the chart above.

  1. The long-term monthly signal has been triggered which suggests risk should be substantially reduced, and;
  2. The market has violated the long-term moving average which has only occurred 3-times previously: 2000, 2007, and 2015.

As John concluded in his article as well:

“That’s because a bull market usually has three ‘up-legs,’ and it’s just completed the third one.”

The Biggest Threat To The Bull Market

Mike ‘Wags’ Wagner: ‘You studied the Flash Crash of 2010 and you know that Quant is another word for wild f***ing guess with math.’

Taylor Mason: ‘Quant is another word for systemized ordered thinking represented in an algorithmic approach to trading.’

Mike ‘Wags’ Wagner: ‘Just remember Billy Beane never won a World Series .’ 

– Billions, A Generation Too Late

While Billions is a hugely entertaining show, especially if you are in the business, the writers pull storylines straight from real life. As JP Morgan previously noted:

“Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets.

While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals. Fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago.

Herein lies the single biggest threat to the bull market.

As long as the algorithms are all trading in a positive direction, there is little to worry about. Algo’s were not a predominant part of the market prior to 2008 and, so far, they have behaved themselves by continually “buying the dips.” That support has kept investors complacent and has built the inherent belief “this time is different.”

But what happens when these algo’s reverse course and rather than “buying the f***ing dip,” they begin to “sell the f***ing rallies” instead?

It may have already started.

Technically Speaking: “Will Santa Visit Broad & Wall?”

In this past weekend’s missive, “Stuck In The Middle (Range) With You,” I discussed the view from John Murphy via Stockcharts.com that the S&P 500 may have more downside to come. To wit:

The daily bars in the chart shows the S&P 500 retesting previous lows formed in late October and late November. And it’s trying to hold there. The shape of the pattern over the past two months, however, isn’t very encouraging. Not only is the SPX trading well below its 200-day average. The two red trendlines containing that recent sideways pattern have the look of a triangular formation (marked by two converging trendlines). Triangles are usually continuation patterns. If that interpretation is correct, technical odds favor recent lows being broken.

If that happens, that would set up a more significant test of the lows formed earlier in the year. Other analysts on this site (besides myself) have also been writing about that possibility. That would lead to a major test of the viability of the market’s long-term uptrend.”

Yesterday, the market opened flattish as concerns over the “Huawei Incident” continue to linger. Via Zerohedge:

“China warned both Canada and the US over Huawei CFO’s arrest, warning of ‘retaliation’ and ‘further action’, with the US countering with ‘hard deadlines’ and concerns of ‘predatory behavior.’)”

But it isn’t just China that is the issue.

“Here’s a non-exhaustive list of potential risk-off drivers hanging over Monday’s open (as succinctly summarized by Bloomberg’s Garfield Reynolds):

  • China summons U.S. Ambassador over the Huawei case
  • Trump Chief of Staff Kelly to leave, amid a welter of fresh Mueller developments
  • China reports weaker trade and inflation data
  • May pushes ahead on Brexit vote despite Cabinet, DUP opposition
  • Soggy U.S. payrolls, though not soggy enough to stop a December Fed hike
  • France protests intensify, raising concerns of economic damage”

The biggest concern currently, from a technical perspective, is the important support levels the markets are currently testing.

Most importantly, the most recent failure at key resistance levels has set the market up to complete the formation of a ‘head and shoulder’ process. This is a topping pattern that would suggest substantially lower asset prices going into 2019 ‘IF,’ and this is a key point, ‘IF’ it completes by breaking the lower ‘neckline.’” 

On Monday, the market did indeed break the “neckline” and successfully tested the 2018 lows. However, since the market rallied back, and closed, above that support level the “break” is not valid. This keeps the current consolidation range intact for now.

While the market was able to hold that level on Monday, the overall market action was very poor. More importantly, as shown in the series of charts below, the technical backdrop is not suggestive of a market which has completed its corrective process as of yet.

The daily Relative Strength Index (RSI) is NOT oversold as of yet despite the market testing recent lows.

Sentiment is not grossly “bearish” yet, either.

This is confirmed by our broad market fear/greed gauge which is the combined reading of AAII, INVI, MarketVane, NAAIM, and the volatility index. Which the greed levels have been reduced, we are not yet at levels which have historically represented more lasting market bottoms.

The broad market. as measured by the S&P 1500 (comprised of large-cap S&P 500, mid-cap S&P 400, and small-cap S&P 600) has currently registered a cross of the 50-dma below the 200-dma which suggests further downward pressure on prices. However, with the high-low percentages plumbing recent “wash out” levels, the potential for a “reflex rally” is highly likely over the next couple of weeks. This is supportive of a “Santa Rally” as we will discuss momentarily.

The advance-decline percentages and volumes are also turning lower which, with the market already at recent lows and on important support, suggests pressure remains to the downside as well.

An important change, and warning, for investors is that unlike the sell-off in February which tested the long-term moving average and traded ABOVE it, which confirms the bullish trend, the major markets are now all trading BELOW that long-term average which is bearish. 

Technically, the backdrop of the market is about as poor as it can get currently. The majority of the shorter-term signals are bearish and longer-term signals are turning lower as well.

It’s Now Or Never For Santa

However, as noted above, with the market oversold, and flirting with important support levels, it is now or never for the traditional “Santa Rally.” As Michael Lebowitz noted last week:

“For this analysis, we studied data from 1990 to current to see if December is a better period to hold stocks than other months. The answer was a resounding ‘YES.’ The 28 Decembers from 1990 to 2017, had an average monthly return of +1.70%. The other 11 months, 308 individual observations over the same time frame, posted an average return of +0.62%.

The following graph shows the monthly returns as well as the maximum and minimum intra-month returns for each December since 1990. It is worth noting that more than a third of the data points have returns that are below the average for the non-December months (+0.62%). Further, if the outsized gains of 2008 and 1991 are excluded, the average for December is +1.05%. While still better than the other months, it is not nearly as impressive as the aggregate 1.70% gain.”

“Next, we analyzed the data to explore if there are periods within December where gains were clustered. The following two graphs show, in orange, aggregate cumulative returns by day count for the 28 Decembers we analyzed. In the first graph, returns are plotted alongside daily aggregated average returns by day. Illustrated in the second graph is the percentage of positive days versus negative days by day count along with returns.”

Here is the important point of that analysis:

IF “Santa” is going to visit “Broad & Wall” this year, it will most likely occur between the 10th through the 17th trading days of the month. Such would equate to Friday, December 14th through Wednesday, December 26th.

As I have discussed previously, with mutual funds finishing up their annual distributions, portfolio managers and hedge funds will likely look to “Stuff Their Stockings” of highly visible positions to have them reflected in year-end statements.

While the current oversold condition is supportive of a rally over the next couple of weeks, that does not mean this is a “stocking” you should shove everything into. Given the overall technical backdrop, any rally may be short-lived going into 2019 unless some of the pressure from weaker economic data, Brexit, Washington politics, “trade wars”, balance sheet reductions, and softer-earnings growth is relieved.

Therefore, here are the rules for the “Santa Rally.”

Rules For “Santa Rally”

If you are long equities in the current market, we continue to recommend following some basic rules of portfolio management.

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

Notice, nothing in there says “sell everything and go to cash.”

Remember, our job as investors is actually pretty simple – protect our investment capital from short-term destruction so we can play the long-term investment game. Here are our thoughts on this.

  • 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%)
  • 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.

With forward returns likely to be lower and more volatile than what was witnessed over the last decade, the need for a more conservative approach is rising. Controlling risk, reducing emotional investment mistakes and limiting the destruction of investment capital will likely be the real formula for investment success in the decade ahead.

This brings up some very important investment guidelines that I have learned over the last 30 years.

  • Investing is not a competition. There are no prizes for winning but there are severe penalties for losing.
  • Emotions have no place in investing.You are generally better off doing the opposite of what you “feel” you should be doing.
  • The ONLY investments that you can “buy and hold” are those that provide an income stream with a return of principal function.
  • Market valuations (except at extremes) are very poor market timing devices.
  • Fundamentals and Economics drive long-term investment decisions – “Greed and Fear” drive short-term trading. Knowing what type of investor you are determines the basis of your strategy.
  • “Market timing” is impossible– managing exposure to risk is both logical and possible.
  • Investment is about discipline and patience. Lacking either one can be destructive to your investment goals.
  • There is no value in daily media commentary– turn off the television and save yourself the mental capital.
  • Investing is no different than gambling– both are “guesses” about future outcomes based on probabilities.  The winner is the one who knows when to “fold” and when to go “all in”.
  • No investment strategy works all the time. The trick is knowing the difference between a bad investment strategy and one that is temporarily out of favor.

As an investment 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.

Technically Speaking: Is The Bull Back, Or Is It A “Bull Trap?”

In this past weekend’s missive, “Did The Powell Put Change Anything?,” I discussed the surge in the market following Jerome Powell’s change of stance on Fed policy and the potential for a Trump to acquiesce to China in order to boost the stock market.

“While Goldman is leaning more towards an “escalation,” President Trump has staked his entire Presidential career to the stock market as a measure of his success and failure.

If President Trump was heading into the meeting this weekend with the market at record highs, I think a “hard-line” stance on China would indeed be the outcome. However, after a bruising couple of months, it is quite possible China will see an opportunity to take advantage of a beleaguered Trump to keep negotiations moving forward.

This is also particularly the case since the House was lost to the Democrats in the mid-term. This is an issue not lost on China’s leadership either. With the President in a much weaker position, and his second tax cut now “DOA,” there is little likelihood of any major policy victories over the next two years. Therefore, the risk to the Trump Administration is continuing to fight a ‘trade war’ he can’t win anyway at the risk of crippling the economy and losing the next election.”

Not surprisingly, that is exactly what happened.

With smiles and much back-patting to go around, the G-20 meeting ended with a “roar of applause but the accomplishment of nothing.”

Nonetheless, as I also pointed out, the market did reach extremely oversold levels during the October/November correction which provided the necessary “fuel” for a short-term rally. All the market needed was a “reason” and Trump’s weakened stance with China over trade provided just that.

The Bullish View

The good news is that on Monday the market cleared the 50- and 200-day moving averages. This was an important level of overhead resistance the market needed to clear to get back onto more bullish footing. However, in order for that break to be validated, it must hold through the end of the trading week.

Also, on a very short-term basis, the market has triggered a short-term “buy signal.” From a trading perspective, this does provide support for a rally in the short-term. As Richard Mojena noted in his commentary this past weekend:

“The nearly 5% gain this past week was an impressive surge off the primary downtrend’s lows from just the previous week, with some key resistance trend lines taken out. The model’s technical indicators leapt in response, notably tripping two key indicators (index vs month-end trend and statistically significant weekly percent increase) from sells to buys. Monetary and sentiment indicators improved some as well.

This buy signal came just after the confirmation of a new primary downtrend at 9 weeks with a decline of -10%. Just one week ago the S&P 500 at -10.2% from its September high visited correction territory and at +0.1% was barely above water year-to-date, breathing only from its dividends. The index itself (without dividends) was off -1.5% YTD. And now the SPX is up 5% year-to-date. What a difference a week makes. The model now believes with 80% probability that a new primary uptrend is underway, although its realization may very well be rocky.”

If he is correct, then our longer-term indicators should turn positive the weeks ahead as well. As noted at RIA PRO we did add some equity exposure to portfolios on Friday, but are still holding a higher level of cash than normal. As shown below, the 61.8% Fibonacci retracement level, and the 2016 bullish trend line, have remained formidable adversaries to the previous rally attempts. However, if the lower “sell signal” is reversed, such would likely coincide with a breakout above resistance and confirm a new uptrend is underway.

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

  1. If the market remains above the 50-dma AND breaks above resistance at 2820, then another attempt at all time highs is likely. (Probability Guess =40%)
  2. However, if this rally fails such will result in a continuation of the correction back to recent lows. (Probability Guess = 60%)”

The Bearish View

So, why did I give Option #2 a greater weighting?

This is because, despite the recent oversold surge from lows, the primary backdrop of the markets has not changed markedly.

  • The “trade truce” was nothing more than that. China is not going to back off its position on “Technology Transfers” as that is the key to their long-term economic future. This means that either Trump caves into China or we will be back to a full on “trade war” in 2019.
  • The Federal Reserve is still reducing their balance sheet by $50 billion per month which has removed a primary buyer of U.S. Treasuries at a time when the Government has gone on an unfettered spending spree.
  • With the Democrats in control of the House, there will likely be “no” constructive legislative action to note in the next year. However, there is almost an absolute guarantee of more anti-Trump actions being lofted from the “Pelosi House.”
  • Valuation remains extremely elevated despite the recent correction. 
  • Most importantly, year-over-year earnings growth rates are set to deteriorate markedly in 2019 as both the effect of the 2018-tax cuts vanishes and end-of-year estimates still remain way too high.
  • The deterioration in credit is accelerating
  • Economic growth has likely peaked. 

As noted by Carl Swenlin of Decision Point this past weekend:

“SPY’s departure from the secular bull market rising trend line reached about +39% this year, as opposed to a departure of only +26% in 2015. That kind of excess begs for a correction. The monthly PMO has topped and crossed down through the signal line. This typically forecasts a lengthy period of decline.”

As he concludes:

“The S&P 500 hasn’t had a ‘Death Cross’ yet (50EMA passes down through the 200EMA), but 51% of S&P 500 components have. I continue to believe that we are in a bear market; however, recent price action has certainly been encouraging for the bulls. The promise of the positive divergences on the chart just above has been partially fulfilled, but the short-term indicators are becoming overbought, and time could be running out on the rally. It will take an advance of just +6.5% for the market to make new, all-time highs, but, if I am right about the bear, it’s not going to happen.”

Balancing Act

Weighing both the short-term bullish view and the longer-term bearish outlook is difficult. Despite the rally on Monday, the market still remains mired on a primary “sell signal,” has violated it’s long-term bullish trend and faces a substantial amount of headwinds heading into 2019.

The risk current remains to the downside, and we must wait until the end of the week to see if the “bulls” can take back the reins of the market.

There is little doubt the “bullish bias” persists currently, and the volatility this past year has made managing money more difficult than usual.

But that is the nature of markets and how “topping processes” work.

Given we are in the “seasonally strong” period of the year, it would not surprise me to see the markets try and muster a rally into January. But there are certainly some challenges to face over the next week or so as mutual funds are now firmly into their annual distribution period and Jerome Powell may reassert his “hawkishness” again next week which could spoil the party.

A look at the weekly internals of the market shows some notable deterioration in the advancing-declining issues. With a weekly “monthly” sell-signal in place, caution remains a primary consideration. Importantly, given these are monthly signals, it does NOT MEAN stocks can’t rally in the short-term. It simply suggests there is selling pressure on stocks and the path of least resistance currently is lower.

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

While anything is certainly “possible”, we have to manage money on “probabilities.”

And right now, the probabilities remain to the negative.

Conclusion & Suggestions

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

Step 1) Clean Up Your Portfolio

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

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

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

Step 3) Have positions ready to execute accordingly given the proper market set up.

As noted previously in 10-Investment Wisdoms:

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

We haven’t gotten to that point just yet.

Technically Speaking: The Difference Between A Bull & Bear Market

Wall Street loves to label stuff.  When markets are rising it’s a “bull market.” Conversely, falling prices are a “bear market.” 

Interestingly, while there are some “rules of thumb” for falling prices such as:

  • A “correction” is defined as a decline of more than 10% in the market.
  • A “bear market” is a decline of more than 20%.

There are no such definitions for rising prices.

Simply, rising prices are “bullish.”

It’s all a bit arbitrary and rather pointless.

As investors, it is important to understand what a “bull” or “bear” market actually is.

  • A “bull market” is when prices are generally rising over an extended period of time.
  • A “bear market” is when prices are generally falling over an extended period of time.

Here is another extremely important definition for you.

Investing is the process of placing “savings” at “risk” with the expectation of a future return greater than the rate of inflation over a given time frame.

Read that again.

Investing is NOT about beating some random benchmark index which requires taking on an excessive amount of capital risk to achieve. Rather, our goal should be to grow our hard earned savings at a rate sufficient to protect the purchasing power of those savings in the future as “safely” as possible.

As pension funds have found out, counting on 7% annualized returns to make up for a shortfall in savings leaves individuals in a vastly underfunded retirement situation. Making up lost savings is not the same as increasing savings towards a future required goal.

Nonetheless, when it comes to investing, Bob Farrell’s Rule #10 is the most relevant:

“Bull markets are more fun than bear markets.” 

Of this, there is no argument.

However, understanding not only the difference between a “bull” and “bear” market, but when a change is occurring, is critical to capital preservation and appreciation.

So, what really defines a “bull” versus a “bear” market.

Let’s start by looking at the S&P 500.

Bull and bear markets are obvious with the benefit of hindsight.

The problem, for individuals, always comes back to “psychology” with respect to our investing practices. During rising, or “bullish,” markets, the psychology of “greed” not only keeps individuals invested longer than they should be but also entices them into taking on substantially more risk than they realize. “Bearish,” or declining, markets do exactly the opposite as “fear” overtakes the investment process.

Most importantly, it is difficult to know “when” the markets have changed from bullish to bearish. Over the last decade, there have been several large corrections which have certainly looked like the beginning of a turn from a “bull” to a “bear” market. Yet, after a short-term corrective process, the upward trend of the market resumed.

So, while it is obvious that missing a bear market is incredibly important to long-term investing success, it is impossible to know when the markets have changed.

Or is it?

The next couple of charts will simply build off of the weekly chart above.

Identifying The Trend

“In the short run, the market is a voting machine but in the long run it is a weighing machine” – Benjamin Graham

In the short-term, which is from a few weeks to a couple of years, the market is simply a “voting machine” as investors scramble to chase what is “popular” as prices rise; or “panic sell” everything when prices fall. But these are just the wiggles along the longer-term path.

In the long-term, the markets “weigh” the substance of the underlying cash flows and value. During bull market trends, investors become overly optimistic about the future bid up prices beyond the reasonable aspects of the underlying value. The opposite is also true, as “nothing has value,” during bear markets. This is why markets “trend” over time as excesses in valuations, in both directions, are reverted to, and beyond, the long-term means.

While the long-term picture is quite clear, valuations still don’t do much in terms of telling us “when” the change is occurring.

Change Starts Slowly, Then All At Once

“Tops are a process and bottoms are an event” – Doug Kass

Last week, I discussed the change to the markets overall attitude.

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

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

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

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

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

Today, Central Banks globally are ending their monetary injection programs, rates are rising, and the surge in global economic growth is fading. With stock valuations at historically extreme levels, the value being ascribed to future earnings growth is being revised lower as interest rates rise.

As I have written previously, prices can only move so far in one direction before the laws of physics take over. To wit”

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

The chart below shows the deviation in the price of the market above and below the 75-week moving average. Note that whenever prices begin to approach 200-points above the long-term moving average, there have been corrections. The difference between a “bull market” and a “bear market” is when the deviations begin to occur BELOW the long-term moving average on a consistent basis. 

For only the third time in the last decade, the market has now slipped below that longer-term trend.

The difference, this time, is there are no Central Banks talking about coming to the markets rescue – at least not yet.

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

  • Downside Risk Dwarfs Upside Reward. 
  • Global Growth Is Less Synchronized
  • Market Structure Is One-Sided and Worrisome. 
  • Higher Interest Rates Make It Hard for the Private and Public Sectors to Service Debt
  • Trade Tensions With China Are Intensifying
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
  • Peak Buybacks. 
  • China, Europe and the Emerging Market Economic Data All Signal a Slowdown
  • The Democrats won control of the House in the Mid-term elections which will effectively nullify fiscal policy agenda moving forward.
  • The leadership of the market (FAANG) has faltered.

Here is the important point.

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

Sure, this time could be different. However, as Ben Graham stated back in 1959:

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

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

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

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

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

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

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

Technically Speaking: Why This Market Is Incurring A “Revision Of Belief”

Last year, I penned an article titled: “It’s a Turkey Market” and with Thanksgiving just a couple of days away, I thought it was an apropos time to revisit that post.

“What’s a ‘Turkey’ market?  Nassim Taleb summed it up well in his 2007 book ‘The Black Swan.’

‘Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say.

On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey.

It will incur a revision of belief.’

Such is the market we live in currently.

I noted on Friday, that despite two 10% corrections this year so far, investors have not yet “incurred a revision of belief.” The VIX, Interest Rates, and Gold have yet to demonstrate that a change from “complacency” to “fear” has occurred.

As my friend and colleague Doug Kass noted previously:

“Tops are a process and bottoms are an event, at least most of the time in the stock market. If you looked at an ice cream cone’s profile, the top is generally rounded and the bottom V-shaped. That is how tops and bottoms often look in the stock market, and I believe that the market is forming such a top now.”

Take a look at the chart below which is the S&P 500 leading up to and following the Dot.com crisis.

There are two very important things to notice with respect to that chart:

  1. You can see the “rolling top” of the market which began in 1999. Although prices were still rising, the rate of the increase slowed.
  2. Most importantly, note the deviation of the market from the 75-week moving average. The reversal of the deviation above the moving average was an indication of the change in trend that was approaching.  

The same exact backdrop occurred leading up to the start of the “financial crisis” as well.

The market became extremely deviated above it’s long-term moving average. The “early warning” signal came as the deviation began to reverse as the market formed a “rounded top” once again.

While obvious now, in hindsight, it wasn’t then. As I noted in this past weekend’s newsletter:

“Notice that from January 1st through September of 2008 the market had already declined from the peak by 14.5%. This ‘slow-bleed’ decline was dismissed by the bullish media as we were in a ‘Goldilocks economy:’

  • There was no sign of recession
  • Rates were rising due to a strong economy. 
  • Earnings expectations were high and expected to continue to expand bringing “Forward P/E ratios” down to historical norms.
  • Economic growth was robust and expected to accelerate in the next year.
  • Global growth was expected to pick back up.

Sound familiar?”

Fast forward to the current market and we again see much of the same backdrop. There are numerous issues which are issuing warning signs and undermine the “strong economy” narrative of the Fed. As Doug noted:

  • Downside Risk Dwarfs Upside Reward. 
  • Global Growth Is Less Synchronized
  • Market Structure Is One-Sided and Worrisome. 
  • Higher Interest Rates Make It Hard for the Private and Public Sectors to Service Debt
  • Trade Tensions With China Are Intensifying
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
  • Peak Buybacks. 
  • China, Europe and the Emerging Market Economic Data All Signal a Slowdown

Let me add a couple more:

  • The Democrats won control of the House in the Mid-term elections which will effectively nullify fiscal policy agenda moving forward.
  • The leadership of the market (FAANG) has faltered.

Importantly, notice the extreme deviation of the market above the long-term moving average which was the present condition prior to the last two market reversions.

The good news, currently, is the S&P 500 is still maintaining support at the 75-dma. However, it is highly likely that support will give way going into 2019 and a more significant reversion will ensue.

The Difference Between A Bull & Bear Market

Now, go back and review the two previous charts.

The difference between a “bull market” and a “bear market” becomes much clearer. During a bull market, prices trade above the long-term moving average. However, when the trend changes to a “bear market” prices trade below that moving average.

Yep, it’s pretty much just that simple.

Currently the “bull market” is still intact as prices remain above the long-term moving average. However, evidence continues to mount that support is at risk of giving way.

That is why this is a “Turkey” market.

Unfortunately, like Turkeys, we really have no clue where we are on the current calendar. We only know that today is much like yesterday, and while the weather has turned a bit colder and the leaves have changed colors, there is no reason to suspect much else has changed.

The recent sell-off has really been nothing more than a “correction in a bull market”…so far.

But the possibility of a “revision in belief” has clearly risen. Historically speaking, when such occurs, it has been the point where a “head separating event” occurs.

Importantly, this doesn’t mean you should “sell everything” and hide in cash. But it does mean that being aggressively exposed to the financial markets is no longer opportune.

You can try and fool yourself that weak earnings growth, low interest rates, and high-valuations are somehow justified. The reality is, like Turkeys, we will ultimately be sadly mistaken and learn a costly lesson.

Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” –Benjamin Graham

Technically Speaking: Major Markets Are All Flashing Warning Signs

In this past weekend’s newsletter, I touched on the outcome of the mid-term elections and why it would likely not be as optimistic as the mainstream media was portraying it to be. To wit:

“It is likely little will get done as the desire to engage in conflict and positioning between parties will obliterate any chance for potential bipartisan agenda items such as infrastructure spending.

So, really, despite all of the excitement over the outcome of the mid-terms, it will likely mean little going forward. The bigger issue to focus on will be the ongoing impact of rising interest rates on major drivers of debt-driven consumption such as housing and auto sales. Combine that with a late stage economic cycle colliding with a Central Bank bent on removing accommodation and you have a potentially toxic brew for a much weaker outcome than currently expected.”

I also wrote:

“With portfolios reduced to 50% equity, we have a bit of breathing room currently to watch for what the market does next. It is EXTREMELY important the market rally next week above Wednesday’s highs or we will likely see another decline to potentially test the recent lows.”

Unfortunately, on Monday, nothing good happened. While the week is not over yet, the failure of the S&P 500 at the 50-dma now turns that previous support to important resistance. Furthermore, the failure of the market to hold the 200-dma also increases the downside risk of the market currently.

There is an important point here to be made about “bull markets” and “bear markets.”

While there is no “official” definition of what constitutes a “bull” or “bear” market, the generally accepted definition is a decline of 20% in the market.

However, since I really don’t want to subject my clients to a loss of 20% in their portfolios, I would suggest a different definition based on the “trend” of the market as a whole. As shown in the chart below:

  • If prices are generally “trending higher” then such is considered a “bull market.”
  • A “bear market” is when the “trend” changes from positive to negative.

The vertical red and green lines denote the confirmation of the change in trend when all three indicators simultaneously align.

  • The price of the market moves below the long-term moving average. 
  • The long-term overbought condition is reversed (top indicator) 
  • The long-term MACD signal changes from “buy” to “sell” X

Importantly, note that just a violation of the long-term moving average is not confirmation of a change to the ongoing bull trend. Over the last decade, there were several violations of the long-term moving average which were quickly reversed by Central Bank interventions (QE2 and Operation Twist).

In late 2015, all indications of the start of a “bear market” coincided as the Federal Reserve had launched into their rate hiking campaign. However, that bear market was cut short through the injections of liquidity from the ECB’s own QE program.

Currently, with Central Banks globally beginning to reduce or extract liquidity from the financial markets, and the Federal Reserve committed to hiking rates, there seems to be no ready “backstop” for the markets currently.

However, since this is a monthly chart, we will have to wait until December 1st to update these indicators. However, if the market doesn’t begin to exhibit a more positive tone by then, all three indicators of a “bear market” will align for only the 4th time in 25-years. 

But it isn’t just the S&P 500 exhibiting these characteristics.

The S&P 400 has not only failed at a retest of the longer-term moving average but mid-caps are close to registering a “change in the trend”  as the 50-dma crosses below the 200-dma.

(Note: we have previously closed all mid-cap positions in our portfolios)

While the S&P 600 is not a close as the S&P 400 to registering a “change in trend,” it likely won’t be long before it does. The failure of small-caps at the 200-dma is confirming additional downward pressure on those companies as concerns over ongoing “tariffs” and “trade wars” are most impactful to small and mid-sized company profitability.

(Note: we have previously closed all small-cap positions in our portfolios)

The Russell 2000 is also confirming the same. The index is extremely close to registering a “change in trend” as the 50-dma approaches a cross of the 200-dma. Also, with the index failing at the 200-dma and turning lower, just as with small and mid-cap indices above, a break of recent lows will confirm a “bear market” has started in these markets.

But what is happening domestically should not be a surprise. The rest of the world markets have already confirmed bear market trends and continue to trade below their long-term moving averages. (The very definition of a bear market.) While it has been believed the U.S. can “decouple” from the rest of the world, such is not likely the case. The pressure on global markets is a reflection of a slowing global economy which will ultimately find its way back to the U.S.

(Note: we closed all international and emerging market positions in our portfolios at the beginning of this year.)

Just as a side note, China has been in a massive bear market trend since 2015 and is down nearly 50% from its previous highs.

While much of the mainstream media continues to suggest the “bull market” is alive and well, there are a tremendous number of warning signs which are suggesting that something has indeed “changed.” 

“The tailwinds that existed for the market over the last couple of years from tax cuts, to natural disasters, to support from Central Banks have now all run their course.

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.”

The ongoing deterioration in the markets continues to confirm, as I wrote back in April, the bull market that started in 2009 has ended. However, we will likely not know for certain until we get into 2019, but therein lies the biggest problem. Waiting for verification requires a greater destruction of capital than we are willing to endure.

(Note: Just because the bull market has ended doesn’t mean it will never resume again. It is simply a transition to remove excesses from the market. Bear markets are a good thing as it creates long-term opportunities.)

We have already taken steps to reduce equity risk and will do more on rallies that fail to re-establish the previous bullish trends in the market. If I am right, the more conservative stance 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.” 

If you have taken NO actions in your portfolio as of yet, use rallies which fail at resistance to “do something.” I have reprinted our portfolio management rules as a guide.

RIA Portfolio Management Rules

  1. Cut losers short. (Reduce the risk of fundamentally poor companies.)
  2. Set goals and be actionable. (Without specific goals, trades become arbitrary and increase overall risk.)
  3. Emotionally driven decisions void the investment process.  (Buy high/sell low)
  4. Follow the trend. (80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  5. Never let a “trading opportunity” turn into a long-term investment. (Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  6. An investment discipline does not work if it is not followed.
  7. “Losing money” is part of the investment process. (If you are not prepared to take losses when they occur, you should not be investing.)
  8. The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  9. Never, under any circumstances, add to a losing position. (As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  10. Markets are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short. (Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  11. When markets are trading at, or near, extremes do the opposite of the “herd.”
  12. Do more of what works and less of what doesn’t. (Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  13. “Buy” and “Sell” signals are only useful if they are implemented. (Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  14. Strive to be a .700 “at bat” player. (No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  15. Manage risk and volatility. (Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

It should be remembered that all good things do come to an end. Sometimes, those endings can be very disastrous to long-term investing objectives. This is why focusing on “risk controls” in the short-term, and avoiding subsequent major draw-downs, the long-term returns tend to take care of themselves.

Everyone approaches money management differently.

This is just our approach and we are simply sharing it with you.

We hope you find something useful in it.

An Update On The U.S. Treasury Bond Breakout

Since the start of the year, I’ve been watching and showing that the “smart money” (commercial futures hedgers) have been bullish on U.S. Treasury bonds and bearish on crude oil, in direct contrast to the “dumb money” (large trend-following traders) and the mainstream financial community. Two weeks ago, I showed several charts that seemed to indicate that U.S. Treasury bonds were breaking out to the upside. As usual, I wasn’t making market predictions, but pointing out observations that I thought were worth paying attention to.

After their initial breakout from triangle patterns, Treasury bonds eased a bit as traders braced themselves ahead of last week’s Fed meeting. Since that meeting, however, U.S. stocks have resumed their sharp sell-off, which has helped to buoy Treasuries and create follow-through after their breakout two weeks ago.

As the chart below shows, the 30-year U.S. Treasury bond broke out of its triangle and appears to be gunning for its next major resistance level, which is the downtrend line that started in September 2017:

30 Year Treasury Bond DailyThe 10-Year Note shows a similar pattern. If the 10-Year can break above its downtrend line in a convincing manner, it would give a bullish confirmation signal.
10 Year Note Daily

The 5-Year Note recently broke out of a channel/wedge pattern as well as its downtrend line that started in September, which is a bullish sign, as long as this breakout holds.

5 Year Note Daily

The 2-Year Note also broke out of a channel and is testing its downtrend line. If it can break above this resistance, it would be a bullish sign.2 Year Note Daily

As I’ve been showing, the “smart money” or commercial futures hedgers are quite bullish on the 10-Year Note. The last time they became this bullish, Treasuries rallied (despite extreme public bearishness).10 Year Note Weekly

As my colleague Michael Lebowitz showed last week, U.S. Treasury yields have been bumping up against a very important, long-term trendline that goes all the way back to the late-1980s. If Treasury yields can close above this line, it would be bullish for yields and bearish for Treasury bond prices, but if they can’t close above this line, it may lead to another decline in yields (and surge in Treasury bond prices).

3-tens

Crude oil is worth watching closely in order to understand U.S. Treasury bond movements (crude oil and Treasury bond prices move inversely). WTI crude oil is sitting just under its $65 resistance level, which marked the highs in January and February. If crude oil fails to break above this resistance and falls back down, it would be bullish for Treasuries (and vice versa).

WTI Crude Daily

Brent crude oil is sitting just under its $70 resistance level:

Brent Crude Daily

As I’ve been showing, the “smart money” are even more bearish on WTI crude oil than they were in early-2014, before the oil crash. If the “smart money” are proven right and oil experiences another strong bearish move, it would be bullish for U.S. Treasuries.

WTI Crude Weekly

The latest bout of weakness in the U.S. stock market has been helping to support U.S. Treasuries. Treasuries often benefit from the “flight to safety” effect when risk assets such as stocks sell-off. As the chart below shows, the SP500 is sitting just above an important uptrend line that started in early-2016. If the market sell-off continues and the SP500 breaks below this line in a decisive manner, it would be a worrisome sign for stocks, but a bullish sign for Treasuries. If the SP500 is able to stage a strong rally off this uptrend line, however, it would be bearish for Treasuries.

SP500 Weekly

As usual, I will keep everyone updated on these charts and markets I’m watching.

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Why Oil Prices Could Remain Low

There is much hope in the financial markets, with individual investors and oil company employees that oil prices will rise in the months ahead. Many point to the 2008 commodity crash as THE example as to why the oil price decline is likely temporary.

Oil-Price-2000-Present-011816

However, if we look back further in history we see another situation where the crash in commodity prices marked an extremely long period of oil price suppression.

Oil-Price-1946-Present-011816

What was the difference? It was the supply to demand imbalance.

In 2008, when prices crashed, the supply of into the marketplace had hit an all time low while global demand was at an all-time high. The fears of “peak oil” were still a recent memory as the financial crisis took hold pushing prices to the lowest levels seen in years.

OIl-Supply-Demand-011816

This supply-demand imbalance, combined with suppressed commodity prices, was the perfect cocktail for a surge in prices as the “fracking miracle” came into focus. The surge of supply alleviated the fears of oil company stability and investors rushed back into energy-related companies to “feast” on the buffet of  accelerating profitability into the infinite future.

Banks also saw the advantages and were all too ready to lend out money for drilling of speculative wells. As investors gobbled up equity shares, the oil companies chased ever potential shale field in the U.S. in hopes to push stock prices higher. It worked…for a while.

Oil-Supply-Price-011816

The problem is now the supply-demand imbalance has reverted. With supply now back at levels not seen since the 1970’s, and demand waning due to a debt-cycle driven global economic deflationary cycle, the dynamics for a sharp rise in prices in the months to come is unlikely.

However, this is just assuming that current supply remains status quo. The problem, as I have discussed in the past, is that while the U.S. is curtailing CapEx and some production, it is being offset by production from China, Russia, and now Iran. According to the NYT:

“And yet, after many Western sanctions against Iran were lifted over the weekend, Iranian oil officials said they would quickly be ramping up exports by 500,000 barrels a day. Iranian production has been about 2.9 million barrels a day, with much of that oil sold to customers in Asia. Iran also consumes a lot of its crude domestically.”

The NYT goes on to address the problem with demand.

“One big uncertainty is how demand for oil will fare. Slowing growth in China has been a factor in falling demand. And the recent turmoil in the financial markets that began in China but that has spread globally has raised questions about whether underlying economic weakness around the world could become worse — with even growth in the United States beginning to slow.”

The supply-demand problem is not likely to be resolved over the course of a few months. The current dynamics of the financial markets, global economies and the current level of supply is more akin to that of the early-1980’s. Even is OPEC does reduce output, along with the U.S., it is unlikely to rapidly reduce the level of supply currently. Since oil production, at any price, is the major part of the revenue streams of energy-related companies, it is unlikely they will dramatically gut their production in the short-term. Therefore, it is quite likely that low oil prices are likely to be with us for quite some time.

As shown in the chart below, the correlation between oil companies and the commodity price have become extremely correlated since the turn of the century. (I have used XOM and SLB as a proxy for refiners and drillers going back to the early 80’s. XLE is added for recent history)

Oil-XLE-NYE-SLB-History-011816

It is quite likely that oil prices will eventually stabilize in the $30-40 range as the markets come to grips with recent volatility. From that point, the markets will likely shift their focus to supply glut and what that entails for the future.

From an investment standpoint, energy companies will likely present a good opportunity at lower price levels in the not so distant future. However, investors should realize that forward returns may return to more muted levels as supply continues to weigh on prices and profitability in the future.

Just something to consider.

Lance Roberts

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