“Gimbal’s Manager: ‘Ok people – tomorrow morning, 10 A.M., Santa’s coming to town!’
Buddy: ‘Santa! Oh, my god! Santa here? I know him! I know him!’” – Elf
It is hard to believe that Christmas is just TWO Friday’s away and the volatility over the past week has put a bit of a damper on holiday cheer. However, hopes remain high that “Santa will soon come to Wall Street.”
Of course, that reminds me that I have not done any shopping as of yet. (With four kids and a phenomenal wife, I should be able to make up any slack in the retail sales figures.)
But I digress. Despite the hopes of a stronger economy and earnings environment at the beginning of this year, those hopes failed to come to fruition. However, even as earnings and corporate profits have deteriorated, along with many of the underlying economic data points, the market has made NO gains for the year. The good news? There has been no inflation to chip away at the purchasing value of cash.
In early November, I discussed the need for many hedge and mutual funds, which were lagging their respective benchmarks, to play catch up. The chart below shows the S&P 500 as compared to the Morning Star Hedge Fund index. You can see the underperformance of funds this summer and the resulting performance chase to date.
In that missive, I laid out the expectation (dashed blue line) of a market decline back to support which would facilitate the year-end advance.
“With the markets currently oversold on a very short-term basis, the current probability is a rally into the ‘Thanksgiving’ holiday next week and potentially into the first week of December. As opposed to my rudimentary projections, the push higher will likely be a ‘choppy’ advance rather than a straight line.
In early December, I would expect the markets to once again pull back from an overbought condition as mutual funds distribute capital gains, dividends, and interest for the year. Such a pullback would once again reset the market for the traditional ‘Santa Claus’ rally as fund managers ‘window dress’ portfolios for their end-of-year reporting.”
Here is the updated version of that chart which shows the markets playing out very closely to that previous projection.
As we now approach the end of mutual fund distributions, the market should be able to gain some traction through the end of the year as fund managers put positions back on their books for year-end reporting.
This suggestion of a year-end rally also aligns with the markets in 2011 which also experienced a sharp summer decline and a very warm winter which allowed for stronger economic activity. (via Market Anthropology)
“The SPX analog that we mentioned a few weeks back, continues to hold congruence with the closing weeks of 2011. With the SPX achieving a lower low in Wednesday’s session, the comparative window for the much heralded Santa Rally would open tomorrow.
Considering the timing with next weeks Fed meeting and greater clarity with posture and policy, a bullish outcome over the near-term would certainly not be out of the question in equities.”
However, while the seasonal tendencies suggest that such will be the case, there is no guarantee. With economic remaining weak and the Federal Reserve on the verge of tightening monetary policy further, while the global economy struggles with a deflationary backdrop, there is a rising possibility that “Santa fails to visit Broad and Wall.”
5 Charts Suggest Markets On The Naughty List
While I do suspect that the markets will likely end positively by year-end, it is 2016-2017 that is becomes more worrisome.
From a statistical standpoint, the odds of both a recessionary environment and negative market returns rise substantially over the next two years as shown in the charts below.
2016 has the lowest average positive return of all years, with 2017 posting the most negative average rate of return. However, both 2016 and 2017 have posted negative return years more than 40% of the time. Considering that most negative return years coincide with a recessionary environment, 2017 is tied for the second most recessions of the ten-year cycle.
Okay, you can breathe easy, right? Statistics say no recession likely until 2017. As I stated previously in “The Coming Market Meltup and 2016 Recession:”
“There are plenty of reasons that that the market could lapse into a far bigger correction sooner than the historical evidence would otherwise suggest. Such an event would not be the first time that an “anomaly” in the data has occurred.
The inherent problem with most analysis is that it assumes everything remains status quo. The reality is that some unexpected exogenous shock is likely to come along that causes a more severe reversion as current extensions become more extreme. “
The following 5 charts suggest a rather substantial possibility that something could “break” within the markets sooner, rather than later.
1. World GDP Is Contracting. According to the IMF’s most recent report, world gross domestic product contracted by 4.9% in 2015. The only other time that world GDP has contracted to such a degree was in 1980, starting year of the IMF database, when it fell by 5.9%. The U.S. experienced a recession at that time as well as in 2001 and 2009 which also coincided with global economic declines. Despite many beliefs to the contrary, the U.S. is not an island that can withstand the drag of a global recession.
2. Junk Bond Warning. As David Keohane points out in this past week’s FT article:
“Late stages of every credit cycle, by definition, are built on a theory as to why this time is different. This type of attitude was prevalent going into 2015, when credit markets largely dismissed the oil sector distress, choosing to believe that this was an isolated issue and will stay that way. Historical evidence pointed to the contrary, where no earlier precedents existed of the largest sector being in distress and the rest of the market remaining firm. Today, two out of three sectors in US HY have more than 10% of debt trading at distressed levels.”
3. Institutions Are Selling. According to BofA, institutions continue to offload equities to retail clients. This is typical of a late stage market cycle as “smart money” harvests their gains while telling their “retail clients” to “just buy and hold for the long term.” (Just a question to ponder – “if they don’t buy and hold, why exactly is it good for you?”)
4. International And Emerging Market Divergence. As I stated above, there is currently a belief that the U.S. can remain isolated from the rest of the world. Given the global interconnectedness of the world today, there is little ability for the U.S. to permanently diverge from the rest of the world. As shown below, historically when international and emerging markets have declined, the U.S. has been soon to follow.
5. Combined Monthly Sell Signals. Lost in the day-to-day volatility of market action, is the longer term look at the underlying TREND of price action. Much like driving a car at full speed, assuming you don’t crash along the way, the car will continue to “coast” for some distance even after the tank runs dry. The same is true for the market. When investors are “exuberant” about the markets, they can keep prices elevated longer than underlying fundamentals and logic would dictate. However, like a “car running out of gas,” the momentum of the market begins to substantially slow until its inevitable conclusion of the advance. If we look at various measures of price action on a MONTHLY basis, we can clearly see warnings that have only previously existed at major market peaks. While this does not mean the markets will immediately crash, historically it has suggested that investors were much better served by becoming more risk adverse.
Whether or not a recession begins in 2016 or 2017 is largely irrelevant. The reason is that by the time the BEA backward adjusts their data, and the National Bureau of Economic Research declares the start of the recession, it will be far too late react.
What is clear, is the “risk” of being overly exposed to the market currently far outweighs the potential reward. This is why understanding the difference between “possibilities” and “probabilities” is critically important going forward.
Is it “possible” the markets could advance further over the next 12-24 months. Absolutely.
However, the “probabilities” are mounting that such will not be the case and the resulting negative outcome to investors’ portfolios will be more than most expect. This is the inherent risk/reward dynamic that all investors face, the difference is whether or not you do something with the information at hand.
In the meantime, Wall Street has some great stocks for you to buy.
No! Low Oil Prices Are Not A Boon
I have pointed out many times in the past, and discussed on the radio show, that falling energy prices WAS NOT good for the economy or the markets.
Here is the latest mis-statement by the media in this regard which was published by Martin Wolf in the FT:
”(A) $40 fall in the price of oil represents a shift of roughly $1.3 trillion (close to 2 per cent of world gross output) from producers to consumers annually. This is significant. Since, on balance, consumers are also more likely to spend quickly than producers, this should generate a modest boost to world demand.“
On the surface, this sounds correct.
If someone spends less at the gas pump, then they have more to spend somewhere else, right?
In order to have MORE to spend, you must have MORE income. Let me use a simple example to explain my point.
- John has $100 to spend each week.
- John normally spends $20 a week on gasoline and $80 on other living needs.
- This week John only spent $10 on gasoline, spent $80 on living and bought took his wife to dinner with the remaining $10.
(See, he just spent his “extra” $10 at the restaurant on his wife. I will address the problem of taking a spouse to a $10 dinner in a future missive on the “5-reasons for divorce.”)
- From a personal standpoint – John had an “extra” $10 to spend elsewhere in the economy.
- From an economic standpoint, which is most important, John still only spent $100.
The gas station where John fills up lost $10 in revenue. The restaurant gained $10. The net economic effect of shifting spending in the economy is zero.
Furthermore, the issue with Mr. Wolf’s view is the negative impact to production. In any economy, it is “production” that creates the “jobs” which provides the “incomes” for “consumers” to “spend.”
The negative impact of a $1.3 trillion decline in output to producers is increased job losses, reduced economic activity and capital expenditures, and lower output. The negative ramifications to the production side of the equation outweigh the positive shift to consumers.
As Doug Kass recently pointed out:
“We see this in the weakness in certain regional manufacturing data (e.g., the Dallas Fed’s manufacturing index), in the rig count contraction, in the jobs market (e.g., job count and wages) in energy dependent states, in stagnating housing activity, in a plunge in energy-related capital spending, in a weakening high-yield market, and in a (likely) meaningful subtraction ($5/share to $7/share) in 2015 S&P forecasts.
We have yet to see the benefit of lower oil prices in retail spending or in automobile industry sales.
If lower oil and gas prices are anticipated to catalyze domestic economic growth, why is the yield on the 10 year U.S. note still around 1.75%?
The entirety of the Sell Side on Wall Street as well as the Buy Side keep telling us low oil price is good for the economy (and by abstraction earnings and the stock market). BUT the market rips every time market blips up (the last two days), and sells off when the price of oil goes down.
The lesson: Watch what they do, not what they say!”
Lastly, and most importantly for investors, here is the ongoing meme from Wall Street as to why you should “stay invested” despite the fact they are dumping stock like crazy:
“If you extract the energy sector, earnings are still very positive for the year.”
Here is the problem with that argument.
When oil crashes to $40/bbl and the bullish argument of profitability is under attack, it is suggested you strip out the “bad” so that everything else looks “good.”
But when oil was at $110/bbl, analysts weren’t suggesting that you consider marginalizing surging corporate profitability because of surging oil prices. Such would have significantly reduced forward estimates and increased valuations. Neither of those is good for suckering, uh I mean, providing expert and unbiased investment advice to clientele.
Something to think about.
Portfolio Strategy & Analysis
Recent Correction Sets Up Short-Term Trade
As I stated in the main part of this weekly missive, the market was due for a correction back to support to set up a more seasonal year-end rally. The correction has accomplished most of that work, BUT I suspect we could see a bit more weakness next week.
Just this past week, StockTrader’s Almanac suggested much of the same. To wit:
“Even before the month of December arrived, expectations were running high for the market in the final month of 2015. Historically, the market is rarely down in December and when it is it is usually just barely. Remember, this is for the full month. History has also shown a tendency for the market to be weaker during the first part of the month as tax-loss selling and yearend portfolio restructuring has been happening sooner and sooner in recent years.
It seems reasonable to assume that some of this has been taking place already this month. Some of the year’s biggest losers have been hit the hardest lately specifically, energy-related stocks and crude oil. Tax-loss selling appears to only be exacerbating broad commodity weakness that has existed all year. It does not look like the global economy is decelerating further. As long as the market can hold its November lows between now and mid-month December, then the market is still on track for a typical yearend rally that has historically commenced around mid-month.”
(That sure does sound awfully familiar. Oh yes, I wrote that at the beginning of November.)
As I have reiterated over the last several weeks, the rally and subsequent correction are playing right along with previous expectations.
However, as I have also noted, this is only a “set up” for more nimble and short-term focused traders. As I discussed in detail recently, the underlying dynamics of the market are substantially weak and on a longer-term basis are more akin to market peaks than the beginning of new bull market advances.
While anything is certainly “possible,” when it comes to investing your personal savings it is always more prudent to side with what is “probable.” As John Maynard Keynes once stated:
“It is always better to be approximately right, than precisely wrong.”
Working With A Model Allocation
Let’s review the model.
NOTE: The following is for example purposes ONLY. It is in no way a suggestion, recommendation, or implication as to any portfolio allocation model currently in use. It is simply an illustration of how to overweight or underweight a model allocation structure.
Again, this is just for educational purposes, and I am not making any specific recommendations. This is simply a guide to assist you in thinking about your own personal position, how much risk you are willing to take and what your expectations are. From that starting point design a base allocation model and weight it accordingly. The closer you want to track the S&P 500 Index, the less fixed income, real estate and cash your portfolio should have. For a more conservative allocation reduce allocations to equities.
Got it? Okay.
The Sector Allocation Rotation Model (SARM) is an example of a basic well-diversified portfolio. The purpose of the model is to look “beneath the hood” of a portfolio to see what parts of the engine are driving returns versus detracting from it. From this analysis, we can then determine where to overweight sectors which are leading performance, reduce in areas lagging, and eliminate those areas that are dragging.
The Sector Allocation Rotation Model continues to deteriorate suggesting that markets are significantly weaker than they appear. As suggested all through this missive, a reflexive bounce in the market can be traded but not bought.
Over the last several weeks I have suggested waiting for a correction back to support that was combined with an oversold condition for entering short-term trading positions.
As of today, both of those criteria have now been met.
This set-up provides an opportunity for a tradeable rally in the improving and leading sectors of the market. (Stay with “winners” as they tend to be safer for short-term trading opportunities.)
- Adding To: Energy, Industrials, Materials, and Technology this week as shown in the model allocation below.
- Watching: Healthcare, Staples, Discretionary and International for some improvement before further increasing exposure in those areas.
- Selling/Profit Taking: Bonds, Utilities, REITS
It is still recommended to take profits in fixed income as rates had reached their target levels. REDUCE bond allocations in portfolios back to original allocations (take profits).
Small and Mid-capitalization stocks continue to struggle and should be avoided for now. Volatility risk is substantially higher in these areas and are better used during a firm growth cycle versus a weak one.
The same advice for bonds applies to UTILITIES and REITS which have also performed very well as of late. However, that outperformance is has faded for now.
The recent bounce in the market has achieved initial goals for cleaning up portfolios and reducing overall equity risk. The recommendations for “pruning and trimming” exposure over the past couple of months has already done a big chunk of this work so there should be relatively only minor changes needed currently.
S.A.R.M. Model Allocation
I have adjusted the SARM Model to reflect the changes discussed above.
- Add Materials
- Add Industrials
- Hold Discretionary
- Add Energy
- Add Technology
- Reduce Utilities
- Hold Staples
- Hold Healthcare
- Hold Financials
- Reduce REITs
- Reduce Bonds
These actions would rebalance the example portfolio to the following:
With the rally over this past week, there is now a potential for a short-term rally through the end of the year. As you will notice in the SAMPLE model below cash was reduced to 30% of the portfolio. This is for a SHORT-TERM trading opportunity only. If you a longer-term investor it is advisable to wait for a clearer bull-market confirmation to be made.
It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance.
As you can see, there are not DRASTIC movements being made. Just incremental changes to reducing overall portfolio volatility risks. However, if the expected bounce fails at resistance, then further reductions will be required in accordance with the risk reduction modeling.
Remember, as investors, our job is not to try and capture every single relative point gain of the market as it rises. While we certainly want to participate in the rise, our JOB is to protect our capital against substantial losses in the future. A methodology that regularly harvests gains, reduces risk and keeps the portfolio focused on longer-term goals will lead to a more successful outcome.
401K Plan Manager
Market Sets Up For Seasonal Rally
As discussed above, the recent pullback to support, and reaching oversold conditions, sets the markets up for a seasonal rally into the end of the year.
However, as cautioned, such a rally could well be short-lived so caution is advised.
The 401k Model is NOT being tactically adjusted at this time because the suggestion of a tradeable rally is far different that an increase in risk for long-term investors. The current market environment is NOT conducive for a long-term allocation adjustment.
Portfolio management rules still apply for now. If the recent market volatility has made your nervous as of late, you are probably carrying too much risk in your portfolio.
As always, your portfolio, much like a garden, must be tended too in much the same way. By doing so, it will ensure that it prospers and grows over time and yields a fruitful bounty.
- HARVEST: Reduce “winners” back to original portfolio weights. This does NOT mean sell the whole position. You pluck the tomatoes off the vine, not yank the whole vine out of the ground.
- WEED: Sell losers and laggards and remove them garden. If you do not sell losers and laggards, they reduce the performance of the portfolio over time by absorbing “nutrients” that could be used for more productive plants. The first rule of thumb in investing “sell losers short.” So, why are you still hanging onto the weeds?
- FERTILIZE AND WATER: Add savings on a regular basis. A garden cannot grow if the soil is depleted of nutrients or lost to erosion. Likewise, a portfolio cannot grow if capital is not contributed regularly to replace capital lost due to erosion and loss. If you think you will NOT EVER LOSE money investing in the markets…then STOP investing immediately.
- WATCH THE WEATHER: Pay attention to markets. A garden can quickly be destroyed by a winter freeze or a drought. Not paying attention to the major market trends can have devastating effects on your portfolio if you fail to see the turn for the worse. As with a garden, it has never been harmful to put protections in place for expected bad weather that didn’t occur. Likewise, a portfolio protected against “risk” in the short-term, never harmed investors in the long-term.”
As I have discussed many times in the past, the trend of the market is still positive and there is no reason to become extremely defensive as of yet. However, this does not mean to become complacent in your portfolio management practices either.
If you need help after reading the alert; don’t hesitate to contact me.
Current 401-k Allocation Model
401k Choice Matching List
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