Market Breakout

June 3rd, 2014
in contributors

X-Factor Report, 02 June 2014

by Lance Roberts, Streetalk Live

Over the last couple of months, I have been running a consistent analysis of the market consolidation that began in early February. During the last two weeks in particular, I began discussing two possibilities which included a market breakout or another market failure. This week, the market did the former by breaking out of the consolidation and continuing its current bull market cycle.

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Two other things have also occurred in the past week coincident with the breakout. The "good news" is that an "initial buy" signal has finally been triggered after the "sell signal" was issued in early January.

We choose to remain allocated in our models due to the fact that despite the "sell signal" being in place the markets had technically done nothing wrong. However, even if you did observe the "sell signal" and raise cash it did little harm and certainly would have reduced the emotional "seesaw" that occurred thereafter.

This is an important point. The "buy" and "sell" indicators really aren't so much designed to capture every percentage point advance in the market. Nor are they designed to keep you from losing money. The real value of the signals is to reduce portfolio volatility to a point to where you don't make emotional mistakes. Acting emotionally rarely works out well in the markets, or in life. This is why I focus so heavily on price movement to dictate portfolio actions. I am a believer that we must invest for the long term; however, I also understand that not managing short-term risks can have detrimental consequences.

The chart below shows a longer term picture of the market. This is where the "bad news" is contained. If you look at the bottom part of the chart, you will see a short term MACD which acts as the initial "buy/sell" indicator. While it has turned positive, it has done so in a declining trend. I have drawn red lines over the previous periods where the same set up has occurred.


The declining trend of the indicator is a "divergence" from market price action. Such divergences are typically associated with near term market tops both large and small. But this isn't the only such divergence that are concerning at the present time.

The next chart shows the "volume" of the market relative to the recent advance.


The decline in volume is very suggestive of a rally that is unlikely to be maintained in the short term. This analysis is also confirmed by another divergence in the "participation" of the overall market as shown by the number of stocks on "bullish buy signals."


The same is true with the net number of stocks making new highs.


All of these signs are suggestive of a very tired market.

These divergences tied together with extremely high levels of bullish exuberance and complacency make for a perfect breeding ground for a rather nasty market correction. (These charts are extracted from "Signs Of An Aging Bull Market" if you want to see the rest.)



The point here is simple. The "breakout" of the markets this past week confirms the continuation of the recent bull trend. Therefore, our portfolio allocation model remains unchanged at current levels (fully allocated) for the time being.

However, the internal deterioration of the markets does suggest that "risk" of a correction is rising. This is particularly the case as the Federal Reserve continues to extract liquidity support from the markets. (The recent release of the Federal Reserves Permanent Open Market Operation schedule confirms only $25 billion in purchases in June with NO buys on Fridays.)

Lastly, the breakout of the markets above 1900 this past week, at a time when the Fed is extracting liquidity, is also something that we saw in 2011.


I am NOT suggesting that the current market cycle will exactly replicate the 2011 experience as there have been enough market period chart comparisons as of late. However, what I am suggesting is that a similar "set up" had a negative consequence and the current market cycle should not be taken for granted. Markets don't repeat, but they do rhyme quite often.

Therefore, it is important that you remain keenly aware of the internal weightings of your portfolio and overall allocation model.

3 Phases Of A Bull Market

Phase 1) "What bull market? The fall is right around the corner"

Following a massive, mean reverting, correction - markets tend to bottom and begin an initial recovery.

Most individuals who had been crushed by the previous market decline have only recently "panicked sold" into cash.

There are many signs during this initial phase that a new bullish uptrend has started. Money flows from defensive names in order to chase higher yield, market breadth improves, and volatility declines substantially.

However, despite those indications, many individuals do not believe that the rally is real. They use the rally to sell into cash and angrily leave the markets or continue to stay in cash expecting another failure.

Note: The fastest price appreciation in the market happens during the first and third stages of the bull market.

Phase 2) Acceptance stage

During the second phase individuals gradually warm up to the idea that the markets have indeed bottomed the psychology changes to one of acceptance. At this point, the market is generally considered "innocent until proven guilty."

The overall psychology remains very cautionary during this second phase. Investors continue to react very negatively to short term market corrections believing the bull market just ended. They continue to remain underweight equities and overweight defensive positions and cash. The media regularly touts that "this is 'hated' bull market."

During the second phase stocks continue to climb higher, and market corrections are short-lived. It is between second and third phases that a deeper market pullback occurs. This pullback tests the resilience of the rally, shakes weak hands out of the market, and allows for new bases to be formed. This deeper pullback is used as a buying opportunity by institutions, which missed the initial stages of the rally, and their buying continues to push the markets to new highs.

Phase 3) Everything will go up forever

During the first phase, most individuals remain skeptical of a market that has just gone through a high-correlation, mean-reverting correction. It is at this point that most investors are unwilling to see the positive change in market dynamics.

In phase two, however, investors gradually turn bullish for the simple reason that prices have been steadily rising for some time. Analysts and strategists are also turning universally "bullish" in an attempt to manage their career risk and attract investor dollars.

In the final phase of the bull market, market participants become ecstatic. This euphoria is driven by continually rising prices and a belief that the markets have become a "no risk opportunity." Fundamental arguments are generally dismissed as "this time is different." The media chastises anyone who contradicts the bullish view, bad news is ignored, and everything seems easy. The future looks "rosy" and complacency takes over proper due diligence. During the third phase, there is a near complete rotation out of "safety" and into "risk." Previously cautious investors dump conservative advice, and holdings, for last year's hot "hand" and picks.

The chart below shows these three phases of the bull market over the past three market cycles.


Note: I have highlighted with blue vertical lines the deviation between current prices and the linear trend of the index. The current extreme price divergence is not indefinitely sustainable.

While the current bull market remains "bulletproof" at the moment to geopolitical events, technical deterioration, overbought conditions and extremely complacent conditions; it is worth remembering what was being said during the third phase of the previous two bull markets:

  • Low inflation supports higher valuations
  • Valuation based on forward estimates shows stocks are cheap.
  • Low interest rates suggest that stocks can go higher.
  • Nothing can stop this market from going higher.
  • There is no risk of a recession on the horizon.
  • Markets always climb a wall of worry.
  • "This time is different than last time."
  • This market is not anything like (name your previous correction year.)

Well, you get the idea.

Are we in the third phase of a bull market? Most who read this article will immediately say "no." But isn't that what was always believed during the "mania" phase of every previous bull market cycle?

As stated above, the allocation model remains unchanged this week as the market remains confined to its current bullish uptrend. However, associated risks that have previously led to rather sharp market corrections are present and only lack a "catalyst" to spark a rush for the exits.

We continue to advise using this current rally to rebalance overweight equity positions back to original portfolio weightings. Beware of chasing yield. REITs, MLP's, and Junk Bonds are extremely rich, and these positions are heavily leveraged which will become a real "bitch" during a market reversion.

Have a great week.

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