Market Rally And Existing Sell Signals

August 25th, 2014
in contributors

X-factor Report 25 August 2014

by Lance Roberts, Streetalk Live

Three weeks ago, as shown in the chart below, the market registered an early warning signal. The following week, as I noted in the newsletter, an initial sell signal was issued.

Since the beginning of August, the markets have staged a strong rebound, which is abnormal for this time of year, as worries about geopolitical risk were dismissed and the Federal Reserve continued to confirm their ultra-accommodative policies going forward. This rally has obviously spurred many questions asking if the rally had reversed the "sell signal."

Follow up:

The short answer is "No." As shown in the chart above the sell signals are still in place. However, if the rally continues into next week, and is fairly robust, the signal will likely be reversed.

SP500-Chart1-082214

This is why last weekend's newsletter was full of warnings with respect to the initiation of the "sell signal" to wit:


"IMPORTANT MESSAGE BEFORE YOU SELL ANYTHING

The current "sell" signal does not mean "panic sell" everything you own in your portfolio and run to cash. As shown in the chart above, these initial sell signals can be short lived particularly when the Federal Reserve is still intervening in the markets.

Furthermore, by the time a WEEKLY sell signal is issued the markets are OVERSOLD on a short term basis. It is very possible, that a rally will ensue in the markets over the next week back to resistance that could be used to rebalance portfolios and reduce risks more prudently."


I am NOT CONVICTED that the current "SELL" signal is going to grow into a bigger correction at this time. THERE IS A FAIRLY HIGH DEGREE OF PROBABILITY that the current signal could be reversed in very short order.

However, the risk of the signal being wrong and having to increase equity exposure in the very quickly is far outweighed by the possibility of the signal being right which could have a far greater capital destruction effect.


SP500-Chart2-082214

Last week ALL indicators were"oversold"on a short term basis.This oversold condition provided the"fuel"necessary for stocks to rebound this as I predicted.It will likely require a move in the markets back to"new highs"in order to reverse the current sell signal.

IF this happens then I will reverse the "sell signal" accordingly and begin to rebuild equity positions in portfolios.


I made a very specific point last week that I must reiterate:"It is very likely that the recent selloff has reached a short term bottom. A rally back to the moving averages is very possible. A failure at those levels will be very significant."

The rally back to the moving average has been completed. What happens next is what is critically important. Either the market will fail and turn lower thus validating the current signal or will blast to new highs invalidating the signal and requiring a reversal of current actions.

IMPORTANT NOTE:While it may seem frustrating that an instruction to reduce portfolio risk could be quickly reversed, this is part of the "risk management" process of portfolios. Failing to act accordingly is what leads ultimately to larger than expected losses. However, this is why the instructions are in a series of deliberate "steps" as the MARKET, not our emotions, dictates what actions need to be undertaken.


As you can tell, I substantially hedged my bets against the sell signal because of the excessive artificial underpinnings beneath the markets which have continued elevate markets over recent months.

Take a look at the chart below.

SP500-CorrectionSizes-081414

Does this look normal or sustainable to you? If you answered "No," then you and I agree.

There are two important points to note. First, each correction since the end of QE2 has been increasingly smaller. This is very much in line with a prediction madein November, 2013 by John Hussmanwhen he stated:

"A discussion of bubble risk would be incomplete without defining the term itself. From an economist's point of view, a bubble is defined in terms of differential equations and a violation of 'transversality.' In simpler language, a bubble is a speculative advance where prices rise on the expectation of future advances and become largely detached from properly discounted fundamentals. A bubble reflects a widening gap between the increasingly extrapolative expectations of market participants and the prospective returns that can be estimated through present-value relationships linking prices and likely cash flows.

As economist Didier Sornette observed in Why Markets Crash, numerous bubbles in securities and other asset markets can be shown to follow a 'log periodic' pattern where the general advance becomes increasingly steep, while corrections become both increasingly frequent and gradually shallower. I've described this dynamic in terms of investor behavior that reflects increasingly immediate impulses to buy the dip."

Hussman-LogSP500-wmc131125-081414

Secondly, I have noted in the chart above (red vertical dashed line) the onset of the most recent QE program. As noted, corrections since December of 2012 have never taken the markets back to extremely oversold levels as had occurred previously. With the Federal Reserve now reducing monetary interventions, it is likely that volatility will increase, and corrections will once again become deeper.

The issue, as discussed by Hussman, is the current "risk on" environment will most assuredly swing to "risk off." It is at this point that most investors are paralyzed into inaction as the realization of what was said 'could not happen, does.

Just keep that in mind for now.


Meanwhile...Back At The Ranch

The expected rally has now occurred with the markets breaking out to new highs. This suggests, that for RIGHT NOW, the current bull market trend continues to remain firmly entrenched. As I stated above, the ongoing injections of liquidity by the Federal Reserve continues to create an artificial support to stock prices. Also, artificially low interest rates have provided corporations with sufficient leverage to increase share repurchases which has been a major driver of asset prices over the last couple of years in particular. (Share buybacks are being used to artificially boost profits per share for reporting purposes.)

As I wrote in "3 Things Worth Thinking About:"

"As discussed above, one to the impacts of rising interest rates is an increased cost of capital which makes two things MUCH less lucrative. The first, and most importantly, is the 'carry trade' which has been a primary driver of asset prices over the last five years. Banks have been able to borrow capital at effectively zero, leverage it, and then buy higher yielding assets to capture the spread. This has created an immense amount of profitability for banks, in particular, in recent years. However, higher borrowing costs significantly reduce that profitability.

Secondly, corporations have been using exceptionally low interest rates to borrow capital, not for the purposes of ramping up production and capital investments, but to buy back stock to artificially boost profits per share. The focus on share buy backs has been intense over the last couple of years as the benefits of cost cutting, employment reductions and wage suppression met their inevitable limits. Like other profitability gimmicks, share buybacks are also finite in nature. After more than two years of increased share repurchases, recent data suggests that this may be coming to an end. As Brett Arends penned:

'U.S. corporations have been spending hundreds of billions of dollars a year buying in their own stock, simultaneously increasing the demand for the stock and reducing the supply. And this matters right now because...er...they just stopped.

The amount spent on share buybacks plunged by more than 20% last quarter...As SG notes, 'US corporates (have) been the major net buyer of US equity in recent years, purchasing over $500 billion of stock last year alone. 'But, notes the bank, this happy trend may be drawing to a close.'

The ready supply of 'free capital' has been a 'punch bowl' to corporations from which they have drunk deeply. According to the Federal Reserve, corporate debt has risen 27% over the past five years to $9.6 trillion. So, much for those deleveraged balance sheets and when the Federal Reserve does increase interest rates; a major supporter of asset prices in recent years will disappear."


Preparing To Reverse Course

Those two inputs, liquidity and stock buy backs, are now ending which begins to put the current bull market trend at some risk. However, in the short term, as stated, the trend remains in place so we need to act accordingly by reducing the cash reserves raised over the last couple of weeks and increasing equity exposure opportunistically.

David Kotok, of Cumberland Advisors, agrees with this viewpoint.

"Cash reserves have been pared back, and monies have been redeployed into exchange-traded fund (ETF) strategies.

Expectations for the continuation of a benign and positive low-interest-rate Federal Reserve policy are emerging and, we expect, will be confirmed in Jackson Hole, WY. At the same time, European Central Bank President Mario Draghi will affirm his central bank's policy stance that suggests very low interest rates for a very long time and a possible introduction of additional quantitative easing measures.

What this means is that the two largest central banks in the world, the Eurozone's ECB and the US dollar zone's Fed, will be at zero interest rates for at least another six months and maybe a year or longer.

There is no apparent inflation acceleration that would cause the Fed or ECB to act. The current data does not support tightening. At year-end, the Fed will be at neutral, and the ECB will be at neutral or easing. Add that the Bank of Japan appears to be preparing for another round of quantitative easing, and the outlook for continued global monetary ease remains intact.

The end result is that monetary stimulus worldwide remains positive. The markets have made substantial corrections. The US economy appears to continue its gradual recovery. It's not robust, but it is improving and not slipping back into recession. For us that means that the upward bias in stock prices is intact.

So, we are back into the markets with a nearly fully invested posture. We do not think markets are cheap. Fairly priced, perhaps, but not cheap. We think there is an upward bias in stock prices. The US economy is recovering at a gradually improving rate. As John Maynard Keynes said, "When things change, I change with them."

On July 3 and 16 we built a cash reserve to be safe. It appears that amount of cash is too much to hold now that there is a little more clarity. That does not mean risk has gone away. Nimble strategies with ETFs can be accommodative on a very quick basis.

For today we are back in, but we are fully prepared to change rapidly if risk premia warrant such action."

I agree very much with that analysis on many levels. I too, like Mr. Kotok am continually studying the inherent risks in the market. The economic underpinnings are not nearly as strong as much of the headline data suggests, and the underlying foundations of the markets, on a technical basis, are deteriorating.

It is important to remember that in the short term, market psychology trumps underlying fundamentals. In the long term, fundamentals matter very much.

No Change To Model Allocation - Yet

With this in mind, and considering that the sell signals are still in place, I am NOT going to change the allocation model this weekend. As I showed last weekend, the model was reduced to 45% from 60% equity.

Portfolio-Allocation-Model-081614

I also gave the following instructions to be used on the current rally which were really more of a "clean up" of current portfolios by getting rid of "toxic" assets and taking profits out of winners.

To wit:

  • "Sell 'laggards' and 'losers' in FULL. These are positions that have performed very poorly relative to the markets. Positions that are out of favor on the run-up - tend to fall faster in declines.
  • Trim positions that have been big winners in your portfolio, back to their original portfolio weightings. (ie. Take profits)
  • Positions which have performed inline with the market should also be reduced back to original portfolio weights.
  • 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.

These are suggestions on how to align your portfolio with the current level of elevated risks. However, it is also important to remember that currently the Federal Reserve is still pushing liquidity into the markets, therefore, a surge to new highs is not entirely out of the question. "

If you followed these suggestions, the underlying portfolio should be fairly clean with an overweight position in cash. Despite the higher cash levels, the portfolio should have gained ground over the last week with only minor underperformance relative to the benchmark index.

For this week, I suggest remaining "pat" and awaiting for market action to confirm the recent breakout. With the markets still on "sell signals" currently, there is a possibility that the current corrective action in the market is not over as of yet.

Investor "bullishness" and excessive complacency have quickly returned to the market which is now once again very overbought on a short term basis. Any dip in the market that does not violate short term supports, and reduces some of the short term overbought conditions, can be used to add selective exposure back to equities.

Do not misunderstand me, there is a fairly high degree of risk in the markets currently and just as the recent "sell signal" was quickly reversed, it can go in the opposite direction just as quickly. As Mr. Kotok stated: "For today we are back in, but we are fully prepared to change rapidly if risk premia warrant such action."

Next week, depending on market action, I will revisit the portfolio allocation model and adjust accordingly.

Please feel free to send your comments or questions to me at lance@stawealth.com or tweet me.









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