Can You Trust the Bounce?

October 27th, 2014
in contributors

X-factor Report 27 October 2014

by Lance Roberts, Streetalk Live

Over the last few weeks, the markets have seen wild vacillations as stocks plunged and then surged on a massive short-squeeze in the most beaten up sectors of energy and small-mid capitalization companies. While "Ebola" fears filled mainstream headlines the other driver behind the sell-off, and then marked recovery, was a variety of rhetoric surrounding the last vestiges of the current quantitative easing program by the Fed. As I have shown many times in the past, there is a high degree of correlation between the Fed's liquidity programs and the advance in the markets.

Follow up:


Here is something to consider if you believe that the Fed will end their monetary purchases next week, as I suspect they will. The chart below shows the recent sell-off and rebound matched to the Fed's current monetary interventions.


What do you think is going to happen when the Fed is absent altogether? There is just one round of purchases, roughly $1 Billion, left for October which happens on Monday

Making The Case

Beginning in late 2012, as the Federal Reserve announced their latest innovation of "quantitative easing," the markets launched into an uninterrupted advance that lulled investors into a complacent slumber. Well, that is until a couple of weeks ago when volatility returned with a vengeance and reminded investors that markets can indeed go down.

The markets were, after a near 8% fall, able to garner a bit of a rally from the intraday lows of last week that now has everyone asking whether the current correction is over. For example, Brett Arends recently asked that exact question:

"So how much further might the market fall?

If this is merely a regular correction in the course of a regular economic expansion, the answer may be: Not much further.

Corrections of 5% to 20% are a normal part of the stock market. Legendary Wall Street mogul J.P. Morgan, JPM +0.77% once asked for a stock-market forecast, confidently predicted that share prices would fluctuate. And he's been right ever since."

However, could the current correction be the start of something bigger?

First, let's put the current "massive market correction" into perspective. The chart below shows the S&P 500 overlaid against the Volatility Index (VIX). While volatility did spike higher over the last couple of weeks, it is well within the bounds of the excessive complacency that has been the hallmark of the recent bull market surge.


In last week's newsletter (click here for free weekly e-delivery) I stated:

"The markets did rally to initial resistance but failed to climb above it at this point. However, the markets are oversold enough on a short-term basis that we may see further rally attempts next week particularly if the Federal Reserve holds the line on their current 'tapering' process."

That rally has indeed occurred as expected as "dove-ish" talk from the Federal Reserve, along with an impotent ECB, continues to make "hope" spring eternal for market bulls. Here is the problem. The Federal Reserve will end its current liquidity program next week and the ECB will likely be unable to expend enough "firepower" to pull the Eurozone out of its deflationary spiral.

Furthermore, for the first time since 2012, the markets have experienced "real" technical damage which will take some time and effort to repair. As I touched on last week, the S&P 500 has now broken its bullish "uptrend" for the first time in 3 years as shown below.


The break of the bullish trend line is important and suggests that a further corrective process is likely. The last two times that the markets behaved in this way was in 2011 and 2012. Let's take a look at what happened to the markets in these two periods to see if we can derive an assumption about what may lay ahead currently.

In 2010, the world was just rebounding off of the financial crisis lows as the Federal Reserve's first round of QE had injected over $1.2 Trillion into the financial system. Inventories had rebounded and nascent signs of economic growth had taken hold (remember "green shoots?"). However, as the Federal Reserve brought their liquidity support to an end, economic weakness resurfaced, and markets began to slide.

After an initial sharp break of the bullish trend, markets rebounded sharply to the upside giving "hope" to market bulls that the "selloff" was over. It wasn't.

The ensuing months led to a further decline and a basing process that eventually ended as the Federal Reserve, concerned about the prospects of a recessionary relapse, stepped in with a second round of quantitative easing. It was at this point that Ben Bernanke, then Chairman of the Federal Reserve, made "asset prices" an implicit target of Fed policy.


With the support of the Fed's liquidity flows, asset prices recovered and began to rise once again. But it did not last long.

In 2011, the world was saddled with a global deflationary pressure caused by a manufacturing shutdown as Japan was devastated by the tsunami, tidal wave and a near nuclear disaster. The only thing that was missing was Godzilla smashing up Tokyo.

That summer, the Fed's second round of QE had come to an end, and the market once again began to slide breaking through the bullish trend at that time. The resurgence of economic weakness combined with a "debt ceiling debate" and a threat of a "government default" sent stock prices plunging almost 20% in just over three weeks. The markets initial rebound was short-lived, and the market found a "lower low" over the next two months.


The Federal Reserve, again worried about a potential relapse in the economy stepped up with "Operation Twist" that had a more muted impact on liquidity inflows. However, combined with the ECB's "Long Term Refinancing Operations," market participants once again found the liquidity support necessary to start the next leg of the bull market journey. The market was then accelerated when the Federal Reserve "threw gasoline on the fire" with QE3 in late 2012.

Importantly, in both cases, the initial plunge in the market that broke the bullish trend lines led to a basing process that lasted for a period of time before the "bull market" was able to resume. IMPORTANTLY, the initial rebound in the market was NOT A BUYING opportunity, but rather an opportunity to reduce portfolio risk.

With the Fed's liquidity support now ending, the markets have once again plunged below the bullish trendline. The current rally, like every other time, is most likely a short-lived rebound from extremely oversold short-term conditions.


Importantly, the deterioration in the internal dynamics of the market also suggest that the current rebound is not the resumption of the current bull market cycle, but rather a bounce that will likely be used to liquidate holdings. This will likely lead to a retest of lows, or even perhaps the setting of a new low, before a bullish trend can be re-established.

That is, of course, assuming that the current breakdown in the market is just a rest-stop along the path of a continued "bull-market."

With global deflationary pressures picking up steam, high-yield credit starting to signs of instability, and the lack of liquidity support from the Federal Reserve, a case can be made that the current rout is the start of potentially a larger intermediate-term correction.

Reiterating Instructions

In last week's missive I stated:

"The markets are very oversold short-term which means that we should NOT 'panic sell' at the moment. However, as I have recommended repeatedly over the last several weeks, on a bounce it is advisable to rebalance portfolios.

Once the market does bounce I will likely reduce the portfolio allocation model by 25% depending on the strength and duration of that bounce. More importantly, a failure of the market to obtain a new high will likely indicate that a more immediate top is being formed with substantially more downside to come.

It will be critically important to pay attention to your portfolio in the coming weeks as things could begin to evolve quickly."

As shown in the chart below, the market deterioration has now confirmed the "signal limbo" that we have wrestled with over the last several of weeks.


Last week, the initial sell signal was triggered, but I suggested NOT taking action at that time because, on a "short-term" basis, the markets were oversold. I suggested waiting for a bounce to resistance to begin taking further actions in portfolios outside of the rebalancing instructions I have issued over the last couple of months.

Last week I laid out the following three levels of resistance for a rally in the market.

1900 -is the previous psychological support which is now resistance. This is a good level to reduce major laggards or losers in the portfolio. A little "house cleaning" will free up cash for reinvestment at a later date.

1925 -This is the long-term moving average that has held the bullish uptrend since 2012. This moving average is now major resistance for the market and a failure at this level will signal that the correction is not yet complete. Reduce more towards target levels if this level is reached.

1960 -This is the short-term moving average which is also now resistance. If the short-term moving average crosses below the long-term, we have a real problem. I seriously doubt that the markets can make it above this level in the near term.

2019 -However, should the markets somehow find the strength to surge to all-time highs from here, which is a possibility, then the cash raised from the rebalance and portfolio cleanup can then be reallocated back into portfolios.

Importantly, as I stated previously:

"There is little risk in practicing some form of portfolio 'risk management.' The real risk is doing nothing and then spending the next advance in the market making up previous losses. That has been a successful investment strategy 'nowhere, never.'"

As of the time of the writing on Friday, the market has cleared both initial resistance points put failed to exceed the 1960 hurdle. With the initial sell signal still firmly in place, it is now time to take action and use the recent recovery to rebalance allocations to new target levels.

As discussed last week, I have reduced the model allocation by 25% and had suggested using the reflex bounce in the markets, which occurred as expected, to underweight portfolios temporarily.


With the second "sell" signal not yet confirmed, there is no need currently to reduce portfolio allocations any further.

IMPORTANT: Reducing allocations does not mean "selling everything and going to cash." It is a rebalancing of holdings to correspond with the overall portfolio allocation model. For example, and this is for illustrative purposes only and not a recommendation to buy or sell any security, the following table shows a sample portfolio and the rebalancing process.

As you can see, it is not a wholesale liquidation of assets across the board but simply a reduction and rebalancing of the portfolio relative to economic and financial metrics.


Here are the rebalancing instructions I have provided repeatedly over the last several weeks. This is still the best course of action from a portfolio risk management viewpoint.

  1. Positions with outsized gains for the year should be reduced to original portfolio weights.
  2. Losing positions should immediately be sold in their entirety.
  3. Interest rates have fallen as anticipated this year. This has been a boon for bond-related investments.
  4. Reduce weighting to "high yield" or "junk bonds." Time to "take the money and run."
  5. Cash raised from rebalancing should just be held pending the next buying opportunity.

"Hence the skillful fighter puts himself into a position that makes defeat impossible and does not miss the moment for defeating the enemy." - Sun Tzu

Have A Great Week.

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