Time to Increase Allocation?

February 7th, 2015
in contributors

X-factor Report 07 February 2015

by Lance Roberts, StreetTalk Live

After a very bumpy December and January, I wrote this past Monday that the markets had reached enough of an oversold condition to bounce. That call was almost perfect as the markets had one of their biggest rally weeks in the past three years.

Follow up:

To wit:

"However, during any correction, or more importantly during a mean-reversion process, the financial markets do not move in a singular direction but rather like a "ball bouncing down a hill." For investors, it is these short-term bounces that should be used to rebalance exposure to "portfolio risk."

As shown in the chart below, the S&P 500 has gotten oversold on a short-term basis and is due for a bounce to the current downtrend resistance line. Importantly, the market is sitting on what has been critical support in recent months at the 150-day moving average. A failure of this support will lead to a retest of the October, 2014 lows."

(The chart below is from Monday)
SP500-DailyChart-Analysis-020215-2

The rally this past week did move the market above the downtrend resistance as noted in the updated chart below. In addition, as you will notice, the oversold condition that did exist, has evaporated. It is now IMPERATIVE that the markets clear the next two levels of overhead resistance and substantially breakout to new highs if this rally is to be sustained. The support line has become a critical component of the markets over the last several months. A significant break of that support (blue line) could signal the onset of a much bigger correction. Pay attention.

SP500-Chart1-020615

NOTE: These near vertical pushes higher, as witnessed since the end of October, are not historically typical. However, the clearance above the downtrend resistance does give some room to increase equity exposure in the portfolios (see 401k plan manager below for details).

A rally from this support line could last several days to a couple of weeks. It is advisable to use the rally to "clean up" existing portfolios by selling laggards, reducing high-beta risk and rebalancing winners by taking profits and rebalancing back to target weights.

(Important note: Notice that I did not say "rebalance portfolios" which implies selling winners to buy losers. The goal here is to let winning positions continue to flourish by simply "pruning" the position, and "weeding" the portfolio by selling the losers dragging on overall performance.)

However, any action you take should be done with EXTREME CAUTION. As stated, any action should include the regular and consistent instruction to rebalance portfolios, trim winners and sell laggards which has only enhanced portfolio stability to date.

Just as a reminder, here they are again:

  • Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.
  • Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.

    Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low


    Important "Sell Signal" In The Works

    Lastly, the long-term chart of the markets are beginning to flash warning signs that this extremely long bull-market cycle may be at risk. While it is still too early to make a more defensive call now, there are signs of significant deterioration in the overall "momentum" of the market.

    The chart below shows two of the three indications on a monthly basis labeled S1 (sell signal 1) and S2 (sell signal 2). There have only been three periods since 1998 where the S1 indicator has been triggered. The first was in late 1999 as the markets climaxed toward their peak in 2000; the second was in late 2007, and the third was in January of this year.

    Monthly-Sell-Signal

    Considering that market momentum is waning, deflationary pressures are rising and economic growth is slowing on several fronts (along with a rather rapid decline in corporate earnings) it certainly suggests that risks are beginning to outweigh the rewards significantly. Is this suggesting that the next major bear market is underway? No. It does suggest, however, that investors should pay much closer attention to the inherent risk in portfolios currently.

    The S1 signal could be reversed with a very strong rally that propels the markets to new highs. While this is certainly possible, it has historically not been the case. However, the market over the last few years, due to massive Central Bank interventions, has repeatedly defied statistical analysis and historical comparisons.

    The next couple of weeks will be extremely important for the markets to regain their"mojo" otherwise the risk of a much larger correction remains a dominant threat. As we saw with the Seattle Seahawks during the SuperBowl, making the wrong call late in the game can have disastrous consequences.


    Oil And Energy Stocks

    Last week, I heard a money manager proclaim that "no one could have foreseen the collapse in oil and energy stock prices."

    Really? I guess he doesn't read my weekly missive because beginning in early June of 2014 I begin warning about the deviation between oil and energy stock prices and that a massive correction would have to eventually come. To wit:

    "In early May I set a target for oil prices at $106. That target has now been reached. With oil prices extremely overbought, now is a good time to take profits in energy related stocks. This is particularly the case in operators and drillers that are directly impacted by changes in oil prices."

    Those warnings intensified into the early summer as I warned:

    "While oil prices have surged this year on the back of geopolitical concerns, the performance of energy stocks has far outpaced the underlying commodity.

    The deviation between energy and the price of oil is at very dangerous levels. Valuations in this sector are also grossly extended from long term norms.

    If oil prices break below the consolidation channel OR a more severe correction in the markets occurs, the overweighting of energy in portfolios could lead to excessive capital destruction."

    Sector-Oil-Energy-080214

    And the again in August:

    "Oil prices have now broken down below the long term consolidation channel which suggests further economic weakness as well. Be warned that if oil prices do not begin to firm soon, overweighting of energy in portfolios could lead to excessive capital destruction."

    Sector-Oil-082214

    And then again in early September:

    "Oil is currently VERY oversold on a short-term basis and will likely bounce in the next couple of weeks potentially giving a lift to energy stocks. This would likely be a good time to lift some exposure and reduce weightings to the sector for the time being."

    And again:

    "Energy stocks have violated intermediate term support. Profits should be harvested on a rally and overall portfolios weightings reduced. As discussed above in this week's missive, the spike in the dollar is negatively impacting oil prices and the massive deviation between energy stock prices and oil could be filled. Caution is advised until performance improves."

    Then the most important warning came in November:

    "Those comments fell on deaf ears back then (August). However, the good news is that the recent rally in energy stocks has gotten the sector into the previously shown "sell zone."If you have gotten yourself trapped in this sector, are overweight energy, or need to rebalance your portfolio - this is the opportunity to do so.

    The deviation between oil prices and stock prices will be filled with most likely energy prices falling further. This has been a decent "dead cat" bounce as I suggested several weeks ago. Time to take the money and run...for now."

    Sector-Energy-112114

    Okay, you get the idea. It was easy to see coming if you paid attention, unfortunately, since most money managers run an emotionally driven portfolio (fundamental analysis is hugely subjective and emotionally bound) they rarely can see the risks that prevail and the damage that is coming until it is far too late. This is why the large majority of money managers ultimately produce relative performance to their indexes.

    You can do better.

    (See Sector Analysis Section for update on Energy Stocks and Oil Prices)


    Earnings Scorecard

    Via Zacks Research

    Comparing the results thus far with what we have been seeing from the same group of companies in other recent quarters in terms of growth rates, beat ratios, and guidance presents a mixed picture.

    The charts below show the comparison of the results thus far with what we have seen from this same group of companies in other recent quarters.

    Zacks-1-020615

    We have discussed the Apple (AAPL) effect in this space before and the effect is very pronounced.

    The charts below provide a side-by-side comparison of the Q4 earnings and revenue growth rates for the 274 S&P 500 companies that have reported results, with and without Apple in the numbers (the left side is with Apple and the right side is excluding Apple). The comparisons are with what we have seen from the same group of companies in 2014 Q3 and the average of the preceding four quarters.

    Zacks-2-020615

    We should keep in mind however that Apple isn't the only 'unusual' factor this earnings season. Results from the Finance sector, particularly tough comparisons at Citigroup (C) and J.P. Morgan (JPM), have been a drag on the aggregate growth picture. And then we have the whole oil situation, with profitability of the Energy sector companies following what has been happening to oil.

    The chart below shows the results thus far excluding the effect of Apple and the Energy sector. As you can see, the earnings growth picture is broadly comparable with historical levels on this basis.

    Zacks-3-020615

    But irrespective of whether we look at the results as a whole or piecemeal, the weakness on the revenue side comes through - revenue growth rate is tracking below other recent quarters whether we look at the results with or without Apple, Finance or Oil.

    Another common theme in the reports thus far is the impact of a strong dollar and sharp fall in oil prices. The oil price impact hasn't been restricted to the Energy sector alone, even companies like Caterpillar (CAT) have been affected. Estimates for Q4 had fallen more than normal due to the oil development and we are seeing the trend play out in a big way in estimate revisions for the current and following quarters.

    In fact, the magnitude of energy-driven negative revisions for 2015 Q1 and Q2 is so severe that the first half 2015 earnings growth rate for the S&P 500 index as a whole has almost evaporated. The chart below shows what is happening to 2015 Q1 and Q2 earnings estimates for S&P 500 companies.

    Zacks-4-020615

    Earnings are showing signs of slowing and will likely deteriorate substantially more over the next couple of quarters as the effect of declining energy revenues and reduced capital expenditures reverberates through the entire manufacturing complex. Some caution is advised.

    Deflation Is A Big Problem

    In the first six weeks of this year a stunning 16 central banks have reduced interest rates. The question is why is there such a rush to increase liquidity and ease monetary policy?

    This seemingly coordinated move in by central banks is likely the function of deflationary pressures that are surging on a global basis. As shown in the chart below from ANZ's Global Economics team it is likely that the rate cuts were desperately needed.

    ANZ-Policy-Chart2

    The warning is clear. It is highly unlikely that the deflationary pressures that are building on a global basis can ultimately be avoided by the U.S. It is likely only a function of time before the economic growth data in the U.S. shows a more severe deterioration which is already being reflected in everything from corporate earnings and trade deficits.

    Closing Comments

    While the markets can defy logic for longer than one can imagine, it will not last indefinitely. While I will address the addition of equity exposure in the 401k plan manager below, it is important to remember that it should be done cautiously and with a very tight sell discipline.

    Eventually, something will go wrong. When it does, like with energy related equities, the excuse you hear from your advisor should not be "well, no one could have seen it coming."

    See you next week.


    Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer.









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