April 27th, 2015
by Lance Roberts, StreetTalk Live
I have frequently written about the fallacy of long-term investment objectives and actual investor behaviors. As repeatedly shown by Dalbar studies, despite what investors and advisors say about long-term investing, the reality is that actions clearly speak of much shorter-term realities.
This is where the disconnect exists between fundamental and economic analysis and portfolio risk management exists. While there is interesting discussion daily on the current economic or fundamental backdrop as it relates to the markets, the reality is that these measures are of little use in actually managing portfolios in the short-term where investors actually operate. Fundamental and economic data points are extremely slow to mature, and even slower actually to have an impact on investor behavior.
Case in point is the ongoing debate about valuations. Valuations are currently at the second highest level in history, as discussed yesterday. Yet, because the market continues to rise in price, due primarily to a flood of Central Bank liquidity, it is has been concluded that "this time is different." It isn't. When the next major market reversion occurs, it will become clearly obvious that the markets were extremely overvalued, and valuation measures will once again be "valued." However, by that point, it will be far too late to do anything about it as investors "panic sell" the next market low.
While fundamentals DO MATTER over the longer-term in determining "WHAT" to buy or sell, in the shorter-term, where investors actually operate, it is price movement that determines the "WHEN". This is even why the famous William J. O'Neil, founder of Investor's Business Daily, stated in his book "24-Essential Lessons For Investment Success" that:
"It is definitely not an 'either-or' question. Rather than limiting yourself, you must consider both fundamental information about the strength, quality, and soundness of the company and the technical side of how a stock is performing in the marketplace."
It is this "technical side" of the story that I want to examine today specifically.
Since the end of the 2012, coincident with the Federal Reserve's implementation of QE3, the market has been on an unrelenting bullish trajectory that has defied weakening underlying economic data and market fundamentals. In other words, price momentum has deviated from underlying fundamentals as investor exuberance has escalated. Such deviations have been witnessed near the peak of every major bull market throughout history. This time is no different.
Even though the liquidity driven interventions came to an end in October of 2014, the market has continued its upward advance as momentum has kept prices afloat. While price volatility has certainly increased in recent months, I have maintained a fully allocated portfolio model as the primary bullish trend has remained intact. However, it is worth noting that the current bullish trend is extremely long by historical standards. This is shown in the chart below.
I have also noted the historical buy and sell points as noted by long term MACD trends. Importantly, the MACD indicator is very close to issuing only its 5th signal since the turn of the century. While this does not mean that the next "financial crisis" is set to be unleashed upon the financial world, such signals have only been associated with previous major market tops.
However, it is the recent market action that is most concerning. While the majority of the mainstream analysts and commentators continue to suggest that the markets will continue their bullish advance for a seventh year in a row, historically unprecedented by the way, the current price consolidation may be sending a different message.
As shown in the chart below, the market has been remained trapped in a tightening pattern of higher lows and lower highers. This type of action is like the compression of spring. In the next few days, the markets will make an important decision. A breakout to the upside of this consolidation will confirm the current bullish trend, and portfolio actions should remain allocated and tilted more heavily towards equity related risk. However, a break to the downside will likely suggest a more significant correction in the near term. It is worth noting that this consolidation in the market is happening during a decline of relative strength. This is a warning sign that generally bodes poorly for the bulls.
Since portfolios are currently fully allocated to the market, if the market breaks out to the upside of the current consolidation this will simply confirm that the "bulls" are still currently in charge of the market. No action will be required.
However, as shown in the chart below, a break to downside suggests that more significant risk of capital destruction could be in the offing.
There should be some initial support at the long-term bullish trend line. However a break of that level, which will be very likely, will quickly see a test of 2000 on the S&P 500 index. A failure of that psychological support level, and the market will begin searching for support at 1925ish and 1850. (I have noted again in the upper part of the chart that relative price strength has NOT been confirming the bullish price advance in the market since the middle of 2014. Also, the lower part of the chart shows the current market buy/sell signal. Why still currently on a "buy," there is little margin for error at this point.)
In order to reinforce the importance of the "buy/sell" indications driven by price momentum, I have stepped the chart out to a much longer time frame on a MONTHLY price basis. As shown, the MACD indicator at the bottom of the chart is confirmed by the price momentum oscillator just above it. Since 1999, there have only been four prior signals with each being critical turning points in the markets.
As stated, the next few days to a couple of weeks are going to be extremely critical for the markets in terms of price action. A downside break of the current consolidation pattern will likely result in a bigger correction during the summer months which would align with historical market tendencies.
Furthermore, the markets are long overdue for a more substantial market correction of 10%, or more, following one of the longest unabated bull market runs in history.
While none of this means that the current bull market is set to end, it does suggest that the risk of a more substantial downside correction has increased. This is where prudent portfolio management and risk controls will pay large dividends over the media's "buy and hold" mentality. Caution is advised.