May 4th, 2015
by Lance Roberts, StreetTalk Live
I have been discussing the potential resolution of the consolidation pattern that I have been monitoring for the past several months.
Let's start with this past Monday's missive:
"As shown in the chart below, the market has been remained trapped in a tightening pattern of higher lows and lower highs. 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 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."
The upside breakout last Friday, which suggests that the bullish trend remains intact, keeps portfolios tilted towards equity exposure. However, as I stated then:
"...this does NOT mean that all market risk is now resolved, or that investors should return to their complacent slumber."
Unfortunately, the selloff on Thursday failed to confirm that breakout. Let me explain.
First, the analysis I use is based on WEEKLY data in order to slow down portfolio management actions. If you are a "day trader" a more appropriate chart setup might be in 15 MINUTE increments. You might want to use DAILY time frames if you are more of a "swing or very short term" type. However, as an investment manager, I want to lower portfolio turnover and focus on longer term trends from wealth building purpose which requires WEEKLY or MONTHLY data points.
The importance of that note is that it is ONLY THE END OF WEEK CLOSE that ultimately matters. The reason is mid-week the market might take a plunge, but then quickly recover the next day. Therefore, by only using weekly ENDING data, portfolio positions are not "panic sold" due to "knee-jerk market reactions."
Secondly, based on this weekly data, a "breakout" of a "consolidation pattern," as discussed, requires that the price remain above the upper trend line. As of Friday, that FAILED to happen and, therefore, the "breakout" has been voided for now. We REMAIN in the consolidation range currently and will have to re-evaluate overall conditions next week.
The BULLISH note here is that the sell-off on Thursday tested and held, the current support trend of this particular consolidation. The BEARISH note is that the failure of the breakout continues a market consolidation process that could be a TOPPING process ahead of a more substantial correction during the seasonally weak summer months.
Importantly, we are effectively caught in limbo awaiting the markets to make a decision either bullish or bearish. With portfolios fully allocated currently, there is little need to "make a guess" but rather just be patient and let the market TELL US what to do next.
In order for the bullish trend to be maintained, a sustained breakout to the upside of the consolidation needs to happen soon. Momentum, relative strength and many other indicators are suggesting that the bull market cycle that started six years ago is rapidly "running out of gas."
How Can A Market Get Overbought / Sold?
I got into a bit of a "Twitter Debate" last week on the meaning of overbought/oversold. The age old argument is that a market, or stock, can NOT get overbought or sold because there is a "buyer for every seller and vice versa."
While the point is correct that there is a buyer for every seller...what is missed by such a simple argument is the importance of PRICE.
The correct statement should be: There is a "buyer for every seller at a specific PRICE."
Here is a very simplistic model explaining it.
When markets are OVERSOLD, it means that at a given price, the number of SELLERS willing to sell at that price have been exhausted. Therefore, if a buyer wants to make a transaction, the price will begin to move higher to find a new seller at that price.
Conversely, when prices are rising, there is a point where the number of BUYERS willing to buy at a given price are likewise exhausted. Prices then must begin to fall to find new buyers.
IF markets were simply a function of equal buyers and sellers - then prices would be linear. However, as shown below, that has never been the case.
Recognizing that markets become both overbought and oversold is a primary tool for investors. While fundamentals are useful in determining WHAT to buy, it is PRICE that is the single best tool for determining the WHEN to take profits or sell a position entirely.
Importantly, as stated earlier this week:
"The market is currently more overbought now that at any other point in history going back to 1940."
The vertical dashed white lines show that when the extreme overbought condition begins to decline it is coincident with past historical peaks in the market. Furthermore, the long term MACD (moving average convergence divergence) has also turned down which has also historically aligned with more significant market peaks and corrections.
Importantly, this overbought indication is "longer-term" in nature and is slow to move. This means that in the short-term, stocks can, and most likely will, continue to try and advance further due to underlying price momentum. As I have discussed previously:
The effect of momentum is arguably one of the most pervasive forces in the financial markets. Throughout history, there are episodes where markets rise or fall, further and faster than logic would dictate. However, this is the effect of the psychological, or behavioral; forces at work as 'greed' and 'fear' overtake logical analysis.
This is the basic application of Newton's Law Of Inertia that states 'an object in motion tends to remain in motion unless acted upon by an unbalanced force.' In other words, when markets begin strongly trending in one direction, that direction will continue until an 'unbalanced' force stops it.
Currently, with Central Banks fully engaged in monetary interventions on an unprecedented global scale, there is seemingly nothing that can stop the current advance. Of course, it is that very "thought process" that has been a hallmark of exuberant markets in the past.
Reiterating Last Week's Portfolio Management Rules
The combined overbought, overleveraged condition of the financial markets is of extreme risk to investors currently. While the bullish trend remains intact currently, it is extremely prudent to perform some risk management in portfolios.
"...it is worth remembering that portfolios, like a garden, must be carefully tended to otherwise the bounty will be reclaimed by nature itself. If fruits are not harvested (profit taking,) they 'rot on the vine.' If weeds are not pulled (sell losers), they will choke out the garden. If the soil is not fertilized (savings), then the garden will fail to produce as successfully as it could.
So, as a reminder, and considering where the markets are currently, here are the rules for managing your garden:
- HARVEST: Reduce "winners" back to original portfolio weights. This does NOT mean sell the whole position. You pluck the tomatoes off the vine, not yank the whole plant from the ground.
- WEED: Sell losers and laggards and remove them garden. If you do not sell losers and laggards, they reduce the performance of the portfolio over time by absorbing 'nutrients' that could be used for more productive plants. The first rule of thumb in investing: 'Sell losers short.'
- FERTILIZE AND WATER: Add savings on a regular basis. A garden cannot grow if the soil is depleted of nutrients or lost to erosion. Likewise, a portfolio cannot grow if capital is not contributed regularly to replace capital lost due to erosion and loss. If you think you will NEVER LOSE money investing in the markets...then STOP investing immediately!
- WATCH THE WEATHER: Pay attention to markets. A garden can quickly be destroyed by a winter freeze or a drought. Not paying attention to the major market trends can have devastating effects on your portfolio if you fail to see the turn for the worse. As with a garden, it has never been harmful to put protections in place for expected bad weather that didn't occur. Likewise, a portfolio protected against 'risk' in the short-term, never harmed investors in the long-term."
With overall market trend still bullish, there is little reason to become overly defensive in the very short-term. However, I have this nagging feeling that the "spring" is now wound so tightly, that when it does break loose, it will likely surprise most everyone.
Have a great 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.