Time To Get More Cautious?

June 15th, 2015
in contributors

X-factor Report 14 June 2015

by Lance Roberts, StreetTalk Live

Over the last several months, the market has been in a broader consolidation trend that has defied the underlying deterioration in overall price action. It is important to remember that the "price" of the market on a daily, weekly, monthly or even a yearly basis is a picture into the "psychology" of the "herd" of market participants that make up the market.

Follow up:

That psychology, as I have shown this many times in the past with the following chart, explains why price often become dislodged from fundamental realities for longer than rational logic would dictate.


All three sections of this week's missive are going to be focused on the current market action as it relates to current portfolio allocations.

A Review Of Where We've Been

Apparently, judging by the number of emails, the recent volatility in the stock and bond markets has finally awoken many complacent investors. To wit:

"Stocks and bonds are both declining in value at the same time. What should I do to protect my portfolio as I am bleeding money over the last couple of weeks?"

First, had you been following this missive over the last few months your portfolio should actually be in pretty good shape given the repeated advice to weed, prune and harvest the portfolio. (Instructions are once again repeated in the 401k plan manager section below.)

However, the decline in stock prices as of late is a "real" issue. The reason that I say it is the "real" issue is because the decline is barely perceivable when put into relative context of the market advance.


This deterioration is suggesting that the risk of a more substantial decline is rising. Given the length of time that the market has advanced without a 10% or greater correction, such a decline should not come as a suprise. As shown by the chart below, we are in the 3rd longest advance in history without such a correction.


Secondly, the risk is particularly elevated given the deterioration in momentum across all of the major indicators as I discussed this past week:


Bullish Trend At Risk

However, while the bullish trend of the market does indeed remain intact, for now, it is extremely noteworthy that the deterioration in the underlying technical structures has gained momentum as of late. As I discussed with a financial reporter this past Friday, holds true through this week as well.

"The markets are starved for liquidity. The stronger than expected jobs report, which doesn't jive with the economic data, paves the way for the Fed to hike rates in June or September.

This is a further restriction in liquidity. Remember, the markets have been rallying on BAD news because it pushes out Fed rate hikes. Good news - is technically bad for stocks at this late stage of the economic and market cycle."


"Here is the problem, the markets need to rally and close positive on Friday. Otherwise, the downward pressure will likely continue into next week putting the recent breakout at risk.

The collision of the short-term moving average and the bullish trend makes Friday's closing action very important. A closing break below that level could trigger more selling next week.

Mind you, this is like weather forecasting. It is currently cloudy with a chance of rain. However, things can change which is why it is critical, as an investor, to be prepared to REACT. In other words, if we think it MIGHT rain we take an umbrella with us. We don't walk around with it open; we are just prepared in the event it begins to rain.

The market has been sending repeated warnings as of late which suggests that investors remain on HIGH ALERT. With portfolio's fully allocated currently, the risk to principal of a sharp downward contraction is elevated.

Oversold Enough For A Bounce

I stated last week that, on a very short-term basis, the market has gotten oversold enough to facilitate a bounce in the days ahead. We saw that short-covering bounce on Wednesday of this past week, but it failed to clear upper resistance levels.


Let's zoom into just year-to-date price action for a clearer picture.


If that market is going to regain its "mojo," stocks MUST hold the longer-term moving average that has primarily defined the "bull trend" since the beginning of 2013, and subsequently break out to new highs. A failure to do so will likely lead to a bigger correction in the coming weeks ahead.

As shown in the chart above, the market is currently in a very defined downtrend currently. It will be critical that the market continues to hold the 150-day moving average as it did earlier this past week. A break below that level will suggest a much bigger correction in the works as stated previously.

Warning Lights

With the longer-term bullish trend still intact, there is little reason to become overly defensive in the allocation model currently.

However, all of the indicators are suggesting that investors should be AWARE of the mounting risks. Therefore, investors SHOULD rebalance portfolios as instructed in the 401k Plan Manager over the last several weeks which will slightly increase cash holdings.

These "warning" signals suggest the risk of a market correction is on the rise. However, all price trends remain within the confines of a bullish advance. Therefore, portfolios should remain tilted toward equity exposure "currently."

The mistake that most investors make is trying to "guess" at what the market will do next. Yes, the technicals above do suggest that investors should "theoretically" hold more cash. However, as we should all be quite aware of by now, the markets can "irrational" far longer than "logic" would suggest. Trying to "guess" at the next correction has left many far behind the curve over the last few years.

These "warning signs" are just that - "warnings." It means that we should be prepared to take action WHEN the trend of the market changes for the worse.

While I agree that you "can't time the market," I do suggest that you can effectively and consistently manage the risk in your portfolio.

Our job as investors is to navigate the financial markets in a manner that significantly reduces the destruction of capital over time. By spending less time making up previous losses, our investments advance more quickly towards our long-term objectives.

Currently, the markets are sending a very clear warning. When the "lights" are flashing, it has generally been a good idea to "slow down" a bit to avoid the danger that may be lurking ahead.

Bonds Look Appetizing

As I discussed recently in "OMG, Putting Jump In Interest Rates Into Perspective:"

"First, let's put the recent "short covering squeeze" in the bond market into perspective. The chart below is a 40-year history of the 10-year Treasury interest rate. The dashed red lines denote the long-term downtrend in interest rates."


"The recent SURGE in interest rates is hardly noticeable when put into a long-term perspective. After rates dropped to their second lowest level in history of 1.68%, only exceeded by the "great debt ceiling default crisis of 2012" level of 1.46%, the recent bounce to 2.26% was expected."

Over the last couple of weeks, as the ECB frontloaded much of their QE program, the combination of a lack of liquidity in the bond market combined with a repositioning of US dollar/Euro positions, has lead to a sell-off in Treasuries that sent interest rates higher.

This is NOT THE END OF THE BOND BULL MARKET. Rather, it is likely a very good opportunity to be adding bond exposure back into portfolios for two reasons:

The first is that interest rates, on a weekly basis, are now extremely overbought. Given the inverse relationship between bonds and interest rates, this means that bonds are now very oversold. As I wrote in this past weekend's missive:

"Bonds got extremely overbought in a market that is short on supply. It takes very little to sharply move interest rates from such low levels. However, if the 10-year rate rises it slows economic growth, housing, and CapEx. In an already weak economic environment, there is very little room for rates to run."


"Importantly, notice that, in the top part of the chart, interest rates are once again extremely overbought which suggests this continues to be an excellent opportunity to increase bond exposure in portfolios.

However, given that "timing is everything," the addition of further bond exposure, or the initiation of a position, should be done in incremental stages. Buy some now and add exposure if rates creep higher. It is unlikely that rates will exceed 2.9% in the current economic environment, so the risk for current levels is somewhat limited."

Secondly, bonds will be the beneficiary of a market correction. If the stock market does indeed enter into a bigger correction during the summer months, bonds will likely be the recipient of the rotation out of stocks.

This is an incredibly difficult time for individual investors. While it is easy to be lulled into complacency by the unabated rise in the markets since 2013, it is important to remember that "to all good things an end must come."

While there is little reason to become exceedingly cautious in portfolios today, the risks are mounting simply due to the length of time and distance of the markets advance. Bonds and cash can act as a significant buffer against market declines when they occur. That buffering will limit the "panic" that leads to poor investment decision making by investors over time.

Have a great weekend.

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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