High Alert

July 13th, 2015
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X-factor Report 12 July 2015

by Lance Roberts, StreetTalk Live

NOTE: THERE WILL BE NO X-factor Report NEXT WEEK. I am taking my family on their annual summer vacation. However, I will be posting daily blogs and updates along the way at StreetTalk Live if anything important occurs. Please make sure you are connected via Facebook or Twitter to receive notifications as soon as I post to the website.

Follow up:

Talk about volatility. Over the last week, markets have vacillated wildly but, as of this writing, gained NO ground as concerns over China's bursting stock market bubble finally took Greece off of the front page headlines.


As I sit and write this missive, Greece has essentially folded to European Union pressure and have "sold out" the wishes of the voting public. The recent "NO" referendum appears to be nothing more than a farce that the Prime Minister was hoping to lose by getting a "YES" vote. A "YES" vote would have allowed him the ability to seek aid from the IMF/ECB, going against his parties election promises, in the name of serving the public's voted interest. Given the "NO" vote, he must now go against every promise and voter to get aid for Greece. This will likely not bode well for his political career.

The following is a visual of the latest Greek bailout proposal with additional details in this rundown via Bloomberg.

GreeceNewProposalAFP 0

With Greece's main issue most likely resolved this weekend, at least to some degree, the main focus will turn to China. As I have discussed over the course of the last two weeks, the bursting of the "China Bubble" is of far larger concern to the markets than Greece.

"The perils of margin debt should not be readily dismissed. For a real time example of financial market leverage and consequences, one needs to look no further than the Shangai Index in China. That market is in a complete collapse as plunging prices are forcing investors to sell shares. While the Chinese government has injected liquidity, suspended trading in almost half of the listed equities and encouraged pension funds to buy securities, these actions have done little to stem the decline as investors "panic sell" in a rush to safety. That collapse, if history is any guide, is likely not done as shown in the chart below."


"Also, notice the correlation between peaks in the Shanghai Index and the S&P 500. According to a recent Bloomberg article, margin debt in China reached $264 Billion in April of this year. After adjusting for the size of the two markets, is about double that of the roughly $500 billion in margin debt in the U.S.

This difference in relative size was given as a prime example about how margin debt is not a problem for the U.S. However, the relative size of margin debt in the past has not been a "safety net" that investors should rely on. As shown, the level of real (inflation adjusted) margin debt as a percentage of real GDP has reached levels only witnessed at the peaks of the last two financial bubble peaks in the U.S."


"While no single indicator should be relied upon as a measure to manage a portfolio, it should be well understood by now that leverage is a "double-edged sword." While rising margin debt levels provide the additional liquidity to drive stock prices higher on the way up, it also cuts deeply as prices fall.

China is clearly showing the consequences of the unwinding of leverage. Despite government actions to stem the decline, investors are finding ways to extract their capital back out of the market in fears of a repeat of the 2008 crash. It is a lesson that should be studied and learned by investors today.

Just as the Federal Reserve encouraged investors to jump into the financial markets by providing liquidity and suppressing interest rates, China also encouraged their population to do the same. Instead of taking actions to control the rise, they encouraged it. The problem is that when the "bubble" pops - it becomes uncontrollable."

As I stated, the Chinese Government has passed strict laws against selling stocks, have sent the police to arrest individuals for selling as the Government was buying, have instructed banks and pension funds to buy stocks and have suspended trading on almost half of all stocks on the exchange. It should be NO surprise that stocks rose in trading on Friday with that kind of direct intervention.

The problem is that it is not sustainable. Eventually, stocks will have to be reopened for trading and some laws lifted to allow for normal activity. When that happens, the rush to sell will drive stocks lower again. A "bubble" can not be sustained indefinitely.

The same applies to the financial markets in the U.S.

Looking To Reduce Equity Risk

For the last several months, the markets have defied the deterioration in the internals. Weakening internals from momentum to breadth have all suggested that markets were becoming much more dangerous in the short term.

It was from that stand point that I begin reiterating every week that investors should be taking some actions in portfolios. As per the April 24th Newsletter:

"Just as a refresher, 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:

  1. 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 vine out of the ground.
  2. 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." So, why are you still hanging onto the weeds?
  3. 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 NOT EVER LOSE money investing in the markets...then STOP investing immediately.
  4. 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."

I realize that many of you who are more sophisticated and/or professional investors will find such instructions rather rudimentary. However, the importance of the message was to begin taking some actions in ADVANCE of a market correction rather than being put into a position of REACTING after the correction begins.

Therefore, if you have followed the instructions up to this point, portfolios should be slightly overweight in cash and much of the equity risk has likely been reduced to a good degree. That now puts us in a good position to act accordingly as market events continue to unfold.

That brings us to the market itself. A significant change is potentially occurring in the markets as I write this missive. Take a look at the chart below.


There are several very important considerations in the chart above.

  1. Starting with the topmost indicator. During this entire bull run, when the markets have tested the long-term bullish trend, the upper overbought/sold oscillator has come close to the 50 level on the index. The recent test of the long-term bullish trend has not created a sufficient correction and suggests that more work to the downside still needs to be done.
  2. In the main part of the chart, the market has been holding support at two primary WEEKLY moving averages. Since the implementation of QE3 in December of 2012, corrections in the market have been shallow and primarily running along the short-term moving average. The recent test of the longer term moving average is more serious. Currently, the market has been unable to move back above the short-term moving average which is acting as resistance. IF the market fails to clear resistance and breaks the longer term moving average, there will most likely be a much deeper correction.
  3. Lastly, the bottom two indicators are both registering "SELL" signals for the first time since the beginning of QE3. This suggests that investors should be on HIGH ALERT in the short term as the easiest direction for prices currently is down. A reversal of these indicators is needed to confirm that the bullish trend has resumed, and it is safe to aggressively increase risk profiles.

No Change To Model This Week

While volatility has certainly increased over the last week, along with a deterioration in overall price action, the market held important support keeping the model allocation (see 401k plan manager) unchanged.

As shown in the DAILY chart below, while the market is currently holding important support at just above 2040 on the S&P 500, it has failed to clear the bullish trend line that is now acting as stiff resistance to the advance. Furthermore, the oversold condition of the market is being worked off as the market continues its decline after failing to attain new highs in June.



If the market rallies back to an OVERBOUGHT condition WITHOUT attaining new highs, the model allocation will need to be reduced by 25%. Next weeks action will likely be decisive in the next move that needs to be made within portfolios.

This is no time for complacency. The level of portfolio risk has certainly risen markedly in recent weeks. Just because markets have been able to hold up thus far does not mean that they will continue to do so.

A downdraft in the markets could happen very quickly, and some planning about what actions should be taken must be considered.

As I stated previously, if you think it might rain you generally carry an umbrella with you. If you don't need to use it great. It just sucks to get caught in a downpour without one.

Have a great week, I will be back in two weeks.

(As stated, I will post any important changes to the website directly)

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 at the bottom of this report.

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