Continue To Fade Rallies For Now

September 28th, 2015
in contributors

X-factor Report 27 September 2015

by Lance Roberts, StreetTalk Live

Earlier this week, I penned a discussion of the part of the Fed discussion that killed the short-term rally we were hoping for.

Follow up:

To wit:

"Not surprisingly, the failure of the Federal Reserve to hike overnight lending rates sent a clear message to the markets that the economy was simply not strong enough to withstand tighter monetary policy.

While Chairwoman Janet Yellen did her best to pass off the recent disinflationary trends as transient due to the decline in oil prices, the discussion of the potential for negative rates sent a very different message. From the WSJ:

'Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.

One official called for a negative interest rate in 2015 and 2016, something that has been tried in several European countries to boost growth and inflation. The Fed doesn't identify which officials make specific projections.

One reason for the shifting outlook: Officials have become a bit less optimistic about the economy's long-run growth potential. They projected the economy will grow at a rate between 1.8% and 2.2% in the long-run, down from their June estimate of growth of 2.0% to 2.3% in the long-run. A more lumbering economy has less capacity to bear much higher rates.'

FOMC-negative

"With earnings growth already weak, the recognition that the Federal Reserve is likely trapped at lower rates is problematic. It also brings into question the current valuation multiples being sported by the markets currently.

While it is often noted that "low rates suggest higher multiples," it should be remembered that ultimately earnings growth, outside of accounting manipulations and stock buybacks, is dependent on economic growth. Therefore, low rates also suggest economic weakness which will cap organic earnings growth over time. This makes high valuations problematic longer term.

It was this realization, and disappointment, that likely killed the rally that began in earlier this month."

Speaking Of Earnings

As I wrote in "Not All That It Seems," the drivers behind the growth in earnings are not entirely organic. The idea of "permanent liquidity," and the belief of sustained economic growth, despite slowing in China, Japan and the Eurozone, has emboldened analysts to push estimates of corporate profit growth of 6% annually through 2020. Such a steady rise in earnings per share would push levels to more than $183.00 per share. The problem is that such an earnings expansion has never occurred in history as it completely disregards the course of normal business and economic cycles.

The problem with forward earnings estimates is that they consistently overestimate reality by roughly 33% historically. The chart below shows the consistently sliding revisions of analyst expectations versus the reality of corporate profitability. At the end of 2014, it was estimated that by Q3 of 2015 reported earnings would reach in excess of $131.07. However, Standard & Poors then revised down their estimates to just $104.03 at the end of Q1 in 2015. As of September, those estimates are now just $93.90 as the economy has failed to recover as expected.

Estimates for the end of 2015 have once again been knocked down. While it is hoped that earnings will begin to expand once again by the end of 2015, it is quite likely that such hopes are misplaced given the current state of the global economy and potentially recessionary headwinds.

SP500-Earnings-Estimates-092315

With prices well ahead of expectations, and expectations now on the decline, it is unlikely that this ends well. While there are many that suggest that "this time is different" due to accounting changes, Central Bank stimulus, and low interest rates, history suggests this unlikely to be the case.

What has also been stunning is the surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 190%. This is the sharpest post-recession rise in reported EPS in history. The issue is that the sharp increase in earnings did not come from a similar surge in revenue that is reported at the top line of the income statement. Revenue from sales of goods and services has only increased by a marginal 23% during the same period.

Accounting-magic-092315

For profitability to surge, despite rather weak revenue growth, corporations have resorted have resorted to using debt to accelerate share buybacks. The chart below shows the total number of outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buybacks.

SP500-Op-Earnings-Qtr-Chg-092315

However, companies are not just borrowing to complete share buybacks but also to issue out dividends. According to the most recent S&P 500 company filings, the level of cash dividends per share have now reached $10.55 which is the highest level on record. It is also the greatest deviation from the long-term trend of dividends per share since the financial crisis (highlighted in blue.)

SP500-DividendsPerShare-092315

The reality is that share buybacks create an illusion of profitability. If a company earns $0.90 per share and has one million shares outstanding - reducing those shares to 900,000 will increase earnings per share to $1.00. No additional revenue was created; no more product was sold, it is simply accounting magic. Such activities do not spur economic growth or generate real wealth for shareholders. However, share buybacks and cash dividends provide the basis to keep Wall Street satisfied, and stock option compensated executives and large shareholders happy.

The underpinnings of current earnings growth are something worth watching closely. The recent improvement in the economic reports is likely more ephemeral due to a very sluggish start of the year that has led to a "restocking" cycle. The sustainability of that uptick in the economic data is crucially important if the economy is indeed turning a corner toward stronger growth. Unfortunately, with deflationary pressures rising in the Eurozone, Japan and China, the Affordable Care Act levying higher taxes on individuals, and labor slack remaining stubbornly high it is likely that a continuation of a "struggle" through economy is the most likely outcome. This puts overly optimistic earnings estimates in jeopardy of being lowered further in the coming months ahead as stock buybacks slow and corporate cost cutting becomes less effective.

A Retest Of Lows?

The underlying deterioration in technical and fundamental strength continues to suggest that market rallies should be "faded." (That is technical talk for "sell into strength.")

The recent failure at overhead resistance, combined with a continued weak technical backdrop of momentum and relative strength, suggests that a retest of lows in the weeks ahead is still the most likely scenario. As shown in the chart below, the deviation from the long-term bullish trend line was greater than at the previous two bull market peaks. In both previous cases, a break of the market below the shorter-term moving average (red dashed line) subsequently led to a least a test of the longer-term bullish trend line. However, a "test" would assume that the current cyclical bull market is still intact.

SP500-Technical-092215

If the market fails to hold support at the long-term bullish trend, such a failure will dictate a fully completed transition into a more destructive cyclical bear market.

Importantly, market topping processes take quite some time to develop fully and, unfortunately, are only recognized in hindsight. The problem in waiting for "recognition" is that the destruction of capital is already far larger than previously expected. This leads to a series of "psychological" responses that exacerbate the problem such as "hoping to get back to even."

The last point is critically important. In the world of investing, "hope" has never been an investment strategy that one could profit by. It likely won't be successful this time either.


Portfolio Management Instructions

Repeating instructions from last week, it is time to take some action if you have not done so already.

  1. Sell "laggards" and "losers" in FULL. These are positions that have performed very poorly relative to the markets. Positions that are out of favor on the run-up, generally tend to fall faster in declines. (Energy, Industrials, Materials, International, Emerging Markets, etc.)
  2. Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits) (Discretionary, Healthcare, Technology, etc.)
  3. Positions that performed with the market should also be reduced back to original portfolio weights.
  4. Move trailing stop losses up to new levels.
  5. Review your portfolio allocation relative to your risk tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

How you personally manage your investments is up to you. I am only suggesting a few guidelines to rebalance portfolio risk accordingly. Therefore, use this information at your own discretion.

Sector Analysis

Fade The Rallies

As discussed in the body of this week's main report, the internal deterioration of the market, both fundamentally and technically, continues. Momentum continues to weaken along with leadership and relative strength.

While this does not mean that a major "bear market" is about to commence, these are the hallmarks that have preceded more severe market declines. THEREFORE, it makes much sense currently to remain more cautious allocation wise while awaiting a more secure entry point in the future.

Two Charts To Watch

The first chart is the very short-term trading model of the markets. It measures primarily overbought and oversold conditions to suggest safer short-term entries and exits from the market needed for prudent profit-taking and portfolio rebalancing.

At the end of August, following the market decline, I drew a dash blue-line to represent the forthcoming reflexive rally to resistance and a subsequent decline to retest lows. As you can see, so far the market has almost exactly followed that pattern.

SP500-Market-092515-2

However, on a longer-term basis the market remains very negatively biased. As shown, the breaks of both relative market strength and momentum, measured on a longer-term basis, suggests that the path of the market is currently lower.

Importantly, notice the two moving averages in the main body of the chart, these two moving averages have only crossed at points that preceded market declines of 20%ish or more. The 2011 decline would have likely been substantially worse had it not been for the intervention of the Federal Reserve at that time.

SP500-Market-092515

While I am NOT SUGGESTING that a major bear market is about to crack open, it should be recognized that it IS A POSSIBILITY. We are very late in the current market and economic cycle and the inorganic stimulus for assets is being removed. It is well worth remaining more cautious than normal currently.

Working With A Model Allocation

Let's review the model.

NOTE: The following is for example purposes ONLY. It is in no way a suggestion, recommendation, or implication as to any portfolio allocation model currently in use. It is simply an illustration of how to overweight or underweight a model allocation structure.

Again, this is just for educational purposes, and I am not making any specific recommendations. This is simply a guide to assist you in thinking about your own personal position, how much risk you are willing to take and what your expectations are. From that starting point design a base allocation model and weight it accordingly. The closer you want to track the S&P 500 Index, the less fixed income, real estate and cash your portfolio should have. For a more conservative allocation reduce allocations to equities."

Got it? Okay.

Last week, I stated that on a rally this week, which has now occurred, to begin reducing the model holdings to align with the target model allocation by:

  • selling laggards
  • trimming winners
  • raising "cash."

First, let's review the Sector Allocation Rotation Model.

S.A.R.M. Current

The Sector Allocation Rotation Model (SARM) is an example of a basic well-diversified portfolio. The purpose of the model is to look "beneath the hood" of a portfolio to see what parts of the engine are driving returns versus detracting from it. From this analysis, we can then determine where to overweight sectors that are leading performance, reduce in areas lagging, and eliminate those areas that are dragging.

The Sector Allocation Rotation Model continues to deteriorate suggesting that markets are significantly weaker than they appear. As suggested all through this missive, with the reflexive bounce in the market it is NOW TIME TO TAKE SOME ACTION.

SARM-Model 092515

While much of the market has deteriorated in recent weeks, particularly as global economic weakness was reflected in commodities and industrial measures, Financials, Healthcare and Discretionary stocks were outperforming the broader market. However, that picture has deteriorated considerably.

Importantly, notice that while Discretionary, Staples, and Technology are currently leading the market, they are only doing so by not being down as much. This is not really a victory from a portfolio management standpoint as losses still erode capital over time. They are just not eroding as fast.

This is why several weeks ago I began recommending that it was time to "take profits" in these sectors and reduce allocations.

Almost two months ago I began recommending reducing/eliminating exposure in basic materials, industrials and international stocks as the brief leadership on expectations of economic recovery failed along with those hopes. That has turned out to be very prudent and timely. Furthermore, the economic "uptick" in Europe has now faded which will likely increase downward pressures on these sectors. It is now time to further reduce exposure in these areas, particularly in emerging market economies.

Small and Mid-capitalization stocks have broken down considerably and the suggestion to severely restrict allocations in these sectors several weeks was prescient. Volatility risk is substantially higher in these areas and are better used during a firm growth cycle versus a weak one.

As I have recommended over the past two months, bonds have been markedly improving in recent weeks from previous oversold conditions. The recent rally in bonds has reduced the previous overbought conditions, and it is now more OPTIMAL to ADD further exposure to balance allocations in portfolios.

REITS have also been improving as of late and suggests that weightings be maintained there this week. However, I will continue to monitor this sector closely. REITS ARE NOT a replacement for fixed income.

As I stated seven weeks ago:

"I reiterate, adding Bonds, Utilities, Staples and REITs to portfolios going into August and September are likely to be a good choice as any market disruption will send money flowing into safety related areas."

The recent bounce in the market has achieved initial goals for cleaning up portfolios and reducing overall equity risk. The recommendations for "pruning and trimming" exposure over the past couple of months has already done a big chunk of this work so there should be relatively little impact to portfolios currently.

S.A.R.M. Model Allocation

I stated that according to the S.A.R.M. model, those actions, on a reflexive bounce in the markets, would potentially include:

  • eliminating materials
  • eliminating industrials
  • eliminating energy
  • eliminating international/emerging markets
  • eliminating small capitalization
  • eliminating mid capitalization
  • reduce discretionary
  • reduce healthcare
  • reduce financials
  • reduce technology
  • hold utilities
  • hold staples
  • hold reits
  • hold bonds

These actions would rebalance the example portfolio to the following:

With the rally over this past week, we have a good opportunity to raise extra cash to protect yourself in the face of a deeper correction should one occur. As you will notice in the SAMPLE model below cash will be increased to 35% of the portfolio. It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance.

SARM-Model-091815-1

As you can see, there are not DRASTIC movements being made. Just incremental changes to reducing overall portfolio volatility risks. However, if the expected bounce fails at resistance, then further reductions will be required in accordance with the risk reduction modelling.

Remember, as investors, our job is not to try and capture every single relative point gain of the market as it rises. While we certainly want to participate in the rise, our JOB is to protect our capital against substantial losses in the future. A methodology that regularly harvests gains, reduces risk and keeps the portfolio focused on longer-term goals will lead to a more successful outcome.

401-k Plan Manager

Allocation Model

401k-planmanager-092515

Fade The Rally

As noted last week:

The rally last week back to 2020, was cut decisively short by the inaction of the Federal Reserve and fairly negative commentary on the outlook for the economy which I will write about in next week's blog post.

As shown in the chart above, the market has now triggered all THREE sell signals which technically warrants a reduction in portfolio allocations by 75%.

For those that are much more risk IN-tolerant, using rallies to reduce further risk in portfolios, and raise cash, is completely acceptable.

HOWEVER, for longer-term investors, while the market is decidedly under pressure, it has not broken the bullish trend that began in 2009. It is the break of that trend that will denote a change from a bullish to bearish market and require further allocation reductions. Currently, a break and close below the October lows will denote such a change.

In the short-term, the markets are oversold enough for a bounce, however, such short-term bounces should be used for a continuation of portfolio rebalancing processes.

Continue to review your current portfolio holdings and make adjustments as needed.

"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."

If you need help after reading the alert; don't hesitate to contact me. email


Allocation-Model-082815

Current 401-k Allocation Model

30% Cash + All Future Contributions

Primary concern is the protection of investment capital. Examples: Stable Value, Money Market, Retirement Reserves

35% Fixed Income (Bonds)

Bond Funds reflect the direction of interest rates. Examples: Short Duration, Total Return and Real Return Funds

30% Equity (Stocks)

The vast majority of stock funds track an index. Therefore, select ONE fund from each category.

Keep It Simple.

  • 15% Equity Income, Balanced or Conservative Allocation
  • 15% Large Cap Growth (S&P 500 Index)
  • 0% International Large Cap Value
  • 0% Mid-Cap Growth
Common 401K Plan Holdings By Class

Cash

  • Stable Value
  • Money Market
  • Retirement Savings Trust
  • Fidelity MIP Fund
  • G-Fund
  • Short Term Bond

Fixed Income

  • Pimco Total Return
  • Pimco Real Return
  • Pimco Investment Grade Bond
  • Vanguard Intermediate Bond
  • Vanguard Total Bond Market
  • Babson Bond Fund
  • Lord Abbett Income
  • Fidelity Corporate Bond
  • Western Asset Mortgage Backed Bond
  • Blackrock Total Return
  • Blackrock Intermediate Bond
  • American Funds Bond Fund Of America
  • Dodge & Cox Income Fund
  • Doubleline Total Return
  • F-Fund

International

  • American Founds Capital World G&l
  • Vanguard Total International Index
  • Blackrock Global Allocation Fund
  • Fidelity International Growth Fund
  • Dodge & Cox International
  • Invesco International Core Equity
  • Goldman Sachs International Growth Opp.

Equity

Large Cap

  • Vanguard Total Stock Market
  • Vanguard S&P 500 Index
  • Vanguard Capital Opportunities
  • Vanguard PrimeCap
  • Vanguard Growth Index
  • Fidelity Magellan
  • Fidelity Large Cap Growth
  • Fidelity Blue Chip
  • Fidelity Capital Appreciation
  • Dodge & Cox Stock
  • Hartford Capital Appreciation
  • American Funds AMCAP
  • American Funds Growth Fund Of America
  • Oakmark Growth Fund
  • C-Fund (Common Assets)
  • ALL TARGET DATE FUNDS 2020 or Later

Balanced Funds

  • Vanguard Balanced Index
  • Vanguard Wellington Fund
  • Vanguard Windsor Fund
  • Vanguard Asset Allocation
  • Fidelity Balanced Fund
  • Fidelity Equity Income
  • Fidelity Growth & Income
  • American Funds Balanced
  • American Funds Income Fund
  • ALL TARGET DATE FUNDS 2020 or Sooner

Small/Mid Cap

  • Vanguard Mid Cap Growth
  • Fidelity Mid Cap Growth
  • Artisan Mid Cap
  • Goldman Sachs Growth Opportunities
  • Harbor Mid Cap Growth
  • Goldman Sachs Small/Mid Cap Opp.
  • Fidelity Low Price Stock Fund
  • Columbia Acorn US
  • Federated Kaufman Small Cap
  • Invesco Small Cap

The above represents a selection of some of the most common funds found in 401k plans. If you do not see your SPECIFIC fund listed simply choose one that closely resembles the examples herein. All funds perform relatively similarly within their respective fund classes.

I will modify this list over time as the asset allocation model changes to reflect international holdings, emerging markets, commodities , etc. as the model changes to reflect the addition of those holdings.


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. At times, the positions of Mr. Roberts will be contrary to the positions that STA Wealth Management recommends and implements for its clients' accounts. All information provided is strictly for informational and educational purposes and should not be construed to be a solicitation to buy or sell any securities.

It is highly recommended that you read the full website disclaimer and utilize any information provided on this site at your own risk. Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level, be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and applicable laws, the content may no longer be reflective of current opinions or positions of Mr. Roberts. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his or her individual situation, he or she is encouraged to consult with the professional advisor of his or her choosing.









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