October 12th, 2015
by Lance Roberts, StreetTalk Live
Over the last couple of weeks, I have been discussing the potential for a short-term rally in the markets.
That rally has now occurred and as I addressed this past Thursday:
"As you can see, the markets did retest the late August lows, and when combined with the very oversold conditions, led to a frantic 'short covering' rally back to previous resistance. It is worth noting that the recent market action is very similar to that of the August decline and initial rebound as well."
Importantly, while the market has rallied back to its previous resistance levels, it has also become extremely overbought once again as well. This suggests that a bulk of the rally from the lows is complete, and investors should continue to 'fade rallies' until a more bullish trend resumes.
However, for that more "bullish" outlook to take root, the market will need to rise above 2060 currently. The problem will be the strong level of resistance provided by the two long-term moving averages that have only crossed during more severe market corrections.
With a large number of technical indicators currently suggesting that the easiest path for prices is downward, investors should remain cautious of overly aggressive exposure in the short-term. If the market is still confined within a more 'bearish' trend, the current rally, like the ones that preceded it, will be a 'rally to nowhere.'
The following chart updates that note through Friday's open and shows the market currently working its way back to a normalized 61.8% Fibonacci retracement of the decline from the highs.
GEEK ALERT: Okay, I know, I just threw out a bunch of jargon. Here is what it means in plain english.
If you stretch a rubber band as far as it will go in one direction, the initial snap back will almost encompass the same distance in the opposite direction. Each subsequent back and forth action will encompass progressively smaller distances until the motion is exhausted. In the financial markets, sharp moves in one direction will be offset by a subsequent "snap back." These snapbacks are generally about 50% of the previous decline but can sometimes be a bit more. Fibonacci retracement levels are a mathematical measure of these potential retracements.
Importantly, this potential retracement will encounter extremely heavy resistance from the long-term moving averages that are just overhead. Furthermore, that resistance will be compounded by the now extremely overbought conditions of the market.
IF you have NOT taken any action in your portfolio in recent weeks, or months, this will likely be an excellent opportunity to implement the portfolio management instructions below.
What The Fed Really Said
The market rallied on Thursday after the release of the minutes from the latest FOMC meeting in September. With the market oversold, and sentiment bearish in short-term, the rally was not unexpected as I discussed over the last couple of weeks. However, what did the markets see in the minutes that gave the emboldened the bulls?
To put this into context, you must first understand WHY the Fed raises or lowers interest rates.
Increasing interest rates raises the cost of borrowing money within the economy. Therefore, the higher borrowing costs rise, ultimately the lower the demand for credit in the economy. As the demand for credit falls in an economy, economic growth will slow subsequently bringing down inflationary pressures. The opposite occurs when the Fed lowers interest rates.
The problem is that Fed actions do not occur in a vacuum. As shown in the chart below, this is why monetary interventions by the Fed have consistently led to booms and busts.
As discussed on Thursday, the economic backdrop in the U.S. is very weak and potentially in the early throws of a recessionary onset. However, we won't know that for sure until the backward revisions to the data occur next year.
"Importantly, as with the GDPNow indicator, the CFNAI is showing that the economy is running weaker than headlines have suggested.
Despite Central Bank interventions, suppressed interest rates, and a surging stock market, the economy has failed to gain any significant traction. This is an anomaly that we can also see in the CFNAI data.
If we break the CFNAI down into a "supply" and "demand" model we see a very interesting, and telling, picture emerge."
"As shown the supply side of the index has historically had an extremely high correlation to the demand side. That ended with the financial crisis. Since then the supply components have far outpaced the actual underlying demand in the economy. This goes a long way to explaning the ongoing weakness in economic growth as the lack of aggregate demand continues to weigh on labor and wage growth."
This is clear evidence as to why DE-flation continues to rule the economic backdrop and why the Federal Reserve remains trapped at the zero bound for interest rates. To wit from the latest minutes:
"Nevertheless, in part because of the risks to the outlook for economic activity and inflation, the Committee decided that it was prudent to wait for additional information confirming that the economic outlook had not deteriorated and bolstering members' confidence that inflation would gradually move up toward 2 percent over the medium term."
"Members noted that recent global and financial market developments might restrain economic activity somewhat as a result of the higher level of the dollar and possible effects of slower economic growth in China and in a number of emerging market and commodity producing economies."
While the Federal Reserve is still "hoping" that economic conditions will improve by year end to increase interest rates, the reality is such will NOT be the case. That reality was immediately reflected in Fed Funds Futures which implied a sharp drop in the potential for a tightening of monetary policy by year-end.
While much of the mainstream bullish media continue to suggest that increases in interest rates are NOT a problem for stocks, the truth is quite the opposite. Tighter monetary policy will reduce economic growth and inflationary expectations making already overvalued stocks even more overvalued on a relative basis. REMEMBER - the primary bullish argument for stocks has been the low level of interest rates. Remove the low level of rates and you have a problem.
This was fuel needed by the "bulls." Continued "accommodative" policy by the Fed is good for stocks in the short-term. The long-term consequence of being trapped at zero rates, is an entirely different story and an article in the near future.
For the Federal Reserve, stock price action is very important. A decline in asset prices reduces consumer confidence and as such impacts economic growth. Such a negative event will keep the Fed trapped at zero. This was noted in the FOMC minutes:
"During the discussion of economic conditions and monetary policy, participants indicated that they did not see the changes in asset prices during the intermeeting period as bearing significantly on their policy choice except insofar as they affected the outlook for achieving the Committee's macroeconomic objectives and the risks associated with that outlook."
As I showed in last week's missive, this is why the Fed has been once again expanding their balance sheet which flows directly into financial assets.
"As shown in the chart below, the Federal Reserve has already once again began to quietly expand their balance sheet following the recent downturn. Not surprisingly, the market has responded in kind with the recent push higher. My suspicion is that if such minor interventions fail to stabilize the market, a more aggressive posture could be taken."
Unfortunately, for the Fed, this is the "trap" they have gotten themselves into.
The threat of higher short-term rates causes the dollar to strengthen which causes global funding stresses. Those stresses then create conditions that cause external economic weakness which cycles back into the U.S. economy. Then the Fed says they can't hike rates due to the global economic weakness.
As I have repeatedly stated for the last 18 months. It is highly unlikely the Fed will raise this year. The problem for the Fed is that as the realization occurs they are indeed caught in a "liquidity trap" - the conversation won't be about higher rates, but negative rates of interest.
Economically this is a very bad thing.
Short Squeeze From Hell
While the FOMC minutes gave the "bulls" some confidence - it is the massive amount of short-interest (people betting on markets to fall) that provided the fuel.
The chart below, from ZeroHedge, shows the massive jump in short-interest that has to be covered as stock rise. When players that are "short the market" are forced to cover - it fuels additional buying in the market which requires more shorts to cover. So forth and so on until that "fuel" is exhausted. This is why market rebounds tend to be extremely sharp and fast, but also fade just as quickly.
Importantly, there is a big difference between a fundamentally based "bull market" rally and a short-covering rally in a "bear market" cycle. While it is too early to say that we are indeed in a bear market, there are many indications that may well be the case.
Therefore, as stated above, it is likely wise to use the current rally to take some action in portfolios for now. Remember, it is always easier to get back into the market once the path higher is clear. It is much harder using the next rally simply to make up previous losses.
Portfolio Management Instructions
Repeating instructions from last week, it is time to take some action if you have not done so already.
- 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.)
- Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits) (Discretionary, Healthcare, Technology, etc.)
- Positions that performed with the market should also be reduced back to original portfolio weights.
- Move trailing stop losses up to new levels.
- 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.
Bounce Close To Complete
As discussed in the body of last week's main report, the markets had reached a sufficiently short-term oversold and bearish condition which provided for a reflexive market rally. I also stated such a rally could last through the end of the year. However, that does NOT mean that it will be a straight line higher or that it will achieve new market highs.
As shown in the chart below, the markets are trapped between previous resistance and support at the recent lows. However, importantly, notice that the two long-term moving averages are about to cross. This does not happen outside of a more critical bear market cycle.
The current reflexive rally is likely close to completion in the short-term. However, there is a possibility that the markets will remain trapped within a fairly broad trading range through the end of this year. This is another reason why I stated that any rallies should be traded and not "bought."
As I stated last week in reference to the current deterioration of internal measures:
"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."
The chart below shows the breakdown in internals currently. As shown, these things have only occurred during previous bear market cycles, so we should not dismiss them lightly.
Has Energy Bottomed Yet?
Last week, I discussed that it was time to take profits in bonds as rates had hit our target lows for the time being. To wit:
"With rates now once again back below 2%, much of the potential gain has been seen to this point. It is therefore prudent to once again "take profits" in bond holdings and reduce exposure back to target rates.
With the market oversold it is very likely that any ensuing rally in the market will push rates back up to 2.4% as money rotates from "safety" to "risk." Such an opportunity will once again provide another opportunity to buy bonds more prudently."
Since, a rotation out of bonds is generally associated with an increase in "risk" appetite, the most obvious place for money to flow was into the most beaten up sectors of the market - Energy, Basic Materials and Industrials.
As stated in the main part of this week's newsletter, there is a huge amount of short-interest built up in the market and in the energy sector specifically. Therefore, the recent push higher in energy stocks was not surprising.
However, the question is now: "Was that THE bottom for energy stocks?"
That answer is simple: "No."
During the next recessionary drag, which will likely occur in the next 12-24 months, all equity classes will decline by 30% or more. This includes energy and MLP's as forced selling to cover margin calls will be indiscriminate regardless of fundamental and valuation arguments.
Furthermore, the onset of a global recession will drag commodity prices even lower, including oil, as economic growth and demand falters. This is why oil in the $30's is a viable possibility in the months ahead as supply remains elevated.
By the way, this was the same statement I made in June of last year before the plunge in energy stocks began. It was commonly believed that MLP's would be a "safe harbor" during a decline in the energy market. I stated it wouldn't be as the psychology of risk would overtake fundamental arguments. This will always be the case during a rapid market decline.
The chart below shows the NYSE Energy Index compared to the price of West Texas Intermediate Crude.
While WTIC traded into extremely oversold territory, the failed rally attempts so far has reduced much of that previous oversold condition. Likewise, energy stocks are "reverting" to their more historical correlation with oil prices.
For now, energy remains a trading opportunity rather than a long-term addition to portfolios.
IMPORTANTLY - Energy stocks are NOT CHEAP. Just because they are low in price, relatively speaking, does not mean they are cheap. Ultimately, psychology will define what "cheap" really is, and with everyone still clamoring to jump into energy, it is likely that we will see much lower prices in energy-related exposure first.
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.
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, a reflexive bounce in the market can be traded but not bought.
As discussed previously, the market was due for an oversold bounce which has occurred. However, with the markets now moving into the "seasonally strong period" of the year, it is possible that the markets could begin attempting to trade in a more consolidated pattern over the next couple of months. This provides shorter-term investors with an opportunity to potentially add some selective exposure over the next few weeks.
Last week, I recommended taking profits in fixed income as rates had reached their target levels. That advice has worked out well and provides some additional cash reserves to the portfolio.
Over 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.
However, those sectors have become extremely oversold and the recent bounce in these sectors likely have some more room to run. This also includes international stocks which have begun to show improvement as well. From a short-term trading opportunity only, for now, these sectors can be selectively added to during market corrections. Again, this is a trading opportunity that will likely have a fairly short-trigger.
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. While we are seeing some short-term improvement in performance, the risk is still too elevated to additional exposure now. However, there could be a tradeable opportunity in the weeks ahead.
It is still prudent to REDUCE bond allocations in portfolios back to original allocations (take profits).
The same advice for bonds applies to UTILITIES and REITS which have also performed very well as of late.
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 only minor changes needed 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:
- On Pullbacks - ADD materials
- On Pullbacks - ADD industrials
- On Pullbacks - ADD energy
- Eliminating international/emerging markets
- Eliminating small capitalization
- Eliminating mid capitalization
- Hold discretionary
- Hold healthcare
- Hold financials
- Hold technology
- Trim utilities
- Trim staples
- Trim reits
- Trim bonds
These actions would rebalance the example portfolio to the following:
With the rally over this past week, there is now a potential for a short-term rally through the end of the year. As you will notice in the SAMPLE model below cash was reduced to 29% of the portfolio. This is for a SHORT-TERM trading opportunity only. If you a longer-term investor it is advisable to wait for a clearer bull-market confirmation to be made.
It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance.
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 modeling.
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
Continue To Fade Rallies For Now
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.
As discussed in the sector allocation section, there is a potential short-term trading opportunity in the more distressed areas of the market. However, I suggest such only with the highest degree of caution and uncertainty. Any trade will likely be very short-lived.
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."
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|
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.
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. 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.