October 21st, 2015
by Lance Roberts, StreetTalk Live
Over the last several weeks, I have focused almost exclusively on the potential rebound in the market as we enter into the seasonally strong time of the annual investment cycle.
"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.
Of course, the question that must be answered is whether we have seen the end of the current correction or is this just another "reflexive rally" that will fail?"
The chart below is updated through yesterday's close."
"Currently, the bulls have clearly been in charge of the market. The question is for 'how long?'"
With the markets back to extremely overbought conditions on a short-term basis, a push through the overhead resistance at 2040 is unlikley for now. However, such a prediction could be quickly nullified by a further accommodative stance by the Fed. (ie negative interest rates, more QE, or a further "shadow" expansion of the balance sheet as shown below.)
The following chart also shows a much bigger problem for the markets going forward as the convergence technical deterioration continues to accelerate.
While all of the sub-indicators are triggering "SELL" signals for only the third time since the turn of the century, the market has "yet" to violate its long-term monthly moving average (black dashed line at top.)
However, importantly, the market has closed below the short-term monthly moving average (red dashed line) which has historically been an early warning sign of a market peak. From the initial break of that short-term monthly average the markets struggled for another six months before the markets collapsed into a full-fledged bear market. (Such was noted by a full crossover of the short and long-term monthly moving average)
The problem with waiting for the last signal to "get out of Dodge," is that investors had already suffered a great deal of damage to their investment capital. This is why, as I have noted for the past month, taking action to rebalance and reduce portfolio risk currently is advisable. To wit:
"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."
Until the technical backdrop of price action and momentum stabilizes and begins to exhibit more "bullish" action, that advice remains salient for now.
Remember, while the media and Wall Street want you to remain fully invested so they can collect a fee, it is ALWAYS far easier to get back into the market when a more stable environment returns. Spending the next bull market cycle simply getting "back to even" is not a profitable long-term investment philosophy.
What Drives Returns?
John Coumarianos, via MarketWatch, penned a very interesting note this past week with respect to the view that "volatility" is driving prices.
"The great economist John Maynard Keynes once said: 'Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.'
Few recent writings display this phenomenon better than a blog post by Josh Brown, aka The Reformed Broker, the title of his well-read (usually deservedly so) website.
Brown's post, cleverly titled "Why the stock market has to go down," incorrectly asserts that volatility is ultimately what rewards stock investors who have the ability to withstand it.
This is the standard talk that most advisers give their clients. It comes from the academic 'efficient markets' or 'random walk' school of thought. And it is totally wrong.
The truth is that the stock market doesn't owe you anything, no matter how volatile it is and no matter how long you wait."
This is absolutely true. What drives stock prices (long-term) is the value of what you pay today for a future share of the company's earnings in the future. Simply put - "it's valuation, stupid." As John aptly points out:
"Stocks are not magical pieces of paper that automatically deliver gut-wrenching volatility over the short run and superior returns over the long run. In fact, we've just had a six-year period with 15%-plus annualized returns and little volatility, but also a 15-year period of lousy (less than 5% annualized) returns.
It's not just volatility; it's valuation.
Instead of magical lottery tickets that automatically and necessarily reward those who wait, stocks are ownership units of businesses. That's banal, I know, but everyone seems to forget it. And it means equity returns depend on how much you pay for their future profits, not on how much price volatility you can endure."
"And stocks are not so efficiently priced that they are always poised to deliver satisfying returns even over a decade or more, as we've just witnessed for 15 years. A glance at future 10-year real returns based on the starting Shiller PE (price relative to past 10 years' average, inflation-adjusted earnings) in the chart above tells the story. Buying high locks in low returns and vice versa.
Generally, if you pay a lot for profits, you'll lock in lousy returns for a long time."
Volatility is simply the short-term dynamics of "fear" and "greed" at play. However, in the long-term as stated it is simply valuation. As I showed earlier this week in "4 Warnings And Why You Should Pay Attention" I discussed valuation specifically stating:
"Valuations are a very poor market timing device for short-term investors. However, from a long-term investment perspective, valuations mean a great deal as it relates to expected returns. Chris Brightman at Research Affiliates recently noted this exact point.
'As a long-term investor, we experience short-term price volatility as opportunity, and high prices as risk.'
With earnings growth deteriorating, and valuation expansion having ceased, the risk of high-prices has risen sharply."
Here is the problem.
I had a caller last night on "The Lance Roberts Show" with respect to this very issue.
The caller stated that his advisor told him that "financially speaking" he would be "fine" given his current asset levels and a projected 8% annualized return.
However, there are two main problems with that statement:
1) The Markets Have NEVER Returned 8% EVERY SINGLE Year.
Annualized rates of return and real rates of return are VASTLY different things. The destruction of capital during market downturns destroys years of previous capital appreciation. Furthermore, while the markets have indeed AVERAGED an 8% return over the last 115 years, you will NOT LIVE LONG ENOUGH to receive the same.
The chart below shows the real return of capital over time versus what was promised.
That shortfall in REAL returns is a very REAL PROBLEM for people planning their retirement.
2) Net, Net, Net Returns Are Even Worse
Okay, for a moment let's just assume the Wall Street "world of fantasy" actually does exist and you can somehow achieve a stagnant rate of return over the next 10-years.
The other problem with the analysis is that suggesting you will get some rate of return over time does not include the effects of fees, taxes, and inflation. To show you what I mean let's start with the fantastical idea of 8% annualized rates of return.
8% - Inflation (historically 3%) - Taxes (roughly 1.5%) - Fees (avg. 1%) = 3.5%
Hold on...it gets worse. Let's look forward rather than backward.
Let's assume that you started planning your retirement at the turn of the century (this gives us 15 years plus 15 years forward for a total of 30 years)
Based on current valuation levels future expected returns from stocks will be roughly 2% (which is what it has been for the last 15 years as well - which means the math works.) Let's also assume that inflation remains constant at the current average of 1.5% and include taxes and fees.
2% - Inflation (1.5%) - Taxes (1.5%) - Fees (1%) = -2.0%
Now that is a real problem. If I just held cash, I would, in theory, be better off.
However, this is why capital preservation and portfolio management is so critically important going forward.
Let Me Ask You A Question
There is no doubt that another major market reversion is coming. The only question is the timing. Such an event will wipe out the majority of the gains enjoyed over the last six years.
Assuming that you agree with the statement above, here is my question:
"If you were offered cash for you portfolio today, would you sell it?"
This is the "dilemma" that all investors face today - including me.
Portfolio Management Instructions
Repeating instructions from last week, it is time to take some action if you have not done so already.
- 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.
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. 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.
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