posted on 06 March 2016
by Lance Roberts, Clarity Financial
At the end of January, I discussed the potential for a reflexive rally in the markets and laid out three retracement levels at that time.
Here is the same chart updated through Friday's close:
I pointed out last week that:
The markets were not only able to push into the 1970-1990 level last week but also complete a 50% retracement from the recent lows as shown above. The 8% advance from the closing lows just 4-weeks ago has sent "shorts" scrambling to cover pushing stock prices sharply higher.
But does this change any of the recent analysis?
I'M MISSING IT
It is not surprising that the recent surge in the markets has awakened the "bullish spirits." However, that is an emotionally based response to short-term market volatility rather than a decision to increase equity risk based on a defined and disciplined approach.
This goes to the heart of the portfolio management discipline and philosophy. The chart below shows the model allocation changes since 2013.
As you will note, portfolios have been grossly underweight equity related exposure since April of 2015 creating a positive performance gap between the index and the portfolio. That positive performance gap allows for a more relaxed approached to increasing portfolio allocations when the market re-establishes a positive price trend without sacrificing long-term performance.
The final reduction at the end of January protected portfolios from the decline in February, but has led to a minor performance drag over the last two weeks. But given that risk is still prevalent to the downside, I am willing to give up a potential "bear market rally" for the sake of protecting client capital from loss.
As I have stated before, when the market re-establishes a positive trend, I will recommend putting preserved capital back to work. However, for such an equity increase to be warranted, the market will need to break the current declining price trend and work off some of the currently extreme overbought conditions. This is shown in the updated chart from last week.
There are quite a few moving pieces here, so let me explain.
The last sentence above is the most important. The signal to increase equity related exposure in portfolios will require a breakout above the currently negative price trend. Until that happens, we remain confined in a "bear" market.
TIME TO BUY OIL/ENERGY?
The short answer is "NO."
Let me explain.
First, the rally in "oil prices" is a short-covering/extreme oversold move. While it "seems" like it has been a massive surge in the short term, as shown in the chart below, it barely registers on a longer-term basis. It is always important to keep some perspective.
The chart notes the dates of some of the calls I have been making in this missive since April 2014 when I recommended getting out of oil/energy entirely.
Notice that prior to 2014, the correlation between oil and energy prices was extremely correlated. The deviation I noted in 2014 is now in the process of being corrected, but is not complete as of yet.
The decline in oil is not complete as of yet as there has been little progress in reverting the supply/demand imbalance. This will take several years to rectify and oil/energy prices will eventually settle into a trading range at these lower levels.
Again, for the sake of perspective, here is what happened to oil prices the last time supply and demand were this imbalanced.
As UBS recently explained:
As shown in the chart below, the number of outstanding contracts on oil is still well above the long-term mean suggesting that more unwinding needs to occur before a longer-term bottom in oil prices is made.
With energy-related stock prices once again at extremes, the next most probable move will be to the downside. This is particularly the case given the recent builds in inventories and a likely disappointment from OPEC/Saudi Arabia on March 20th.
Furthermore, the damage to energy company earnings will be accelerated as the last of hedges begin to roll off over the next couple of months. This realization will push energy stock prices lower as companies are re-evaluated for much lower profit margins and rising bankruptcy risk.
More layoffs are expected. As this occurs the negative impact to the Houston real estate market accelerate as homes fail to sell, apartment inventories rise and commercial buildings remain empty. But such will not be just a localized event but as further reductions in CapEx occur the ripple effect to the rest of the economy will grow.
As Art Berman correctly stated in a recent interview:
He also details in the interview how the current oil price collapse represents devaluation from over-investment in unconventional oil - and most commodities - because of cheap capital, and is simply a classic bubble.
It is well worth listening to if you think we have reached a bottom in oil/energy prices.
LOOKS LIKE A COUNTER-TREND RALLY
Eric Bush at Gavekal Research confirmed much of my own analysis on Friday suggesting that the current rally still has all of the earmarks of a bearish counter trend rally. To wit:
Eric is absolutely correct in his assessment. It is completely understandable that after sectors like energy, materials and industrials have had big declines that trying to bet on a bottom is enticing. However, that is the equivalent to "gambling without looking at your cards."
As I stated, since we have been underweight equity risk since last year, there is no need to try and "guess" if the markets have finally bottomed. We only need to wait for the markets to "show" us they have indeed fundamentally and technically turned the corner. At that point, regardless of what the "price" of the market is, the reward to risk ratio for increasing equity exposure in portfolios will be tilted heavily in our favor. Isn't that what investing is really all about after all?
As Dick Russel once quipped:
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