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posted on 03 April 2016

Q1 Ends With A Bang - What's Next

by Lance Roberts, Clarity Financial

A good bit has happened over the last couple of weeks. The S&P 500 staged a sharp recovery from February closing lows due to repeated Central Bank actions during the month as well as an expected reflex rally fueled by short-covering. On a short term basis, the technical backdrop has improved markedly, but was it enough to change the longer-term trend of the markets from bearish back to bullish. This is the topic we will directly tackle this week.

While allocations have been very conservative since last May, avoiding the ensuing volatile declines last summer and the start of this year, I have repeatedly stated that interventions by Central Banks could nullify the "bear case" in the short-term.

Let's start with a short-term (daily) view and update the previous observations.

SP500-MarketUpdate-040116-2

I have added some notations for the flurry of Central Bank activity that has occurred recently to push the markets higher.

1. The shaded areas represent 2 and 3-standard deviations of price movement from the 125-day moving average. I am using a longer-term moving average here to represent more extreme price extensions of the index. The last 4-times prices were 3-standard deviations below the moving average, the subsequent rallies were very sharp as short positions were forced to cover. This was the same action that we saw during the current rally.

2. The top and bottom of the chart show the overbought/sold conditions of the market. The recent rally has responded as expected from recent oversold conditions. With the oversold condition now exhausted, the potential for further upside has been greatly reduced. I have notated with red arrows that when this overbought condition reverses it has marked the end of the previous rally going back to 2014.

3. The red dashed line shows the current descending trend lines that continue to provide resistance to the advance. While the recent advance is now challenging that downtrend line, the collision of resistance levels may prove a challenge to a further advance from current levels. The arching dashed blue line shows the change of overall advancing to now declining price trends.


A Potential "Buy" Signal Approaches

By the time "buy" and "sell" signals are triggered, the initial recovery has already completed most of its initial move. This is completely expected. Importantly, if the markets are indeed reversing course, the entry back into the markets will still be very early into the next overall advance.

The importance of waiting for confirmation of a change in market dynamics, even for shorter term traders, is to establish a higher reward-to-risk ratio when putting investment capital to work. This methodology, while you will not "buy the bottom" or "sell the top," reduces the probability of speculating incorrectly and then becoming emotionally trapped into a position that becomes detrimental to portfolio performance.

In the chart below, you will note that the previous rallies which took the markets to very overbought short-term conditions (top part of the chart). However, those rallies did not reverse the sell-signal in the lower part of the chart. Each of these previous rallies subsequently failed taking stocks lower. This is why the allocation model remained exposed to lower levels of equity risk during this entire period.

SP500-MarketUpdate-040116-4

Currently, as shown above, the short-term dynamics of the market have improved sufficiently enough to trigger an early "buy" signal. This suggests a moderate increase in equity exposure is warranted given a proper opportunity. However, to ensure that the current advance is not a "head-fake," as repeated seen previously, the market will need to reduce the current overbought condition without violating near-term support levels OR reversing the current buy signal.

Again, let me reiterate, the commentary above is for shorter-term, active investors, looking for a set up to take on equity risk. There is currently a HIGH PROBABILITY that the analysis above will be reversed in very short-order.

As a portfolio manager for individuals retirement assets, where risk must be substantially mitigated, there has been NO improvement in the intermediate technicals of the market currently.

SP500-MarketUpdate-040116-5

With relative strength, momentum and price deterioration still on the decline, there is currently little reason to become aggressively exposed to market risk. This is particularly the case given the extreme technical similarities to previous major market peaks.

Furthermore, if the "bulls" have indeed returned to the market, as is being suggested by the mainstream media, we should see longer term measures of market momentum and relative strength turning more positive as well.

SP500-MarketUpdate-040116-6

As you will notice, there has been virtually no improvement in longer-term indicators at this point that would suggest a more "bullish" optimism is prevailing in the markets.

At the very bottom of the chart above is the number of stocks trading ABOVE the 200-dma on the S&P 500. Currently, with the overall index trading well above the 200-dma, only 61.8% of stocks are currently doing the same. This suggests a rather narrow rally over the last month and explains the lack of momentum of the overall index.


CAUTIOUSLY OPTIMISTIC

As I stated two weeks ago in this missive:

"While my 'emotions' are currently screaming to start increasing equity allocations at this juncture, there are several reasons why my discipline is keeping me from doing so currently:

  1. The market is GROSSLY overbought in the short-term and will have either a mild corrective process or consolidation to allow for an increase in equity exposure.

  2. Negative trends are still in place which suggests the current rally, while significant, remains within the context of a reflexive rally.

  3. Volume is declining on the rally suggesting a lack of conviction.

  4. This rally looks very similar to the rally last October except the fundamentals are substantially weaker.

SP500-MarketUpdate-040116-8

While the shorter-term indicators are becoming decidedly more bullish, the fundamental and economic backdrop still remains exceedingly week. Furthermore, with the majority of Central Bank actions now behind us, we are staring directly into the face of earnings season which will likely not be good.

So, while I am cautiously optimistic for an opportunity to increase equity risk exposure modestly in the short term, I also remain exceedingly cautious with a very quick "trigger finger" if I am wrong.


APRIL SHOWERS - EARNINGS & SEASONALITY

As we leave March behind and enter into the second quarter of the year there are several things that we need to focus on:

  1. Seasonal adjustments, which have given a massive boost to recent economic reports due to the unseasonably warm winter cycle, will begin to revert as temperatures realign with more normal seasonal patterns.

  2. While earnings estimates have been dropped markedly to allow companies to play the "beat the estimate" game, profits and revenues will likely show a sharper contraction that currently expected which will push current valuations higher.

  3. April winds up the seasonally strong time of the year and summer months tend to be weak particularly prior to Presidential elections.

Let's examine the 2nd and 3rd points more closely.

As Adam Shell recently penned for USA Today:

"If there's a dark cloud hovering over stock investors, it is the inability of U.S. companies to maximize sales and boost their bottom lines in a period of slow global growth, currency headwinds and still-low energy prices. A so-called "earnings recession" has descended on Wall Street. In the final two quarters of 2015, companies in the broad, large-company Standard & Poor's 500 index have seen earnings contract - not grow. And analyst estimates for the first two quarters of 2016 also point to negative earnings growth.

Wall Street pros don't see the profit picture improving until the second half of the year.

Currently, analysts are forecasting S&P 500 profit to contract 6.9% in the first three months of 2016, and to decline 1.9% in the second quarter."

Here is the problem, such prolonged earnings recessions have never happened outside of recession and substantial market corrections. As noted by HedgeEye:

"While U.S. 4Q GDP was revised up to +1.4%, the corporate profit component showed a -10.5% Y/Y contraction. That marks the second consecutive quarter in which corporate profit growth was down Y/Y. Check out the chart below illustrating why that's such bad news.

Bottom line? In the 30 years since 1985, two consecutive quarters of shrinking corporate profits have preceded a material stock market downturn over the next twelve months in all five occurrences."

Profits

When it comes to seasonality, the picture doesn't improve much.

My friend Dana Lyons recently made the following observation:

"Using the Dow Jones Industrial Average (DJIA) since 1900, the 2nd quarter of election years (i.e., "year 4″) has the lowest average return (-1.2%) of any quarter in the entire cycle. Here are the average quarterly returns of the 4-year cycle in sequential order:"

tumblr_inline_o4x6dhuTW11sq14jh_500

One thing that financial markets absolutely detest is "uncertainty." This is particularly true when a Presidential change is occurring and Wall Street is unsure what new policies may be enacted.

However, this year is likely to be more "uncertain" than usual with the potential mess coming from a contested Republican convention. Should the RNC decide to make a substantial nominee change, or clearly shift the outcome of the convention in an unexpected direction, an increase in market volatility this summer would certainly not be surprising.

Just something to think about.

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