posted on 18 April 2016
by Lance Roberts, Clarity Financial
Is The Bull Market Back, Or Is It A Trap?
I wish I had a more definitive answer for you this week, but the market is standing at the proverbial "crossroads" of bull and bear.
From a "fundamental" perspective there is not much good news. The past week we saw numerous companies beating extremely beaten down estimates. However, while JPM and C got a boost to their stock price, the actual earnings, revenue and profits trends were clearly negative.
But that is the new normal. We live in an environment where Central Banking has taken control of financial markets by leaving investors "no option" for a return on cash. Therefore, the "hope" remains that asset prices can remain detached from underlying fundamentals long enough for them to catch up.
As I noted last week:
But despite collapsing profit margins, ROE, and surging corporate debt levels, asset prices remain near all-time highs. The chart below shows corporate profits after tax and eps as compared to asset prices. Historically, the detachment between fundamentals and prices has not lasted indefinitely and are almost always corrected either through a bear market, recession or both.
But is this time different?
Have global Central Banks actually figured out how to repeal economic cycles and keep investors permanently aligned to the markets? The following charts would appear to suggest such is indeed the case.
The cumulative advance-decline line is breaking out to new-highs after 355 days of correction. Historically, such declines in the A/D line have been more coincident with much more severe market corrections. As noted by Dana Lyons:
The whole piece is worth reading. However, the breakout of the A/D line is not the only piece of evidence that suggests the bull market isn't quite dead as of yet.
Investor sentiment (both individual and professional) is currently at levels that are more normally associated with bigger corrections in the market.
As noted, the 13-week moving average of bearish sentiment has reached levels currently that are more normally associated with bottoms to corrective processes as seen in 2010 and 2011 when the Federal Reserve intervened with QE2 and Operation Twist.
However, while this surge in bearish sentiment has occurred, which normally denotes a substantial level of fear by investors, there has been no substantial change to actual allocations.
While stock allocations have fallen modestly, cash and bond allocations have barely budged. This is a far different story than was seen during previous major and intermediate-term corrections in the market.
This suggests, is that while investors are worried about the markets and their investments, they are too afraid to actually make changes to their portfolio as long as Central Banks continue to bail out the markets.
Again, it's back to fundamentals versus expectations. Someone is going to be very wrong.
The "Rothschild 80/20" Rule
First a quick recap. In May of 2015, I recommended dropping equity exposure in portfolios to 50% and then down to 25% in early February. Yes, I have been underweight equities during the recent rally. Therefore, obviously, I have no clue what I am talking about.
While I have been chastised for not "buying the bottom," the reality is that those that are taunting me didn't either. The reality is they are just working on "getting back to even."
However, what is important, is that my clients have rested easy by not suffering the volatility and declines from the peaks of last year.
Here is my point. As a long-term investor, I don't need to worry about short-term rallies. I only need to worry about the direction of the overall market trends and focus on capturing the positive and avoiding the negative.
As Baron Nathan Rothschild once quipped:
This is the basis of my 80/20 investment philosophy and the driver behind the risk management process.
While I may not beat the market from one year to the next, I will never have to suffer the time loss of required by "getting back to even." In the long run, I will win.
As shown in the table below, a $100,000 investment in the S&P 500 returns a far lower value than the "Rothschild 80/20 Rule" model. This is even if I include a ridiculous 2% management fee.
But here is how it plays out over the long-term.
Yes, it's only a couple of million dollars worth of difference, but the reduced levels of volatility allowed investors to emotionally "stick" to their discipline over time. Furthermore, by minimizing the drawdowns, asset are allowed to truly "compound" over the long-term.
Get it. Got it. Good.
So...Is it Time To Increase Risk?
The short answer is not just yet. However, if the market can muster a rally above the current downtrend resistance next week, there will be push back to old highs.
The bullish arguments are:
There is also a possibility this is a giant trap waiting to be sprung on unwitting investors. Let me direct your attention to the bottom part of the chart above which defines many of my concerns.
Notice that during the previous rally in October of last year, the market similarly rallied to the downtrend resistance and issued a short-term buy signal (blue vertical line). The rally subsequently failed and established a lower low.
The current rally, which is built on a substantially weaker fundamental backdrop, is behaving in much the same way by hitting downtrend resistance, remaining in overbought territory (top part of chart) and issuing a similar buy signal.
However, unfortunately, what small bit of "oversold" condition that existed earlier this week, has been evaporated.
As I stated last week, the markets have currently registered a very short-term buy signal which dictates that we must consider increasing equity risk in portfolios. I would be remiss in not paying attention that signal, but such signals can be a "false flag" during a larger market topping process.
The markets must break above the current downtrend line in order to increase allocations in portfolios. I have already positioned model portfolios to increase exposure back to 50% should such an event occur.
However, it is extremely important to remember that whatever increase in equity risk that I may suggest next week, could very well be reversed in short order due to the following reasons:
It is worth remembering that markets have a very nasty habit of sucking individuals into them when prices become detached from fundamentals. That is the case currently, and has generally not had a positive outcome.
Let me be VERY CLEAR - this is VERY SHORT-TERM analysis. From a TRADING perspective, there is a tradable opportunity being developed. This DOES NOT mean the markets are about to begin the next great secular bull market.
Caution is highly advised if you are the type of person who doesn't pay close attention to your portfolio, or if you have an inherent disposition to "hoping things will get back to even" if things go wrong.
What you decide to do with this information is entirely up to you. As I stated, I do think there is enough of a bullish case being built to warrant taking some equity risk on a very short-term basis. We will see what happens next week.
However, the longer-term dynamics are clearly bearish. When those negative price dynamics are combined with the fundamental and economic backdrop, the "risk" of having excessive exposure to the markets greatly outweighs the potential "reward. "
Could the markets rocket up to 2100, 2200 or 2300 as some analysts currently expect? It is quite possible given the ongoing interventions by global Central Banks.
The reality, of course, is that while the markets could reward you with 250 points of upside, there is a risk of 450 points of downside just to retest the previous breakout of 2007 highs
Those are odds that Las Vegas would just love to give you.
Please be careful.
Investing is not a competition.
It is a game of long-term survival.
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