posted on 02 May 2016
I want to update the short-term analysis from last week.
Thursday and Friday saw the markets give up gains on the back of weaker than expected earnings and economic announcements. The action currently appears to primarily be profit taking after a long advance from the February lows. However, one should not be complacent the current action is simply that and nothing more.
All short-term indicators are overbought and on sell signals. The last time the same combination of signals existed was in November of last year. The resulting outcomes were not pleasant for most investors. There has not been a fundamental or economic development to suggest "this time is different." In fact, in many ways, it is worse.
This more cautionary short-term analysis is supported by the breadth analysis as well. The number of stocks now trading above the 50 and 200-dma, along with bullish sentiment, is pushing more extreme levels. While this is bullish from the standpoint of participation, the extreme nature also suggests a near-term inflection point.
If we take a look at volume-by-price we also see a surge in volume at current levels which is suggestive of distribution by traders as markets reach primary inflection points.
These warning signs are worth paying attention to.
As I have repeatedly stated over the last couple of weeks the current market setup feels like a "trap." I remain cautious and already have an "inverse market" position loaded in our trading system to move portfolios quickly back to market neutral if markets break support.
I suggest you prepare as well.
S.A.R.M. Model Allocation
The Sector Allocation Rotation Model (SARM) is an example of a basic well-diversified portfolio. The purpose of the model is to look "under 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 which are leading performance, reduce in areas lagging, and eliminate those areas that are dragging.
Over the last five weeks, RISK based sectors have continued their streak of improvements as money has flowed out of perceived areas of SAFETY.
Last week saw Energy and Discretionary join the ongoing leadership of Industrials, Materials, Small & Mid-Cap and International sectors. The Financial sector is trying to pay catch up currently.
Utilities, Bonds, Staples, REIT's, Technology continue to weaken as "complacency" rises to more extreme levels. From a contrarian standpoint, this is a classic "set up" for a rotation from RISK back to SAFETY within the next few weeks.
HealthCare, while still very weak on a relative basis, showed a sharp improvement last week as money is chasing laggards in the rally.
You can see the issue of the ongoing "yield chase" more clearly if we expand the time horizon.
Since the end of the "financial crisis," many have assumed that taking on additional risk by small and mid-capitalization stocks would have yield the highest rate of return. However, while performance significantly outpaced the broader S&P 500 index, it was usurped by just buying the dividend-based stocks of the S&P 500.
The problem with this, as I have addressed many times in the past, is simply the extremely level of valuations being paid for these stocks will eventually turn out very badly. Much like the "Nifty Fifty" in the late 70's, when the next recessionary decline comes there will be no "safe place" to hide. As Jeff Gundlach neatly summed up last week:
Lastly, despite the rolling rhetoric that "international and emerging markets" are the place to put money, these areas have been a continuing "anchor" on portfolio performance which is why I have kept these areas at a ZERO weight in the 401k plan manager model portfolio below.
S.A.R.M. Sector Analysis & Weighting
As stated above, the SARM Model is an "equally weighted model" adjusted for risk. The current risk weighting remains at 50% this week.
We continue to watch for improvement in the relative performance of each sector of the model as compared to the S&P 500. The next table compares each position in the model relative to the benchmark over a 1, 4, 12, 24 and 52-week basis. Notice the relative improvement or weakness relative to index over time. For example, notice that sectors like Materials, Financials, Industrials, Technology Discretionary & Healthcare's performance all weakened last week relative to the S&P 500. Normally, these performance changes signal a change that last several weeks.
The last column is a sector specific "buy/sell" signal which is simply when the short-term weekly moving average has crossed above or below the long-term weekly average. The number of sectors on "buy signals" has improved from just two a few weeks ago to 9 this past week. Sectors that are on buy signals tend to outperform in the near term.
The risk-adjusted equally weighted model remains from last week. No changes this week.
The portfolio model remains at 35% Cash, 35% Bonds, and 30% in Equities.
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