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posted on 02 May 2016

Still Looks Like A Trap

by Lance Roberts, Clarity Financial

Over the last couple of week's, I have written extensively about the breakout of the market above the downtrend resistance line that traced back to the 2015 highs.

To wit:

"With the breakout of the market yesterday, and given that 'short-term buy signals' are in place I began adding exposure back into portfolios. This is probably the most difficult 'buy' I can ever remember making."

I also stated that it was probably a trap and that I will be stopped out in fairly short order. But that is the risk of managing money.

It was only a matter of time before the extreme short-term extension of the market begins to correct. Like stretching a rubber band to its limits, it must be relaxed before it is stretched again. The question is whether this is simply a "relaxation of the extension" OR is this a resumption of the ongoing topping and correction process?

Let's take a look at a few charts to try and derive some clues as to what actions we should be taking next.

SP500-Chart1-042616

First of all, it is worth noting that despite all of the recent excitement of the markets advance, it remains extremely confined in a sideways trading range. This can either be good or bad news.

The Good: Sideways consolidations during bullishly biased markets provides the ability to work off excesses built up during the previous advance to provide the "fuel" necessary for the next leg higher.

The Bad: However, sideways consolidations can also mark the end of the previous bullish advance and the beginning of a bearish decline.

How do we know the difference? Normally, fundamentals tell the story. When earnings are still rising, market consolidations tend to resume to the upside. However, declining earnings have historically marked market topping processes much as we see today.

SP500-Chart2-042616

Back to our first chart above, I have denoted the previous declining market trend and an adjusted downward trend line to account for the most recent peak. Both of these downward trending price lines will now act as resistance to the next attempt by the market to rally higher.

With the markets still extremely overbought from the previous advance, the easiest path for prices currently is lower. The clearest support for the markets short-term is where the 50 and 200-day moving averages are crossing. I currently have my stop losses set just below this level as a violation of this support leaves the markets vulnerable to a retest of February lows.

On a short-term (daily) basis, the current correction is still within the confines of a simple "profit-taking" process and does not immediately suggests a reversal of previous actions. As shown in the chart below, support current resides at 2040 with the 50-day moving average now trading above the 200-day.

SP500-Chart3-042616

It is worth noting the similarity (yellow highlights) between the current rally and peak versus the rally and peak during the October through December advance.


Better Smelling Breadth

The good news is that the advance-decline line, currently remains a positive backdrop to the recent price action. My friend and colleague, Dana Lyons, picked up on this last week:

"Thus, we looked at all days since 1965 that saw at least 75% advancing issues on the NYSE, with a gain in the S&P 500 of less than 0.6%. As it turns out, there have been 15 such days, prior to yesterday. Again, 3 of those have occurred just since February."

tumblr_inline_o6bcibgHL01sq14jh_500

"Interestingly, all 16 days have taken place within secular bear markets (if you consider the market to still be in one, as we do). However, all but 1, or maybe 2, took place during cyclical bull markets. Whether or not that is instructive as to the market environment we are in, we won't be able to say for awhile. But we did find it interesting.

What we can say is how the market fared following these days. Now, whether or not the historical results are relevant certainly may be up for debate. However, we did find the results interesting enough to present here.

Here is the S&P 500′s performance following the prior 15 occurrences."

tumblr_inline_o6bowtiCGi1sq14jh_500

"Obviously, again, we're dealing with a limited sample size - and with 1-day phenomenons. However, statistically significant or not, the trend has been for the S&P 500 to show consistent strength, from 2 days to 6 months out. 3 weeks (not shown) following these occurrences, the S&P 500 was higher 14 out of 14 times.

These are the kinds of results that we wondered if we would see following days like last Friday. Obviously, that was not the case. And considering the similarities between the 2 days, the conflicting results cause us to take these results with a grain of salt. However, at least this time, the results do heavily lean to the bullish side."


Risk Still High

Given the fundamental and earnings backdrop, the longer-term market dynamics are still heavily weighted against the bulls. As shown in the next chart, despite the recent surge higher in prices, the technical backdrop still remains bearishly biased.

SP500-Chart4-042616

With the exception of the number of stocks trading above their 200-dma, which still remains well below levels when prices were last at these levels, every other indicator is at levels and behaving as if we are in a more protracted bear market decline.

The question remains whether the markets will continue to "buy" the Federal Reserve's "forward guidance" long enough for fundamentals to play catch up with the fantasy, or not. Historically speaking playing "leapfrog with a Unicorn" has tended to have painful outcomes.


A Note On Oil, The Dollar & Rates

Last week, I wrote a fairly extensive post on why I think oil prices are nearing their peak and made a case for trimming back on oil & energy related exposure. To wit:

"In a nutshell, the very easy near-term gains have likely already been seen. As I will explain below, the fundamental and technical backdrop suggests there will be plenty of opportunities for patient, long-term investors to pick up oil/energy exposure at cheaper levels in the months ahead.

With supply and demand imbalance likely to remain for years to come, it is very likely that we will once again return to a long period of volatile prices within a very confined range as seen during the 1980-1990's. Therefore, for those wanting to invest in oil and energy related positions, the shorter-term price dynamics are going to be substantially more important.

If we take a look at the "Commitment Of Traders" report we see that exuberance over the recent surge in energy prices has pushed the number of oil contracts back to the second highest levels on record."

Oil-Price-Contracts-042616

"As with the past, these surges in contracts have typically denoted short-term peaks in oil prices. This time is likely going to be no different."

A technical look at oil prices also suggests near-term profit taking in energy-related positions is likely a good idea. As shown, oil prices are not only trading at the top of a long-term downtrend channel but are also pushing 2-standard deviations above the mean.

OIL-Chart1-042616

With momentum and prices at extreme overbought conditions, a near-term reversion is very likely. I have noted each previous peak price in oil with vertical blue-dashed lines.

Of course, one of the main drivers of such a reversion would be a reversal of the recent weakness in the dollar. Like the advance in oil, the decline in the dollar has also been just as extreme. As shown below, denoted by yellow highlights, each previous downside extension of the current magnitude has resulted in a fairly sharp reversal.

USD-Chart1-042616

With the Federal Reserve caught in their own "trap" of "strong employment and rising inflation" rhetoric, the markets may stay to worry about a rate hike in June. A perception of higher interest rates would likely reverse flows back into the dollar, and by default U.S. Treasuries, pushing the dollar higher and rates lower.

Speaking of rates, I suggested a couple of weeks ago as rates pushed 1.9% that it was time to once again add fixed income to portfolios. That call has been prescient and was even supported just recently by Jeffrey Gundlach at Doubleline. However, a recent article by Kessler Companies picked up on a key reason why I continue to suggest rates will fall to 1% in the future.

"But, the labor market is a subset of the economy, and while its indicators are much more accessible and frequent than measurements on the entire economy, the comprehensive GDP output gap merits being part of the discussion on the economy. Even with the Congressional Budget Office (CBO) revising potential GDP lower each year, the GDP output gap (chart) continues to suggest a disinflationary economy, let alone a far away date when the Federal Reserve needs to raise rates to restrict growth. This analysis suggests a completely different path for the Fed funds rate than the day-to-day hysterics over which and how many meetings the Fed will raise rates this year. This analysis is the one that has worked, not the 'aspirational' economics that most practice."

outputgap0416

"In an asset management context, US Treasury interest rates tend to trend lower when there is an output gap and trend higher when there is an output surplus. This simple, yet overlooked rule has helped to guide us to stay correctly long US Treasuries over the last several years while the Wall Street community came up with any reason why they were a losing asset class. We continue to think that US Treasury interest rates have significant appreciation ahead of them. As we have stated before, we think the 10yr US Treasury yield will fall to 1.00% or below."

I couldn't agree more which is why I continue to buy bonds every time rates approach 2%.

Okay, enough for now.

Next week should give us more information about what to do next.

"A mariner does not become skilled by always sailing on a calm sea." - Herber J. Grant

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