posted on 22 May 2016
by Lance Roberts, Clarity Financial
Another week of volatility, but with no real resolution to the burning question of "where do we go next?"
This past week, the release of the FOMC meeting minutes from April did little to solve the overall confusion. On Friday, I noted some key highlights from the minutes:
There is a tremendous amount of "hope" built into those statements. And despite the continuing call of economic growth which has remained terminally elusive, the Federal Reserve is faced with numerous challenges ahead.
The central bank already missed the "window of opportunity" for normalizing rates in a manner that doesn't hamper the recovery. This is evident when you look at Janet Yellen's proprietary index that Yellen herself has stated as critical for Fed movement.
As I have repeated discussed in the past, since payrolls tend to track corporate profits by about six months AND the small business confidence gauges are in decline, there will be weakening, not strengthening, in employment as the year progresses.
Such a slowing in payrolls will put the Fed in a difficult position since their entire premise on hiking rates has been a rise in inflation to 2% and a fall to 5% in unemployment. Both have now been achieved. This is why, when combined with a forthcoming Presidential election, the Fed will likely remain quite permanently on hold.
As Rick Reider at Blackrock recently summed up:
For Yellen, it is critical the market holds the current level of support. A break below that level will certainly send markets lower looking to retest February lows once again while completely derailing the Fed's plans for hiking rates.
The Line In The Sand
As of Friday morning, as I am writing this, the "good news" is the market rebounded sharply off of the critical support level at 2040. That level has been acting as the "line in the sand" since April, and as stated above, a violation of that level will likely send stocks heading rapidly lower.
Furthermore, the markets have returned to a short-term oversold condition which has historically provided a catalyst for high prices. Again, this is a very short-term condition that can be exhausted very quickly.
The "bad news" is that the rally on Friday failed to break back above the 50-day moving average. A failure to reclaim that ground by close of business on Monday will return the 50-dma back into resistance versus support.
However, stepping back to a "weekly" price chart, we see the market bouncing off of the short-term moving average putting the new downtrend resistance line at 2090 in focus.
On a weekly basis, the markets remain extremely overbought following the rally from the February lows. This suggests that on an intermediate-term basis the path for prices is likely lower despite the potential for a short-term rally as shown in the daily chart above.
I realize this is a bit confusing, but this is the nature of the markets. For executing a buy or sell of an asset in the market, I like to use daily analysis to determine the "timing" of the transaction.
However, from a portfolio management perspective, I am a long-term investor. Therefore, I need to understand the intermediate to longer-term TRENDS of asset prices. As long as prices are trending positively, I want to remain invested despite potential short-term volatility that may exist. When asset prices began to trend negatively, I do NOT want to be heavily tilted towards RISK.
Currently, despite all of the volatility since last May, the markets have not fully changed their trend from positive to negative. Not yet, anyway.
The weekly chart below shows the market versus a 1-year and 2-year moving average. Currently, the 1-year moving average is just 1-point shy of crossing below the 2-year moving average. Historically, this has only occurred at the peak of the last two bull markets and represents the trend change process. The bottom part of the graph is a moving-average convergence divergence indicator (MACD) which acts an an early warning sign that risk should be reduced in portfolios. That signal was registered in May, 2015 which is when I reduced equity risk in portfolios by 50%.
Furthermore, if we step back even further and look at a monthly chart we see more signs of ongoing deterioration currently. As shown below, there are many measures of the market currently issuing warning signs. These warning signs should not be readily dismissed against a very short-term advance in the market. The longer-term dynamics act like gravity against extremely short-term, headline driven, price volatility.
While the market is currently holding support, keeping current allocations in place, the "gravity" of longer term price dynamics are dragging markets down to earth. But this is the normal process of a market top in progress. As the old saying goes:
Bull Markets Lose Support
Along with this idea that "bull markets" die with a whimper is the loss of one of the major supports of asset prices since 2009. Lu Wang touched on this issue last week for Bloomberg:
It is not just repurchases that companies are cutting. As the profits recession continues for a fourth straight quarter, cost cutting will become a "thing" again as companies search for cash.
The number of firms that have slashed dividends are now at a seven year high. As noted by Political Calculations just recently the pace of dividend cuts in the second quarter is now running well ahead of the first quarter of this year. Most importantly, as shown in the chart below, the pace of dividend cuts are more normally associated with recessionary economic environments.
Furthermore, as economic and profit weakness continues to weigh on corporate balance sheets, delinquencies are rising. As noted by Wolf Richter this week:
So, as asset prices remain suspended based mostly on a "fear of missing out," there is a more distinct air pocket appearing beneath the surface. With support after support disappearing from the market, the risk of a sudden plunge in asset prices has grown markedly in recent months.
Scariest Chart Out There
The following is an excerpt from a post at Hedgeye by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy.
This is not 1995, 2011 or 2012. The dynamics behind the market itself are flashing warning signs where ever you dare to actually look. Being aggressively exposed to equity risk is looking ever more dangerous as we head into the summer months.
The problem is that markets can remain irrational far longer than logic would dictate. Therefore, I continue to urge caution while waiting for the market to finally declare itself either a "bull" or a "bear." But, I will say my "bearish spidey senses" are tingling.
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