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posted on 23 May 2016

Monday Morning Call 23 May

by Lance Roberts, Clarity Financial

I want to update what I wrote last week:

"The ongoing correction last week violated the 50-dma which raises short-term positioning alarm bells. However, as discussed above, the market held support and the recent neckline at 2040."

SP500-Chart5-052016

While on Monday of last week the market did rocket above the 50-dma, it was unable to hold that level this week with Friday's rally failing at that resistance. The 2040 level is now an extremely critical level of support in what appears to be a fairly significant topping process.

As I discussed in Tuesday's "Technically Speaking" post:

"Critically, there is a"head and shoulders" process being formed and the 2040 level is the neckline support of that pattern. A break of that neckline will lead to a more substantial correction process."

SP500-Chart6-052016

"With the 50-dma trending positively above the 200-dma, we do want to give the markets the benefit of the doubt currently, but I am not dismissing my sense of caution."

It will be critical for the market holds 2040 next week and rally back above the 50-dma in order to continue the bullish bias.

Sentiment Update

One interesting aspect of the rally over the last couple of months is that it has not substantially changed the outlook of individual investors about the market. While individuals remain skeptical of the recent rally, the sentiment of professionals has rocketed higher. The chart below is the ratio of individual to professional bullish sentiment.

AAII-INVI-BullRatio-052116

This is interesting because while individuals remain skeptical of the recent rally, they have not changed their asset allocations to a more defensive posture.

AAII-Allocation-Survey-041416

In other words, while they are concerned about a potential "bear" market, they are unwilling to do anything about it due to "fear of missing out." The Federal Reserve has apparently completed its mission of convincing the vast majority of the population that "stocks can no longer go down."

This is potentially a dangerous concept. The chart below is a composite index of both individual and profession net bullish sentiment.

AAII-IINV-NetBullish-Sentiment-052116

The recent downward spike in net bullish sentiment was quickly reversed. While many have pointed to high levels of "bearish sentiment" as a sign of a "major market bottom," the quick recovery back to high levels of net bullish sentiment suggest differently.

As noted above, the quick recovery of bullish sentiment is more again to what was seen during the topping process of the market in 2007. During a more protracted "bear market," net bullish sentiment tends to remain extremely negative as the decline proceeds.

It is worth noting that the composite bull/bear ratio hit the highest levels in the composite's history as QE3 ran its final course. The reversal in sentiment, as stated above, seems to be more akin to the previous topping process than just a correction within an ongoing bull market.

AAII-IINV-Bullish-Sentiment-052116

But like I said above.

"While investors may indeed be worried about a market crash, they really aren't doing much about it protecting themselves from it."

USD Breaks Above Resistance

Two weeks ago, I suggested that the decline in the US dollar had neared completion and that a sharp reversal was likely.

"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 start 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."

Well, with the revelation of the recent FOMC minutes the worries about a June rate hike, as suspected, have indeed surfaced sending the US dollar spiking above resistance.

USD-Index-052116

If this rally in the dollar continues higher, it should coincide with a further decline in the major market averages and specifically the basic materials, industrials and energy based sectors.

Let me repeat again from last week:

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 have not been, or am I currently, convicted about the potential of the market for a further advance from here. Again, this is why allocation models remain extremely underweight equity risk exposure currently.

Short-term portfolio management instructions currently remain:

  1. Tighten up stop-loss levels to current support levels for each position.

  2. Hedge portfolios against major market declines.

  3. Take profits in positions that have been big winners

  4. Sell laggards and losers

  5. Raise cash and rebalance portfolios to target weightings.


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 several weeks, RISK based sectors outpaced performance relative to SAFETY. However, starting last week and continuing this week, that level of outperformance has begun to fade.

SARM-Sector-Rotation-052116

The rotation from defensive to "risk on" sectors is now complete and potentially signals a further short-term correction in the market is possible. However, for now:

LEADING: Energy, Materials, Industrials, Mid-cap, Small-cap, Discretionary. (REIT's are leading as investors chase risk and yield. Financials are rapidly improving playing catch-up)

LAGGING: Utilities, Gold, Bonds, Staples, Technology, Healthcare

The sector comparison chart below shows the 9-major sectors of the S&P 500.

Sector-CandleGlance-052116

Warnings developing:

Discretionary, Industrials, Staples, and Utilities have all broken their longer-term moving average support suggesting profits be taken in these sectors.

Materials, Energy, Healthcare & Financials are dangerously close to breaking down. Caution advised.

In other markets warnings are also developing:

Sector-CandleGlance-052116-2

Small-Cap, Emerging Markets, International, Mid-Cap, Dividend Yield & REIT's are all exhibiting weakness.

As stated above, complacency in this market could be dangerous to your financial health.


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. It will require a move to new all-time highs in order to safely increase model allocations further at this juncture.

SARM-Model-Structure-052116

Relative performance of each sector of the model as compared to the S&P 500 is shown below. The table compares each position in the model relative to the benchmark over a 1, 4, 12, 24 and 52-week basis.

Historically speaking, sectors that are leading the markets higher continue to do so in the short-term and vice-versa. The relative improvement or weakness of each sector relative to index over time can show where money is flowing into and out of. Normally, these performance changes signal a change that last several weeks.

Last week's market action was a direct reflection of the Fed's FOMC minutes. Financial stocks picked up in performance while Staples, REIT's and Utilities sharply declined. The movement in the interest rate sensitive sectors of the market was not unexpected as interest rates ticked up in anticipation of a June rate hike.

SARM-Performance-052116

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 17 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.

SARM-Model-Portfolio-052116

The portfolio model remains at 35% Cash, 35% Bonds, and 30% in Equities.

As always, this is just a guide, not a recommendation. It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance, time frames, and goals.

For longer-term investors, we need to see an improvement in the fundamental and economic backdrop to support a resumption of the bullish trend. Currently, there is no evidence of that occurring.

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