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posted on 27 June 2016

Monday Morning Call 27 June

Written by , Clarity Financial

Caution Advised

While the analysis above was a longer-term outlook of the market, I wanted to touch on the short-term outlook as we head into next week.

I want to note that despite all of the rhetoric, the "Brexit" related meltdown on Friday took the markets all the way back to where they were just one month ago. Yes, tragic for the "bulls" who bought the run-up, not so much for portfolios holding extra levels of cash.

SP500-MarketUpdate-062416-7

As noted in the chart above, there are some warnings to pay attention to going into next week.

  • The volume spike on Friday is very similar to volume spikes in the past which have preceded further sell-offs in the market. This is particularly the case when the spike in volume occurs when there is a negative divergence between market price action and the MACD.

  • While the market is oversold on the short-term following Friday's carnage, which bodes for a short term bounce on Monday, the previous downtrend support line has been broken. That resistance suggests that any bounce seen early next week could be fairly short-lived and should be used for rebalancing risks in portfolios as discussed above.

Furthermore, volatility has picked up markedly over the last week. More importantly, as shown in the chart below, volatility is trending higher on a monthly basis which has historically spelled trouble for the markets in the short-to-intermediate term.

VIX-MarketUpdate-062416-10

One interesting point is on a daily basis, the market appears to be completing a "head and shoulders" formation as shown below. While these patterns are important warnings, on a short-term basis there is a tendency to provide "false flags."

SP500-MarketUpdate-062416-8

While there is a history of these short-term formations to provide misleading information, they should not be readily dismissed as there is also a history of these signals being correct. As always, it is easier to add capital to rising markets rather than spending time making up previous losses.

As I stated last week:

"As shown in the top part of the chart above, when the markets are as overbought as they are now, it has generally been at, or near, a short-term peak in the market.

The short-term outlook continues to suggest more vulnerability to selling. The failure of the markets to hold support at 2080 now sets the market up to test support at 2040.

Stop loss levels remain in place at 2040 currently. A break of 2000 will initiate a market-neutral hedging strategy to reduce overall equity exposure and related portfolio risk."

SP500-MarketUpdate-062416-10

It will be important the markets hold support next week. Risk is extremely elevated at the moment so caution remains advised.

No Change To Allocations

The inability for the markets to advance, but having not yet violated important support levels, keeps portfolio allocation models once again unchanged.

Two weeks, I discussed the portfolio management rules that guide the investment process in my shop. It is through following these basic rules that, with the markets overbought, underlying fundamentals and economics deteriorating, and profits still weak, that I continue to suggest some portfolio actions be taken to reduce, not eliminate, overall risk as noted above.

On a long-term analysis basis, there is still a weight of evidence suggesting the markets are currently working through a major topping process. Yes, maybe this "time will be different," however, historically speaking it hasn't been.

SP500-MarketUpdate-062416-9


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.

This past week, as over the last five weeks, we continued to see the relative rotation from RISK to SAFETY as performance improved in bonds and areas that benefit from lower rates. Furthermore, RISK based sectors have continued to wane in performance and the number of sectors leading the markets have continued to shrink. As I stated previously, such action is indicative of short-term topping process following an advance. This is exactly what we continue to see play out currently, which was the same as we witnessed during the summer and winter of 2015.

SARM-Rotation-Chart-062516

All sectors, with the exception of the major DEFENSIVE areas of Utilities, Gold, and Bonds, lost ground last week.

The sector recommendations last week paid off handsomely this week.

As I recommended last week:

LEADING: Energy, Materials, Mid-cap and Small-cap (Take Profits)

IMPROVING: Financials and Health Care (Hold)

LAGGING BUT SHOWING IMPROVEMENT: Utilities, Gold, Bonds and Staples (Hold and Selectively Add)

LAGGING & WEAKENING: Discretionary, Technology, International, Industrials, & REITs (Reduce)

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

Sectors-CandleGlance-062516

The sell-off last week was most clearly seen in across all sectors of the market last week with the exception of Utilities. The hardest hit sector was Financials as the decline of interest rates, the "Brexit," and the inability of the Fed to hike rates, led to continuing concerns about net-interest margins and balance sheet risk in the sector. Importantly, 6 out of 9 sectors are trading below both their short and intermediate-term moving averages.

Healthcare, which I stated three weeks ago was pushing extreme overbought conditions and some profit taking would be wise, also fell sharply this past week.

The case with Healthcare is now seen in Utilities. The very sharp push in the sector has now pushed it back into extreme overbought territory. While the "yield chase" is still intact, it would be rise to take some profits from the sector near term.

On a short-term basis, bonds and gold are pushing extreme levels of deviation, profit taking at these levels would be strongly recommended.

As I stated last week:

"We saw the early stages of deterioration in leadership in Small and Mid-Cap stocks last week, so profit taking would be suggested."

That proved prescient.

Sectors-CandleGlance-062516-2

In portfolio models, I have continued to admonish international and emerging market exposure. These asset classes have continued to act as an anchor to the performance of traditional asset allocation models. The flight to safety into domestic assets following the "Brexit" last week, continues that run of relative outperformance over international holdings.


S.A.R.M. Sector Analysis & Weighting

The current risk weighting remains at 50% this week. The failure to maintain the breakout above 2100 holds allocation changes for now. With technical underpinnings still "bullishly biased," we want to give the markets the benefit of the doubt for now. However, with those technical underpinnings deteriorating, risk has risen markedly.

SARM-ModelAllocation-062516

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.

SARM-RelativePerfomance-062516

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 2 a few weeks ago to 19 this past week.

The risk-adjusted equally weighted model remains from last week. No changes this week.

SARM-Model-062516

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.


THE REAL 401k PLAN MANAGER

The Real 401k Plan Manager - A Conservative Strategy For Long-Term Investors


401k-PLan-Manager-062516

NOTE: I have redesigned the 401k plan manager to accurately reflect the changes in the allocation model over time. I have overlaid the actual model changes on top of the indicators to reflect the timing of the changes relative to the signals.

There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.

401k-PlanManager-AllocationShift

"Brexit"

As discussed in the main section of the newsletter, the surprise "Brexit" on Thursday sent the markets plunging on Friday. While "bulls" were sent scrambling for cover, the overweight cash and fixed income holdings protected 401k plans nicely this past week.

Furthermore, the technical underpinnings, while still bullishly biased at the moment, are beginning to deteriorate. That, combined with the failure of the market to breakout about 2100 keeps allocation models on hold, again, this week. In other words, we remain in "limbo" and frustratingly so.

As I stated last week:

"With technical buy signals currently in place, it suggests that allocations should be moved up to 75%. However, given the inability to rapidly change allocations in many 401k plans, due to trading limitations, I would rather wait for a clear breakout above resistance and a re-establishment of the "bullish trend" before taking on additional equity risk.

Also, as we head into the seasonally weak time of year, combined with what appears to be a rather volatile Presidential election, "Brexit," and weakening economic underpinnings, some extra levels of precaution seem prudent."

That turned out to be very good advice. Once again, there are no changes to the 401k model this week as risk/reward is still not balanced enough to justify taking on additional model risk.

For longer-term investors, the markets have made virtually no progress since January of 2015. Therefore, there is little evidence to suggest stepping away from a more cautionary allocation...for now.

If you need help after reading the alert; don't hesitate to contact me.

Current 401-k Allocation Model

The 401k plan allocation plan below follows the K.I.S.S. principal. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)

401k-AllocationModel-042316

401k Choice Matching List

The list below shows sample 401k plan funds for each major category. In reality, the majority of funds all track their indices fairly closely. Therefore, if you don't see your exact fund listed, look for a fund that is similar in nature.

401k-Selection-List

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