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posted on 05 September 2016

Monday Morning Call 05 September

Written by , Clarity Financial

Since we are going into a long holiday weekend, I thought it would be worth reviewing and updating a couple of my recommendations from the end of July.

Interest Rates/Bonds

I discussed previously that interest rates had gotten so oversold (bonds overbought) due to the "Brexit" that a reversal was very possible. As I noted previously, the rotation from bonds to stocks confirmed the push higher in the markets.

That rotation is now complete.


With 10-year rates now back to an overbought condition (bonds now oversold), and pushing the accelerated downtrend line that began with the conclusion of QE3, the most likely movement will be down in conjunction with a "risk-off" move in the markets.

As discussed above, the suppressed levels of volatility, extremely confined trading range and the deterioration of momentum all suggest a short-term correction of the market is most likely.

I have been buying bonds fairly aggressively this past week for this reason.

Furthermore, the Treasury to Eurodollar (TED) Spread has recently peaked as well which has historically signaled short to intermediate term corrective moves. By the way, notice the massive increase in volatility in the TED Spread since the end of QE3.


If I am correct, and the markets do experience a short-term correction, or worse, interest rates will likely retest recent lows. One thing is for sure...

"Rates ain't going significantly higher anytime soon."

Oil & The Dollar

At the beginning of July I wrote:

"As shown in the longer term oil chart below, there is little to suggest a recovery back to old levels is in the offing anytime soon. With oil prices back to extreme overbought conditions, a retracement to $35 or $40/bbl would not be surprising particularly if, and when, the US Dollar strengthens. Remain underweight this sector as valuations for energy stocks have entered into 'moon shot' territory."

That call was quite prescient as shown. Not only did we retrace back to almost $40 once, we are likely in the process of doing it again. With oil prices at extreme overbought levels (green dots on top and bottom), a triggering of a longer term sell-signal will likely see a push back towards the $35/bbl range. Importantly, oil prices broke back below the downtrend line and must hold support at the intermediate-term moving average.


Furthermore, the rise in the dollar is likely to continue, particularly if the Fed raises interest rates in September (higher yields attract inflows) which will continue to suppress both oil prices AND earnings. As noted:

"While Central Banks have gone all in, including the BOJ with additional QE measures to bail out financial markets and banks following the 'Brexit' referendum, it could backfire badly if the US dollar rises from foreign inflows. As shown below, a stronger dollar will provide another headwind to already weak earnings and oil prices in the months ahead which could put a damper on the expected year-end 'hockey stick' recovery currently expected. "


Read the review of Q2-earnings here.

Unlike the stock market which is pushing extreme overbought levels, the dollar is at an extreme oversold condition and has only started a potential move higher. This is something to pay very close attention to in the months ahead.

As noted, with interest rates negative in many areas of the world, the push of capital into the U.S. for a higher return on reserves remains likely for now.

Model Update

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

As I have been repeatedly stating over the last few weeks, as boring as it has been, there has not been enough of a correction of the current overbought condition to justify increasing equity allocations in portfolios yet. This is despite the fact the model has been adjusted higher to represent the target levels of equity exposure we want to migrate toward.


While actual portfolio equity risk weightings remain below our target of 75% again this week, the odds of a further correction, as noted above, continue to increase. However, the continued consolidation of the market has improved conditions in recent weeks and has reduced the potential for a deeper downside correction at this point.

(Note: This is an equally weighted model example and may differ from discussions of overweighting/underweighting specific sectors or holdings.)


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.

As noted above, the recent spike in interest rates has now reached the top of the long-term downtrend and suggests that staples, utilities, and bonds will continue to improve in performance over the next couple of weeks. Such improvement will most likely coincide with an ongoing market consolidation or correction.


Notice in the next to last column to the right, the majority of sectors and indices are pushing extreme levels of deviation from their long-term moving average. Such deviations can not, and do not, last long historically. A resolution of those deviations has been occurring with the recent consolidation of the market which providing the necessary risk/reward rebalancing to increase model allocations in the future.

The two charts below graphically show the relationship of each position's performance relative to the S&P 500 Index. If we are trying to "beat the index" over time, we want to overweight sectors/asset classes that are either improving in performance or outperforming the index, and underweight or exclude everything else.


Sectors Currently Outperforming by >1%

  • Financials (Improved last week)

Sectors Currently Performing In Line <>1%

  • Industrials (weakening)

  • Materials

  • Energy (weakening)

  • Staples (improving)

  • Technology (weakening)

  • Utilities (improving)

  • Discretionary (improving)

Sectors Currently Under Performing By >1%

  • Healthcare (improving)


Index/Other Asset Classes Out Performing S&P 500 By >1%

  • REIT's (improving)

  • Emerging Markets (weakening)

Index/Other Asset Classes Performing In-Line With S&P 500 <>1%

  • Mid-Caps

  • Equal-Weight S&P 500 (weakening)

  • Small-Caps (weakening)

  • International Bonds (weakening)

  • High-Yield Bonds (weakening)

  • Dividend Stocks (improving)

  • International Stocks (weakening)

  • Domestic Bonds

Index/Other Asset Classes Under Performing S&P 500 By >1%

  • None

The risk-adjusted equally weighted model has been increased to 75%. However, as stated above, further consolidation in the markets is needed before making any changes.


Such an increase will change model allocations to:

  • 20% Cash

  • 35% Bonds

  • 45% 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 still need to see improvement in the fundamental and economic backdrop to support the resumption of a long-term bullish trend. Currently, there is no evidence of that occurring.

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