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posted on 19 September 2016

Monday Morning Call 19 September

Written by , Clarity Financial

Time To Buy Bonds? Probably.

Last week, I discussed what I believe to be the premature calls for the death of the "bond bull market." As I wrote:

"Given that interest rates had gotten extremely oversold during the 'Brexit,' as money poured into bonds for safety, it is not surprising to see rates have a reflexive move higher. What we saw on Friday was likely rate "shorts" being blown out of positions."


"Importantly, while interest rates could possibly tick higher to the long-term downtrend line at 2.1%, (OMG, run for the hills), the reality is the economy is not growing strongly enough to support substantially higher rates which will push the economy more quickly towards the next recession.

Of course, during recessions interest rates fall sharply which is why I still suspect, given the majority of global economies in negative territory, them to ultimately approach zero."

Jennifer Thomson from GaveKal Research also acknowledged much the same.

"Today, the topic du jour seems to be the impending rise in U.S. rates and the bursting of the multi-decade bond bubble. Before we get too worked up over the chances for an aggressive sell-off in government bonds, let's consider the following chart. In the top pane, we have the spread between U.S. and German 10-year bond yields (green line). The orange dotted lines represent the 25-year average (about 30 bps) and the first and second standard deviations from that average. In the bottom portion of the chart, the pink line is the U.S. 10-year yield (currently 1.70%) and the blue line is the German bund (at 0.03%)."


"Excepting the years following the fall of the Berlin wall, U.S. rates have been higher than their German counterpart in nearly every non-recessionary/ financial crisis year. In addition, the spread has been at a quarter-century, two standard deviation high for almost two years now (since October 2014). At other extremes - highs in 1999 and 2005/6 and lows in 2002 and 2008/9 - the spread has reverted back towards the average much more quickly.

Based on this relationship over the last 25 years, we might expect the spread to narrow from current levels. In order for that to occur, there must be some combination of a fall in the U.S. 10-year yield and/or a rise in the German 10-year yield. Given the ECB's current quantitative easing efforts (and its reliance on German debt, in particular), the probability of a rise in German yields would seem unlikely at best. Which means that the normalization of this relationship is dependent on a further decline in the U.S. yield. No imminent signs of a bursting bond bubble here, folks."

As I said last week - all interest rates are relative. I am still buying bonds.

Walking Up A Down Elevator

A look at momentum currently suggests that investors may have to wait another week, or so, for a short-term trading opportunity to set itself up.

As shown in the chart below, and noted in the missive above, the market is currently holding support at the previous breakout highs. However, the overall momentum of the market is continuing to decline from previously high levels. Looking back over the last 5-quarters, such corrections have tended to correct further after a short term bounce.


As Adam Koos penned on Friday:

"Buying stocks in this environment is like trying to walk up an escalator that's going down. The momentum is not in our favor and we should always analyze how much risk we're willing to take for an assumed reward.

So, at least for the moment, it would be wise to focus on other asset classes for more immediate, positive risk/reward ratios (such as Treasury yields, for instance). As the next six weeks unfold, the market will give us a better picture of what direction it wants to move in the longer-term and from there, we can determine whether we want to buy into this weakness."

I tend to agree.

Sector Snapshot - Looking For Opportunity

The correction in the broader market is much more interesting when looking at the underlying sectors. Had it not been for Apple's (AAPL) surge last week on hopes for strong iPhone7 sales, the market decline would have been substantially worse.

To wit:

"The iPhone maker accounted for about 80 points of the Dow's 127-point gain for the week, or more than half.

Apple was also responsible for about 60 percent of the S&P 500's weekly gain of 0.53 percent, with the technology sector surging 3 percent as the best performer.

Without Apple, the tech sector would have gained just 1.57 percent and the S&P 500 would have gained just 0.19 percent, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices."

As shown in the chart below, there are moving average crossover (sell signals) in Discretionary, Industrials, Materials, Staples, Healthcare, and Utilities.

Furthermore, with the exception of Technology, every sector has broken their respective longer-term moving averages suggesting downside risk currently prevails.


The picture doesn't improve much when looking at major indices.

EVERY index has broken the longer-term moving average which suggests more pressure to the downside in the days ahead


While it is entirely feasible the markets could bounce higher next week, any failure to reverse the short-term damage to the market will likely show up in renewed selling pressure.

On a short-term trading basis, traders may be well advised to sell into any short-term rallies to take profits and rebalance portfolio related risks.

Model Update

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

Well, last week wasn't boring. The market swung in a 2% range all week as portfolio managers repositioned for options expiration on Friday. The question now - is it over yet? The internal damage to the market was substantially greater than the headline index would suggest, so some caution is advised heading into next week. However, we have been looking for an opportunity to increase equity exposure in portfolios and we may get that opportunity soon. We will patiently wait and let the market "tell us" what to do next rather than "guessing" at it.

While actual portfolio equity risk weightings remain below our target of 75% again this week, the odds of a further correction next week keeps us on hold for now until we find a short-term bottom and can redetermine risk/reward ratios.

(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 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 which have previously been pushing extreme levels of deviation from their long-term moving average, have corrected much of those extremes.

Basic Materials, Staples, Utilities, REIT's and Bonds are currently at the biggest deviations below their short-term moving average. Historically speaking, and as noted above, such deviations would suggest these sectors deserve some attention in portfolios as this is where buying opportunities TEND to exist. It also supports the comment above that a further consolidation or correction in the markets is likely as these more defensive sectors tend to benefit from the rotation from "risk" to "safety."

Importantly, if the current pullback is a "buy the dip" opportunity, the sectors that maintain their technical underpinnings and resolve the extreme deviations from short and long-term moving averages will provide good opportunities to add to portfolios.

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%

  • Technology (Weakening - $AAPL related push, narrow advance)

  • Utilities (improving)

Sectors Currently Performing In Line <>1%

  • Healthcare (improving)

  • Staples (improving)

  • Discretionary (improving)

Sectors Currently Under Performing By >1%

  • Energy (weakening)

  • Materials (improving)

  • Industrials (improving)

  • Financials (weakening - $WFC related, could spread to other majors.)


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

  • Mid-Cap (improving)

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

  • Equal-Weight S&P 500 (improving)

  • Small-Caps (weakening)

  • Dividend Stocks (improving)

  • International Bonds (weakening)

  • High Yield Bonds (weakening)

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

  • REIT's (improving)

  • Emerging Markets (weakening)

  • International Stocks (weakening)

  • Domestic Bonds

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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