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posted on 06 November 2016

Sell Signal: Market Breaks Support

by Lance Roberts, Clarity Financial

Let me pick up with where I left off last week:

"But first, let's take a quick review of the markets which currently are flashing some very troubling signs.

Previously, I discussed the ongoing consolidation and struggle as the markets remain "trapped" between downtrend resistance and the crucial support levels of the previous breakout to new highs."

sp500-chart-1-102816

"Importantly, while the market has remained in suspended animation over the past three months, the deterioration of the market is quite evident. As long as the markets can maintain support about 2125, the bull market is still in play, but at this point, not by much."

This past week that support gave way leading to the first 9-day straight decline in the index since 1980.

However, as I explained during the "Real Investment Hour" on Thursday, it is never advisable to "panic sell" when a break of support occurs. This is because that by the time you have an extended period of selling, the markets tend to be oversold enough for a short-term reflexive bounce to rebalance portfolio risk at better levels.

The chart below is a daily chart showing the market currently bouncing off support at the 200-dma combined with a 3-standard deviation move from that short-term moving average. This all suggests a reflexive bounce from oversold conditions is extremely likely.

sp500-chart1-110416

As I have detailed on the chart above, there is a confluence of events currently occurring that suggests further downside risk following the reflexive bounce illustrated by the blue dashed line.

  • The downtrend resistance from the previous highs is colliding with the previous support level which now acts as important resistance.

  • The 50-dma is also trending downward adding further resistance to price advances in the near-term.

  • An important "sell signal" has been registered at fairly high levels and current remains intact.

However, if we step back to a longer-term (weekly) picture we get further evidence of the potential for more corrective action to come.

sp500-chart3-110416

As shown, the sell signals that are currently being registered in the market have typically suggested further deterioration in the markets to come. This supports the idea that any reflexive bounces, particularly post-election next week, should be used to rebalance portfolio risk accordingly.

So, what exactly does that mean? Let me explain.


Gardening Rules For Portfolio Management

I have often equated portfolio management to tending a garden in the past. Have a listen starting at the 3:00-minute mark.

In order to have a successful and bountiful garden we must:

  1. Prepare the soil (accumulate enough cash to build a properly diversified allocation)

  2. Plant according to the season (build the allocation based on cycles)

  3. Water and fertilize (add cash regularly to the portfolio for buying opportunities)

  4. Weed (sell loser and laggards, weeds will eventually "choke" off the other plants)

  5. Harvest (take profits regularly otherwise "the bounty rots on the vine")

  6. Plant again according to the season (add new investments at the right time)

So, with this analogy in mind, here are the actions to continue taking to prepare portfolios for the next set of actions:

Step 1) Clean Up Your Portfolio

  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.

Step 2) Compare Your Portfolio Allocation To The Model Allocation.

  1. Determine areas requiring new or increased exposure.

  2. Determine how many shares need to be purchased to fill allocation requirements.

  3. Determine cash requirements to make purchases.

  4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.

  5. Determine entry price levels for each new position.

  6. Determine "stop loss" levels for each position.

  7. Determine "sell/profit taking" levels for each position.

(Note: the primary rule of investing that should NEVER be broken is: "Never invest money without knowing where you are going to sell if you are wrong, and if you are right.")

Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are looking for a rally which will reduce the short-term oversold condition of the market and allow for a better opportunity to reduce overall portfolio risk.

IMPORTANT NOTE: Taking these actions has TWO specific benefits depending on what happens in the market next.

  1. If the market rallies back to resistance, and fails, the actions clear out the "weeds" and allow for protection of capital against a subsequent decline.

  2. If the rally breaks above resistance, and resumes the bullish trend, then the portfolio has been cleaned up and new positions can be added to participate in the next leg of the advance.

No one knows for sure where markets are headed in the next week, much less the next month, quarter, year, or five years. What we do know is that NOT managing risk in portfolios to hedge against something going wrong is far more detrimental to the achievement of long-term investment goals due to the inability to recover the "time"lost getting back to even.


Sector By Sector

Let's take a quick look at the 9-major sectors of the S&P 500 to determine the overall strength of the bullish bias.

ENERGY

The energy sector is closely tied to the underlying commodity price. Given the ongoing structural dynamics of the commodity, there is still an unrealized detachment between energy sector fundamentals and the markets.

Over a month ago, I warned the OPEC agreement would fail and oil prices would once again approach $40. There is still more correction to occur in this sector so underweight energy exposure is advised for now.

energy-110416

HEALTH CARE

The healthcare sector has been a laggard as of late and has broken down through the bullish trend. With the sector very oversold, there is a reasonable risk/reward setup in the short term for this sector. This is particularly the case as interest rates continue their decline from overbought levels, as I suggested over the last couple of weeks.

healthcare-110416

FINANCIALS

Financials continue to be a laggard with respect to overall relative performance, however, the bullish trend line remains intact for now. I suspect this will give way during the continuation of a market correction and a deeper decline will likely occur. I continue to recommend an underweighting of the sector in portfolios for now.

financials-110416

INDUSTRIALS

Industrial stocks, because of the dividend yield, have been a big beneficiary of the "yield chase." However, this sector is directly affected by the broader economic cycle and with expectations ahead of fundamental realities, risk is high. While the sector continues to hold onto support, I would recommend a reduced exposure to the sector for now until the overall broader market repairs itself. Stops should be placed at the current support level.

industrials-110416

MATERIALS

As with Industrials, the same message holds for Basic Materials, which are also a beneficiary of the dividend chase. This sector should also move to an underweight position for now with stops set at the lower support lines $46.00.

materials-110416

UTILITIES

Utilities have been picking up performance over the last couple of weeks as money begins to rotate back into "safety" plays of bonds and interest rate sensitive sectors. Stops should be set on current holdings at the lower support levels for now and a break above resistance should set the sector up for a further advance.

utilities-110416

STAPLES

Staples, another beneficiary of the yield and safety chase, broke support at the bullish trend line and is currently oversold. However, with the sector flirting at breaking crucial support, a high degree of caution is advised as "stops" are about to triggered.

staples-110416

DISCRETIONARY

As goes Staples, so goes Discretionary. Same advice as well. Portfolio weightings should be underweight at the current time with stops set at lower support levels. With many signs the consumer is weakening, caution is advised and stops should be closely monitored and honored.

discretionary-110416

TECHNOLOGY

The Technology sector has been the "obfuscatory" sector over the past couple of months. Due to the large weightings of Apple, Google, Facebook, and Amazon, the sector kept the S&P index from turning in a worse performance than should have been expected.

However, in the last week, the so-called FANG stocks (FB, AMZN, NFLX, GOOG) have stumbled. As earnings and outlooks disappointed, shareholders have awoken to the new normal low growth world and wiped over $100 billion in market capitalization of the four horsemen of the Fed's wealth creation bubble.

20161104_fang1_0

FANGs are now down 8 days in a row..(h/t Zerohedge)

The sector is oversold and very close to breaking important support levels. Weighting should be moved to underweight and stops set just below current support.

technology-110416

EMERGING MARKETS

Emerging markets have had a very strong performance during the summer but remain in a longer-term downtrend. The strengthening of the US Dollar has started to weigh on the sector and will only get worse the longer it lasts. While the sector is oversold, the majority of the gains in the sector have likely been achieved. Profits should be harvested and the sector under-weighted in portfolios. Long-term underperformance of the sector relative to domestic stocks continues to keep emerging markets unfavored in allocation models for now.

emergingmarkets-110416

INTERNATIONAL MARKETS

As with Emerging Markets, International sectors also remain unfavored in allocation models. The long-term downtrend remains intact and is currently very overbought. Underweight the sector, take profits, and focus more on domestic sectors for now.

international-110416

DOMESTIC MARKETS

As stated above, the S&P 500 is now oversold on a very short-term basis and is sitting on top of the 200-dma. However, with longer-term sell signals in place (bottom section of chart) a further decline is likely following a reflex bounce. With the markets failing repeatedly at the 50-dma, the corrective process is likely not over as of yet. Caution still advised for now.

domestic-110416

SMALL CAP

Small cap stocks have been grossly underperforming the broader market as economic and earnings weakness tends to show up in these smaller capitalization companies first. With the index breaking down and flirting with important support, caution is advised. Reduce exposure to this sector on any rally until performance begins to improve.

smallcap-110416

MID-CAP

As with small cap stocks above, mid-capitalization companies are also barely clinging onto critical support and are underperforming the broad market. Reduce exposure to mid-caps on any rally and wait for overall performance to improve.

midcap-110416

REIT's

REIT's have been under a tremendous amount of pressure in recent weeks due to the rise in rates. However, with rates beginning to retrace from more extreme levels, as "risk" rotates back into "safety," the risk-reward setup to add REIT's to portfolios is positive. Positions can be added, underweight for now, with stops set at $77.

reits-110416

Overall, in the majority of cases, the risk/reward of the market is NOT favorable. As stated repeatedly throughout this missive, the best course of action currently is to use any rallies over the next few days to reduce portfolio risk accordingly.

If, and when, the market begins to re-establish a more bullish trend, equity risk related exposure can be added back to portfolios.

Just be cautious for the moment.

It is much harder to make up losses than to simply put cash back to work in portfolios.

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