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posted on 05 February 2017

Market Trends, Reversions And Analysis

by Lance Roberts, Clarity Financial

Trends Matter A Lot

People ask me all the time why I write so much.

Here is the funny part, when I write I am writing for me. The process of writing helps me distill down the daily barrage of financial information into a more focused analysis to help me in the management of portfolios.

From time to time my writings are picked up by other sources, which is both flattering and humbling, which leads to comment threads by readers. These comments are the most enlightening and educational parts of my day.

I have learned two things in particular.

The first is there is a visible dichotomy between those who lived through the "Financial Crisis" and those who made their first investments afterward. The former has a clear understanding of what happens to capital during a major market correction and the effort required to recoup those losses. The latter has a clear belief "this time is different" and the market can only go higher from here.

The second is there is clear misunderstanding of the difference between "understanding and recognizing risks" and investment posturing (aka being "bearish.")

Currently, our portfolios are nearly fully allocated. As I have discussed over the last couple of months we have added "risk off" trades due to the extreme bifurcation in the markets. We have also added Russell 2000 and international exposure along with various sector exposure and broad market coverages.

This is hardly bearish by any means.

As such, if the market continues to rise, that's great for my clients and my portfolios.

But telling you why the market will keep going up is hardly a useful exercise. For that simply turn on any financial television program or read any mainstream financial publication. Bullishness always reigns. Maybe you should ask yourself why? (Optimism sells products, services, and advertisers.)

For me, when I write, I am analyzing the data for where I could be wrong in both my short, as well as my intermediate-term, outlook. That doesn't make me bearish, although it may sound that way. What you are reading is my struggle to battle "confirmation bias."

And...that is where we are today.

The Bullish View

As I noted last week:

"A 'buyable correction' would suggest a correction back to recent support levels that keep the overall 'bullish trend' intact."

It is the last part of that sentence which is most important in the SHORT-term.

As the monthly chart of the S&P 500 shows below, the bullish trend currently remains firmly entrenched. The market continues to trade above the running bullish trendline AND the 24-month moving average. Currently, it would require a break below 2100 to suggest a change of trend is in the works.

This short-term bullish trend mandates that portfolios remain exposed to equity-related risk as long as corrections do not violate either the 24-month or upwardly trending bullish trend.

Rule #1: In a bullishly trending market portfolios should only be long or neutral.

However, eventually, something will happen to "change the trend" from upwardly sloping to downwardly sloping which will be identifiable by a break of the supportive trendlines. In such a case the second rule applies:

Rule #2: In a bearishly trending market portfolios should only be neutral or short.

For now, the markets are clearly bullish as optimism and exuberance reign.

The Bearish View

It is the over-optimistic and exuberant outlook currently that gives me caution as to the intermediate and long-term views. As noted last week by Brad Lamensdorf there are multiple indications that suggest a much higher degree of long-term caution. To wit:

"Extremely high positive sentiment remains problematic, suggesting that a significant amount of funds available for investment have already been committed. As we've mentioned, sentiment is a contrarian indicator, and extremes typically mark tops and bottoms. Bullish newsletter writers stand at 60.6%, which is an 18-month high. Bearish newsletter writers have fallen to just 17.3%."

"The bull/bear ratio is now in the danger zone at 43.3%. The smart money/dumb money confidence gauge, a proprietary indicator published by, reinforces our view on sentiment. The current spread is exceedingly high, which is another negative for sentiment in general."

"The consumer confidence index measures the confidence level of the general public on the economy based on spending and savings. This tool is not directly linked to the stock market. However, it can be useful for spotting when expectations have become too extreme in positive or negative directions. The current reading of 113 is at its highest in over 15 years. Going back further one can clearly see the elevation of the index in the 1980's and 1990's, recessions occurring at each point thereafter. Extremes typically occur at the beginning or end of a trend. Current expectations are definitely running high!"

"Unlike earnings, which can be easily 'massaged', sales are much more difficult to manipulate. The price-to-sales on the S&P500 is at its second highest in history, rivaled only by the 2000 bubble."

These are just a few of the many indications of the extreme deviations which currently exist. This is in addition to the numerous points I have noted previously of extreme positioning in the markets as well.

When all of these measures are combined, the "risk" in the market currently far outweighs the potential for "reward" over the intermediate to long-term time frames. No chart shows that better than the quarterly view of the markets below.

As you will notice, each time there has a been combination of extreme overbought conditions (red vertical dashed lines) combined with high valuations, which coincides with market exuberance, the resulting corrections back to the long-term logarithmic trend line (green dashed line) has not been kind to investors.

Currently, such a correction would entail a decline in the market by more than 40%.

That's not being bearish.

That's just a historical fact.

Market Analysis & Warnings

Since I did a an extensive review of the major markets and domestic sectors last week, not much has changed this week other than the VIX hitting even lower lows. If you didn't catch last week's piece it is worth reviewing.

I did find some very interesting research pieces which I thought were worth sharing with you as they are supportive of much of my own analysis.

The Other Dow Theory Indicator

Dana Lyons pointed out something I missed with respect to the "Other Dow Theory Indicator."

"One such divergence dealt with the sister index of the DJIA and DJT, i.e., the Dow Jones Utility Average (DJU) (as an aside, for all you Dow Theory disciples, we are not applying the actual Dow Theory rules to the DJU, just the divergence statistics). As it turns out, large divergences of the Utilities historically demonstrated much more reliability as a harbinger of trouble than the Transports, according to our study.

We bring this up today because while the DJIA continues to hang up near its highs, the DJU is once again diverging, sitting well off of its 52-week highs. Thus, we revisited the 2015 post and updated the divergence study. Specifically, we looked for any time that the DJIA traded at a 52-week high while the DJU was at least 10% below its own high. Since 1943, there have been 73 days matching this criteria (many of the dates fell in clusters; though the clusters were of similar numbers of days so we included all such days)."

"As the table shows, in the intermediate-term following these divergences, returns on both the DJIA and the DJU were exceptionally weak. After 3 months, the DJIA was lower by a median -4.1%, with 80% of the occurrences showing losses. The DJU was also down a median of -4.1% after 3 months, with 75% losers. 6 months after the events, median returns were even worse for the DJIA and DJU at -4.9% and -7.5%, respectively. And even out to 12 months, the majority of these divergences saw both indices lower.

So while the recent simultaneous, confirming highs in the Dow Industrials and Transports has Dow Theorists quite bullish at the moment, the lesser-watched relationship between the DJIA and the Utilities is not quite so positive."

I Don't Care About The Price, Just The Dividend

One of the most common things I hear from individuals is:

"I really don't care about the price of the stock, just the dividend."


This is a mantra that is ONLY stated near major market peaks.

The reality is that when the prices of equities fall two things nearly always happen:

  1. The individual will ultimately "panic sell" as the loss of capital exceeds the mental pain threshold.

  2. The reason the stock is falling is generally fundamental which leads to a cut in the dividend.

Dividends are a function of your total return. Which means that capital preservation is required as a part of your long-term investment success.

However, here is a more important point from Political Calculations:

"While that figure [number of firms cutting dividends] is still elevated well above the level that is consistent with some degree of contraction occurring within the U.S. economy, it also represents a decline from the year ago figure of 55, which had come as part of a rising trend for dividend cuts that resulted from the economic distress unleashed by the sustained collapse of oil prices on the U.S. oil and gas industry, which lasted from July 2014 through February 2016."

"Today, some elements of that distress is still lingering in the U.S. oil sector, where oil prices have somewhat recovered and have stabilized, but the effect of rising interest rates is also taking a toll. Finance-oriented firms and other interest-rate sensitive entities such as mortgage-related Real Estate Investment Trusts (mREIT) have become more common in the count of companies that have announced dividend cuts over the last 16 months, as the Federal Reserve has frequently threatened and occasionally acted to drive up short-term interest rates in the U.S. during that time."

Here is the point.

Buying a stock for the dividend alone, and forgetting about the important function of price, is a dangerous way to invest your portfolio. While you may have the best of intentions to hold out for the long-term and collect "the check," it is not a smart way to manage your portfolio as many found out during the last financial crisis.

The Stock-Bond Warning

Michael Kahn had a good piece this week which reiterates a point I have made over the last couple of months about the relationship, longer-term, between bonds and stocks.

"While I still believe the stock market has a date with higher prices this year, the past few days have shown that the path is not likely to be smooth. Right now I see a few items that investors should monitor.

The first is interest rates. In December I took a look at long-dated Treasury yields and concluded they had topped out for the time being. The iShares 20+ Year Treasury Bond exchange-traded fund, which tracks long bond prices and moves inversely to interest rates, landed in a very major support zone"

"The inability for any market to move significantly higher after reaching a major support area is a bearish warning. Should the bond ETF break down, it would push long-term interest rates higher, and I suspect that would be a negative event for the stock market. This, despite market expectations for only two quarter-point federal-fund rate hikes this year.

The opposite end of the quality scale in the bond market also has a potential breakdown in play. Whereas Treasury bonds are considered to be default risk-free, high-yielding 'junk' bonds do carry significant risk. Major ETFs tracking junk bonds, such as iShares iBoxx $ High Yield Corporate Bond, have already seen arguable breakdowns from the post-election rally"

"All told, this is not a positive for stocks as it tells us that investors may be fleeing riskier assets. Junk bonds can be the canary in the coal mine for the stock market."

There is NO SUBSTITUTION for risk management in a portfolio.


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