Is the Sell Signal Still Valid?

by Lance Roberts, Streetalk Live

Editor’s Note: This was written before today’s Fed “no taper now” announcement.

Before we get into this week’s missive I just wanted to thank you for all of the kind, supportive and enlightening emails over the past week regarding the rollout of our new firm:

The title question dominated my inbox last week. I almost got to the point of just cutting and pasting answers to emails for the sake of expediency. However, I personally responded to each and every one as always. Last week I specifically stated that:

“The KEY POINT here is that the market is likely oversold enough to warrant a bounce next week that could be fairly substantial. This bounce will provide the media bulls with ammunition that the short term selloff is over and the ‘bull is back in charge’ through the end of the year. Therefore, the currently rally continues to MOST LIKELY be an opportunity to reduce portfolio allocations and reduce risk.

Last week I posted a chart showing the deeply oversold condition of the market.  These ‘oversold’ conditions act like ‘fuel in a gas tank’ for the markets. Market corrections lead to a pent up demand of buyers, and an exhaustion of sellers, which facilitates sharp reversions. The chart below is the updated DAILY chart from the last two weeks. I have left the previous markings which details the previous oversold condition so that you can see that the very small rally last week has already consumed much of the ‘fuel’ already.”

Now that we are back to much OVERBOUGHT conditions there is likely not much room left to the current rally. The fact that this rally has not broken out to new highs, which it has done every time before, is also concerning.

However, as I also stated last week:

Again, this is just a “wild @$$ guess” at what I think the markets will do based on current price trends, support and resistance points. Anything is possible and portfolio management actions will have to be adjusted accordingly as the market develops.

Again, I cannot restate enough, the issuance of the “confirmed sell” signal is NOT a sell everything and run to cash type of thing. It is simply a signal that suggests that the current market is going through a corrective phase and that we need to reduce our equity risk accordingly, raise some cash, and be prepared to act on the next buying opportunity when it presents itself.

As long term investors, and portfolio managers, our goal is simple “buy low” and “sell high.” If we don’t sell some things along the way, maintain our portfolios and pay attention to our money – inevitably we will wind up making decisions based on “panic” rather than “logic.” Unfortunately, emotionally based decisions rarely work out well.

Pay attention the market over the next couple weeks and reduce allocation models accordingly.”

While the “bounce” exceeded previous expectation levels, due to a greater impact of short covering than anticipated, the rise did allow for portfolios to be realigned fully with our target allocation model. However, did this short term rally reverse the intermediate term “confirmed sell signal” issued two weeks ago? The chart below shows the market versus the confirming buy/sell signal.

What is important to notice is that following the previous selloff in the market – stocks reached a new closing high as they entered overbought territory. This followed a 110 point rally in the index. From that point to the next closing peak was only 40 points. However, NO SELL SIGNAL was ever issued.

There are two primary differences currently:

1. A confirmed sell signal was issued two weeks ago. That signal is still in place and has NOT been reversed.
2. The market has now returned to being overbought without the market attaining a new high close.

This suggests that the market, despite the oversold bounce over the last two weeks, is still likely in a corrective phase. Until the market breaks out to a new high and the confirmed sell signal is reversed investors should err to the side of caution.

That DOES NOT mean sell everything and go hide in cash, buy gold, ammo and can goods, or build a bunker in your backyard. It just simply means that you should pay attention to your hard earned savings.

Since the sell signal has not been reversed we remain allocated at 75% of our target allocation. When the sell signal is reversed we will recommend upping portfolio exposure accordingly.

In this regard, for new readers, I have updated the portfolio management instructions from the past two weeks.

1) The S&P 500 found resistance at 1690 last week. If the market is able to rally on Monday due to the “just reached deal on Syria” above that resistance level – old highs will be the next target.

2) As stated above; review your current holdings and ask yourself “why” you own a specific position. If the position in underperforming, and the only case you can make for owning it is “well, ‘soandso’ on TV said it was a good idea,” then this is a good position to sell. Such positions would currently include gold and emerging markets.

Positions that lag when markets are rising tend to fall faster than the market during the decline. Therefore, if you don’t really understand why you own it – get rid of it now.

3) Positions that are pacing, or outperforming, the market as a whole should be kept but reduced now to raise cash and reduce portfolio risk. Positions that outperform on the way up tend not to fall as fast as the market on the decline, however, they will decline. Take some profits.

4) All funds in a given category (growth, value, large, mid, small, etc.) all tend to track the broad market index fairly closely. Therefore, use the rally to consolidate the 3-5 large cap funds in your portfolio into a single holding. The same goes for mid-cap, small-cap, international, etc. Diversification is not about the number of funds that you own but the non-correlation between the various assets. You can have a fully diversified portfolio with just 3-5 funds in total.

5) Do not rely solely on other people’s opinions – including mine. I take a lot of time, do a lot of research and analysis, in order to come to my opinion – but it is JUST an opinion. Take some responsibility for YOUR SAVINGS and learn what you are investing in and why. Too many individuals invest in the financial markets with no real interest, understanding, or desire to learn about what they are doing. They only invest in the financial markets because they are told they must. There is no requirement you invest at all.

As a I discussed last week that is a good chance that my current assessment of the market is wrong. It is for this very reason that I continue to closely monitor the markets utilizing a variety of different tools, economic, fundamental and technical, to make decisions. It is also why we have changed the way that we manage portfolios so that we can be more responsive to a market that is moving faster, is more volatile, and is more manipulated by major firms than ever before.

If my current assessment of the market is wrong – that is actually good. It will mean the markets are rising and we can increase our allocation in our portfolios back up to full exposure. If I am right – then our cautious stance as of late will pay off as our portfolios will outperform the broader market indices.

However, if I am wrong, I will change my view. At the current time, however, there is nothing that suggests my current view is wrong but that could change next week.

A Listing Of Headwinds

There is a litany of issues currently facing the markets and the economy ahead. Here are a few:

• Syria: While there has been a tentative agreement between Syria, the U.S. and Russia, to destroy Syria’s arsenal of chemical weapons – the reality is that this is the same “dog and pony” show we witnessed with the WMD inspectors in Iraq. Syria will agree to comply up front and then move their weapons to other locations subsequently such as Iraq and Lebanon. Theywill only allow the U.N. inspectors to “see what they want them to see” and“compliance” will be nothing more than an act. This is assuming the Syrian rebels will even let the inspectors into the country. The reality is that in the next few months we will likely be once again talking about limited strikes in Syria.

• Debt Ceiling: We are once again facing the dreaded “debt ceiling debate” where the issues will be increases in spending combined with increases in taxes. What will be critical to the markets is whether, or note, the “debt default” card is once again played. While the government will NOT default onits debt, as they can print currency to pay obligations, the rhetoric will be anegative for the market.

• Eurozone Elections: Angela Merkel is up for re-election in Germany and it is currently estimated that it will be an easy victory for her. However, we have seen such proclamations go awry before and a defeat could cause concerns throughout the Eurozone.

• Interest Rates: The recent surge in interest rates, as shown in the first chart below, is not unprecedented during QE programs. However, it is not just in the U.S. that rates are increasing. European bond spreads are surging as well (second chart below).

  Increases in borrowing costs negatively impact economic growth. This is true for both the U.S. and the very weak Eurozone economies. Importantly, the recent surge in interest rates has not yet completely worked their way into the economy. This means that we are likely to see further economic weakness going into the end of the year.

• Economy: The economy seems to be showing some short terms signs ofrecovery on some fronts. However, at the moment, these bounces in the data appear to be nothing more than just “restocking” activity given the weakness seen in the consumer spending and confidence data. Higher rates will have a negative impact, as discussed above, on consumption which will be reflected in a slowing of economic growth through the end of the year.

• Earnings / Revenue: As discussed recently corporate earnings appear to be peaking as cost cutting has likely reached the limits of its effectiveness. As shown revenue growth remains extremely weak. This is reflective of the sluggish economy and consumer and will be difficult for the market to continue to justify current valuation levels.

• The Fed “Taper:” The market is trying to come to grips with the reality that the Fed is likely to begin tapering their bond purchases soon. The belief is currently that the economy is now able to sustain itself with reduced Federal Reserve assistance. Mohammed El-Erian summed this up well:

“As much as we wish for otherwise (particularly in view of the most positive high-frequency data), there is still not enough evidence to conclude that the U.S. economy will be able to emerge decisively
and durably from its low growth equilibrium in the next few quarters. The impact of sluggish domestic components of aggregate demand is compounded by declining growth in emerging economies, insufficient structural reforms and public infrastructure investments, and stubborn residual pockets of excessive leverage – all of which limit the expansion propensity of corporate America, the one component of the private sector with the wallet (but not the will as yet) to spend.

Congressional political polarization is not helping the outlook for a high and durable fundamental U.S. recovery. At a time when the economy needs a tailwind from Capitol Hill, lawmakers risk creating renewed headwinds when they finally turn their attention to steps to keep the government running and lift the debt ceiling.

As for the Fed, we should all hope for “good” reasons for it to taper – meaning that the central bank has strong reasons to believe that the U.S. economy is approaching “escape velocity.” But the Fed could also taper for “bad” reasons – that is to say that its prolonged experimentation with unconventional monetary policy threatens to create too much collateral damage and unintended consequences (including concerns about misallocation of resources, excessive risktaking and damage to the functioning of certain markets).

In all likelihood, the Fed will taper for a mix of reasons. Specifically, it will likely be comforted by the notion that the American economy continues to heal, but also frustrated by the gradualism of the recovery and the threat of collateral damage. Meanwhile, look for the Fed to try to compensate the potential contractionary impact of tapering by evolving its forward guidance policy.”

• Eurozone: As discussed above the rise in interest rates will ultimately impact the solvency of the Eurozone countries who have done nothing to begin to repair their balance sheets. More needs for bailouts are likely coming sooner than expected and the real question is will the ECB have enough money on hand, and cooperation from Germany in particular, to continue to solve the financial issues going forward.

Market Rally To Nowhere

There is simply one thing that is more important to remember than any of these other short term events – the market rally could certainly go further, however, it will also eventually end.

The chart below is a 113 year, inflation adjusted, chart of the S&P 500.

There are three things to understand:

1) Return on investment is SIGNIFICANTLY impacted by WHERE you started investing during a given cycle.

2) All market rallies eventually corrected and all corrections eventually ended. What made the difference over the long term was not catching the declines.

3) Believing that “this time is different” is a fool’s dream that always turns into a nightmare. Every secular bull market was believed to be different.

The technical indicators currently suggest that the market is likely approaching the end of the current oversold rally. This is does not mean that the markets cannot attain a new high. It is certainly possible. However, the economic and fundamental cycles are now very long into normalized recoveries which suggest that we are nearer the end of the current cycle than the beginning.