Time to Wake Up: Ten Things to Watch

X-factor Report 12 October 2014

by Lance Roberts, StreetTalk Live

What is critically important is the understanding of the prevailing risks to the markets. Here are just a few:

1. The Eurozone is quickly sliding towards recession. As the largest trading partner to the domestic economy, this has serious implications for profit growth in the months ahead.

2. Speaking of profits, according to Factset, analysts’Q3 forecasts have already been sliced from 9% yoy growth at the start of July to just 4.6%. However, the rising dollar will likely slap those estimates down further in the next month.

3. Deflationary pressures are swirling the globe and are beginning to weigh quickly on the domestic economy. As I showed earlier this week, the breakeven inflation rate in the U.S. is declining which suggests weaker economic growth in the months ahead.

4.Commodities continue their plunge with West Texas Intermediate Crude breaking extremely critical long-term support.

As I have suggested for many, many weeks now the divergence between energy stock prices and the price of oil was due to be corrected. This is in process now and likely has much more to go before it is complete.

5. The surge in the U.S. dollar is a drag on both international economies as well as domestic profitability. With hopes extremely high that corporate profitability is set to grow at an extrapolated rate, as shown in the chart below, there is a tremendous risk of disappointment built into the markets currently.

Just in case you weren’t aware, earnings have never in history grown at such a rate as currently predicted.

6. Interest rates continue fall as the realization that real strength is absent from the economy. The 10-year treasury rate has just broken key support after spiking higher last year as the Fed begins inducing $85 billion of liquidity into the market each month. As I have written many times in the past, this spike in rates was FULLY expected as a “risk on” trade was made (short treasuries and go long stocks.) As the Fed ends their liquidity programs, rates begin to fall as money once again seeks safety.

7.The deterioration in US growth is being ignored by the bulk of the mainstream media that continues to cheer on “statistical” headline data without looking at the details that lay beneath the surface.

One of the better indicators of the relative health of a national economy is the year-over-year growth rate of the value of goods traded between the United States and China since they are a huge trading partner to the U.S. (We all love our I-gadgets made in China, right?)

The data in the chart below, via Political Calculations, has been adjusted to account for changes in the currency exchange rates for the U.S. and China over time, so each nation’s import growth rate is represented in terms of its own currency.

“In August 2014, the year over year growth rate of the goods that the U.S. imports from China decelerated to the lowest level recorded since February 2014, corresponding to the period of negative economic growth that the U.S. economy experienced in the first quarter of 2014.”

Currently, the balance of trade between the U.S. and China is just about where it was just prior to the last recession.

8. As I have discussed over the last several weeks, the deterioration in the markets continues to accelerate. As shown below, the number of stocks on bullish “buy” signals has fallen sharply over the last week, and the market now seems to be playing catch up to the deterioration.

The numbers of net new highs on the NYSE are also deteriorating rather aggressively as well.

9. The market sell-off has now awoken the sleeping bear. This past week sent volatility spiking higher, but there is still likely more to go as the VIX remains at very low levels historically speaking.

10. Lastly, there is still too much complacency in the market. Despite the sell-off, the number of “bears” remains at the lowest level in 20-years. I sure don’t want to be on the long-side of the market when this indicator turns upward.

Recommended Portfolio Actions

The markets are very oversold short-term which means that we should NOT “panic sell” at the moment. However, as I have recommended repeatedly over the last several weeks, on a bounce it is advisable to perform the following actions.

Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.

Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.

Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

Review your overall allocation model and adjust weightings to realign it with your longer term goals. These actions will help reduce the risk in the event that the current sell-off begins to mature into a bigger decline.

Once the market does bounce I will likely reduce the portfolio allocation model by 25% depending on the strength and duration of that bounce. More importantly, a failure of the market to obtain a new high will likely indicate that a more immediate top is being formed with substantially more downside to come.

It will be critically important to pay attention to your portfolio in the coming weeks as things could begin to evolve quickly.

Those are my thoughts for this weekend. I apologize for the brevity but will be back to normal next week.

Have a great week.