X-factor Report 15 February 2015
by Lance Roberts, StreetTalk Live
After a couple of rough months in the markets where volatility rose quite dramatically, it now seems as if the bull trend will remain intact at least for a while longer.
It is interesting to note that despite the geopolitical risks (Russia, Iran), financial risks (Greece) and rapidly deteriorating economics and earnings, that the market has sustained only a 3%ish correction over the last couple of months.
This is, of course, due to the extreme level of complacency in the markets like the “irrational exuberance” witnessed in the late 90’s. Now, like then, the level of overconfidence can last for quite some time and should not be underestimated.
What is important to understand, is “when” the eventual correction comes there will be no safe place to hide. In the coming financial reversion, the only save place will be in “cash.”
DO NOT misunderstand me. I am not suggesting that the world is about to end economically and that all you should own in gold, ammo and a can of “beanie-weenies.”
What I am saying is that when the next financial market reversion happens, money will simultaneously flow out of all equity, and fixed income related investments into “cash.” This is simply because money has been piling into the “yield chase” for the last several years which has now pushed normal “defensive” sectors of the markets into levels of extreme overvaluation. The unwinding of that “yield chase” will swallow these normally defensive sectors, technology and real estate whole.
My partner and I had a conversation this past week on the efficacy of long/short equity strategies in a corrupted market. These would seem to be logical places to invest money in anticipation of a market decline. As shown, Boston Partners runs probably the single best long/short fund in the marketplace today. However, these strategies become discounted extremely quickly as liquidations reach extremes.
The long/short equity strategies mostly performed better than the market as a whole during the decline, and had you remained invested, would have likely performed better than the market. However, as shown repeatedly by Dalbar investor research studies, most investors would have dumped such funds at, or near, the bottom of the crash. This is the psychology of investing, and regardless of your personal beliefs, the liquidation process will be all encompassing when it begins. This is why it is important to have a strictly followed “sell discipline.”
It will likely not be much different for the credit markets. The credit market will also most likely take a very heavy beating as the “high yield” complex is smashed. However, since money is generally irrational on the way up, but more irrational on the way down, the liquidation will be quite substantial in the “junk bond” arena. The safest place in the fixed income space will be short duration bond and U.S. Treasury funds as fears of bankruptcies and defaults rise across the corporate spectrum.
The reasoning that there will be mass, irrational, dislocations and liquidations (which will confound and confuse money managers far and wide with models that suggest that such things can’t happen) is tied directly the chart below.
With margin debt near all-time highs, the forced liquidation process, when leverage of this magnitude is unwound, will result in repetitive “margin calls” forcing liquidations to occur very rapidly. This is specifically why the “crash” was so swift following the Lehman bankruptcy.
That Is Not Where We Are Today
As I noted two weeks ago in “Market Oversold Enough For A Bounce” the recent retracement in the markets was not unexpected.
“As shown in the chart below, the S&P 500 has gotten oversold on a short-term basis and is due for a bounce to the current downtrend resistance line. Importantly, the market is sitting on what has been very important support in recent months at the 150-day moving average. A failure of this support will lead to a retest of the October, 2014 lows.”
“A rally from this support line could last several days to a couple of weeks. It is advisable to use the rally to “clean up” existing portfolios by selling laggards, reducing high-beta risk and rebalancing winners by taking profits and rebalancing back to target weights.
(Important note: Notice that I did not say “rebalance portfolios” which implies selling winners to buy losers. The goal here is to let winning positions continue to flourish by simply “pruning” the position, and “weeding” the portfolio by selling the losers dragging on overall performance.)”
Here is that same chart as of today.
With the market now once again back in overbought status, it is critical that the market breaks out to new highs to re-confirm the bullish trend.
The chart below shows the weekly analysis of the current bullish trend.
As noted the “buy signal,” which has been in place since 2012 is now running very “flat.” This signal is very important because on a longer-term basis of identifying trend changes in the market.
Currently, the trend is still bullish and requires money to be allocated to equity exposure accordingly which is why last week I recommended adding a 5% weighting to mid-capitalization stocks in the 401k-plan manager model. If the market can successfully break out to new highs, it will be logical to increase equity exposure further.
However, do not miss the fact that the current bull market is EXTREMELY long in duration and deviation. With earnings growth deteriorating, deflationary pressures still on the rise, and potential financial risk escalated, there are more than enough catalysts to trigger a sharp correction.
While portfolios should be more heavily tilted toward equity exposure currently, it is important to remember that it can and will change quickly. As an investor, you need to be prepared to respond accordingly.
Have Oil Prices Bottomed
Last Monday I penned a piece about whether or not oil, and energy stock related positions, had potentially bottomed. I would suggest taking a look at the whole piece as it is “chock full” of charts and data.
However, here is the crux of the article:
“But, in the short-term there is little argument that oil prices have become exceptionally oversold. The chart below shows oil prices against 2-, 3- and 4-standard deviations of the 4-year moving mean. (Oil prices at 4-standard deviations is a very rare event.)”
“The bounce back in oil prices over the next twelve months could theoretically be quite significant pushing levels in the high-70’s. Such an event will likely suck many investors back into the oil complex believing that the “crash” is over.
However, there are two important aspects to consider.
First, potential dynamics behind the drive higher in oil prices, including the Federal Reserve interventions, have changed. The global deflationary pressures continue to apply downward pressures on economies and energy based demand. Secondly, the surge in oil prices, supported by the Federal Reserve’s monetary interventions, was likely an “echo boom” following the 2008 plunge in prices. That rise in oil prices likely lasted far longer than it should have, and now the completion of the long-term price correction is in process.
This idea suggests that a new range in oil prices will take hold that will fit more closely with actual underlying supply/demand dynamics.
As with all things, recency bias (expecting the recent past to repeat in the future) tends to lead investors astray in making investment bets way too early. So, some caution is advised.
My suspicion is that we may see a very tradable bounce in the near future. But the technical damage done to asset prices and a realignment of supply/demand dynamics will likely lead to another decline and bottoming process. Such an event would flush out the majority of speculative investors and allow valuations to realign which would provide the foundation for a long-term investment opportunity.”
There are many risks in the markets currently but none of them have phased the “bullish” mantra at this point. As I stated above, this has led investors into the belief that they are “bullet proof” which has historically led to very bad outcomes.
Remain invested currently, however, do so with a solid degree of caution.
Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer here.
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