Market Trying To Confirm Bullish Trend

X-factor Report 24 April 2015

by Lance Roberts, StreetTalk Live

Yesterday I discussed the market consolidation that has been occurring for the last couple of months.

To wit:

(Note: Charts have been updated through Friday morning)

“It is this ‘technical side’ of the story that I want to examine today specifically.

Since the end of the 2012, coincident with the Federal Reserve’s implementation of QE3, the market has been on an unrelenting bullish trajectory that has defied weakening underlying economic data and market fundamentals. In other words, price momentum has deviated from underlying fundamentals as investor exuberance has escalated. Such deviations have been witnessed near the peak of every major bull market throughout history. This time is no different.

Even though the liquidity driven interventions came to an end in October of 2014, the market has continued its upward advance as momentum has kept prices afloat. While price volatility has certainly increased in recent months, I have maintained a fully allocated portfolio model as the primary bullish trend has remained intact. However, it is worth noting that the current bullish trend is extremely long by historical standards. This is shown in the chart below.”

Update: I noted that the current level of the MACD indicator (moving average convergence divergence) is at the highest level since 1999. This suggests that the markets are now more OVERBOUGHT than at any time in recent history. However, the chart below takes a look at the MACD indicator going back to 1940 along with a 500 period Williams % R indicator.

The dashed white lines show the current levels of the Williams %R at the peak of market cycles throughout history. Both indicators are extremely long time frames to slow down the volatility of the signals. Both are currently registering levels that have historically denoted major market peaks.

While this does not mean that the markets are set to “crash” tomorrow. It does suggest that the majority of the gains for the current market cycle have already been reaped. The question is whether or not you have harvested the gains from your portfolio or are you leaving them on the “vine to rot.”

Sell Signals On The Horizon

Let’s continue with the analysis.

“I have also noted the historical buy and sell points as noted by long term MACD trends. Importantly, the MACD indicator is very close to issuing only its 5th signal since the turn of the century. While this does not mean that the next “financial crisis” is set to unleash upon the financial world, such signals have only been associated with previous major market tops.

However, it is the recent market action that is most concerning. While the majority of the mainstream analysts, and commentators, continue to suggest that the markets will continue their bullish advance for a seventh year in a row, historically unprecedented by the way, the current price consolidation may be sending a different message.

As shown in the chart below, the market has been remained trapped in a tightening pattern of higher lows and lower highs. This type of action is like the compression of spring. In the next few days, the markets will make an important decision. A breakout to the upside of this consolidation will confirm the current bullish trend, and portfolio actions should remain allocated and tilted more heavily towards equity related risk. However, a break to the downside will likely suggest a more significant correction in the near term. It is worth noting that this consolidation in the market is happening during a decline of relative strength. This is a warning sign that bodes poorly for the bulls.

Since portfolios are currently fully allocated to the market, if the market breaks out to the upside of the current consolidation this will simply confirm that the “bulls” are still currently in charge of the market. No action will be required.

However, as shown in the chart below, a break to downside suggests that a more significant risk of capital destruction could be in the offing.

There should be some initial support at the long-term bullish trend line. However a break of that level, which will be very likely, will quickly see a test of 2000 on the S&P 500 index. A failure of that psychological support level, and the market will begin searching for support at 1925ish and 1850. (I have noted again in the upper part of the chart that relative price strength has NOT been confirming the bullish price advance in the market since the middle of 2014. Also, the lower part of the chart shows the current market buy/sell signal. Why still currently on a “buy,” there is little margin for error at this point.)”

Update: On Thursday and Friday the markets did break out to the upside of the consolidation pattern that began earlier this year. This suggests that the current bullish trend remains intact and keeps the portfolio allocation model fully allocated for the time being. However, the negative divergence in relative strength will likely keep a lid on any advance from this point. Nonetheless, the move to the upside is bullish and should not be entirely discounted.

It Does Not Happen Often

In order to reinforce the importance of the “buy/sell” indications driven by price momentum, I have stepped the chart out to a much longer time frame on a MONTHLY price basis. As shown, the MACD indicator at the bottom of the chart is confirmed by the price momentum oscillator just above it. Since 1999, there have only been four prior signals with each being critical turning points in the markets.

While the market did manage to make a breakout to the upside of the current consolidation pattern, it will be critical for markets to maintain that breakout going forward. A failure of this breakout, next week would quickly reverse the bullish action and put portfolios back onto “alert” status.

It is also worth noting that April and early May, denote the end of the seasonally strong period. A failure of the breakout would not be surprising as we head into the seasonally weak time of the year. This is particularly the case since the markets are long overdue for a more substantial correction of 10%, or more, following one of the longest unabated bull runs in history.

While none of this means that the current bull market is set to end, it does suggest that the risk of a more substantial downside correction has increased. This is where prudent portfolio management and risk controls will pay large dividends over the media’s “buy and hold” mentality. Caution is advised.”

Tending The Garden

Just as a refresher, it is worth remembering that portfolios, like a garden, must be carefully tended to otherwise the bounty will be reclaimed by nature itself. If fruits are not harvested (profit taking) they “rot on the vine.” If weeds are not pulled (sell losers), they will choke out the garden. If the soil is not fertilized (savings), then the garden will fail to produce as successfully as it could.

So, as a reminder, and considering where the markets are currently, here are the rules for managing your garden:

1. HARVEST: Reduce “winners” back to original portfolio weights. This does NOT mean sell the whole position. You pluck the tomatoes off the vine, not yank the whole vine out of the ground.
2. WEED: Sell losers and laggards and remove them garden. If you do not sell losers and laggards, they reduce the performance of the portfolio over time by absorbing “nutrients” that could be used for more productive plants. The first rule of thumb in investing “sell losers short.” So, why are you still hanging onto the weeds?
3. FERTILIZE AND WATER: Add savings on a regular basis.A garden cannot grow if the soil is depleted of nutrients or lost to erosion. Likewise, a portfolio cannot grow if capital is not contributed regularly to replace capital lost due to erosion and loss. If you think you will NOT EVER LOSE money investing in the markets…then STOP investing immediately.
4. WATCH THE WEATHER: Pay attention to markets. A garden can quickly be destroyed by a winter freeze or a drought. Not paying attention to the major market trends can have devastating effects on your portfolio if you fail to see the turn for the worse. As with a garden, it has never been harmful to put protections in place for expected bad weather that didn’t occur. Likewise, a portfolio protected against “risk” in the short-term, never harmed investors in the long-term.

I honestly don’t know what is going to happen here in the short term. Trends are still bullish, which keeps portfolios allocated in the short-term. However, I have this nagging feeling that the “spring” is now wound so tight, that when it does break loose, it will likely surprise most everyone.

Have a great weekend.

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.