Storm Warning

X-factor Report 09 August 2015

by Lance Roberts, StreetTalk Live

Well…after months and months of indigestion, the markets MAY, and I repeat MAY, have finally come to a decision to end the current bull market run.

The reason I say MAY, and not definitely, is that we have seen initial breaks of trends previously (red circles in the chart below) that were quickly resolved by rapid Federal Reserve interventions.

Also, as I have repeatedly stated in the past, by the time that a major “sell signal” is in place the markets are always extremely oversold on a short-term basis. That oversold condition gives investors an opportunity to safely exit the markets on a bounce to previous resistance. Such was clearly evident, to those paying attention at the peak of the last two bull markets.

The chart above makes an important distinction between “PORTFOLIO MANAGEMENT” and “MARKET TIMING.”

Market timing is trying to be “ALL IN” or “ALL OUT” of the market at a specific point in time, preferably tying to hit the exact top and exact bottom of the market. While an individual may get lucky at one point, it is nearly impossible to replicate such timing on a consistent basis. The eventual, and inevitable, miss of a turning point can be a costly investment mistake.

However, portfolio management is simply the process of recognizing that market dynamics have changed and either increasing or reducing the exposure to “risk” related investments accordingly. As shown in the chart above, investors following the “signals” would have NOT sold at the top or bought at the bottom. However, they would have gracefully exited the markets and missed a bulk of the destruction of capital during the last two bear markets and would have garnered a vast majority of the subsequent gains.

This is a fine point lost by the always bullish media. Those who promote “buy and hold” allocation models are simply being “lazy,” or they are not knowledgeable, with respect to the actual practice of portfolio management. This should also elicit the question of exactly what you are paying a fee for?

However, I digress.

Oversold Bounce Likely

As I stated above, by the time the market triggers a “sell” signal, the negative price action has generally exhausted sellers in the short-term.

This is an important point. There is an old adage that says:

“For every buyer, there is a seller.”

This is true – BUT while there is a buyer for every seller, which is required to complete a transaction, it is at WHAT PRICE that counts.

Think about it this way, if a transaction ALWAYS occurred at a given market price, there would be NO price volatility in the market. However, when there are a large number of people willing to sell at “X” price, but only a limited number of people willing to buy at “Y” price, sellers must drop their price to find buyers. At some point, the number of people willing to sell at a given price will become exhausted, and there will be more buyers which will begin to move prices higher.

This is why paying attention to “overbought/oversold” indications can help identify when this potential “exhaustion” phase has occurred.

What the chart below shows is that currently the markets have once again become oversold which sets the market up for a short-term bounce.

However, as highlighted in yellow, the previous “bullish” consolidation has now been reversed into a potential “bearish” trend. With deteriorating relative strength and a lack of real conviction in the markets, the easiest trend for prices currently is downward.

The following chart is a WEEKLY chart which shows the continuation of the markets to fail at the current downtrend resistance. Three failed breakout attempts, and a close below the long-term bullish trend support moving average (black dashed line) all suggest the market will likely retest the 2000 level in the near future. If that 2000 level support is taken out, I have identified further correction levels back to the October 2014 lows. However, a correction of that magnitude will have completely changed the complexion of the market overall.

3 Warnings For Market Bulls

I HIGHLY suggest you read Thursday’s post “3 Warnings For Market Bulls.” However, for those that want the “Cliff Notes” version, here you go:

Lowry Sees Bull Market Ending

There is a very interesting podcast at Financial Sense with Richard Dickson, who is the Senior Market Strategist at Lowry Research.

Dickson says when the broader indexes are approaching a top, the advance is led by fewer and fewer stocks, which has been seen at every major market peak they’ve studied.

This phenomenon registers in the market’s widely followed advance-decline line, however, Dickson points out that relative under-performance by small-cap stocks often provides an earlier warning signal to potential trouble ahead. He notes that small-cap stocks began to deteriorate almost a year ago, and many have already entered bear market territory. This is not healthy action, he says.

Based on research conducted at Lowry, this predicts a market top within 4 to 6 months. In the interim, Dickson will be watching a variety of other technical indicators for confirmation, such as buying power and selling pressure.

Here is a chart of the advance-decline line and small-cap performance relative to the S&P 500.

McClellan: Market Lacking “Escape Velocity”

Tom McClellan, a family famous for the “McClellan Oscillator” recently issued a note discussing the importance of the number of advancing and declining issues and “escape velocity.” To wit:

“To understand this important point, we need to explore and define a principle of rocketry known as ‘escape velocity.’ This term is variously (and sometimes confusingly) defined as the velocity which a projectile needs in order to escape the gravitational field of a planet or other body, and/or the velocity needed to achieve stable orbit as opposed to falling back down to Earth. My purpose here is not to defend either definition; for our purposes, the idea is the same, that there needs to be sufficient energy to keep from falling back down.

The Summation Index can show us that. For this discussion I will be using the Ratio-Adjusted Summation Index (RASI), which factors out changes in the number of issues traded.,,the RASI gives comparable amplitude levels with which to evaluate available financial market liquidity.“

“The +500 level for the RASI is the important go/no-go threshold for this concept of ‘escape velocity.’

Since the 2009 bottom, the Federal Reserve has made sure that there was liquidity available to the financial markets, at least for the most part. The cutoffs of liquidity after both QE1 and QE2 led to vacuums in the banking system, and stock prices fell into those vacuums. The question for 2015 is whether Fed actions are going to take away the liquidity punch bowl, and create a problem for the next rally’s ability to achieve escape velocity.

We saw this principle of diminished liquidity back in 1998-2000, and again in 2007-08, as highlighted in this historical chart. When the RASI failed to climb back up above +500, it said that there were liquidity problems which ended up keeping the stock market from being able to continue itself higher.”

“My leading indication from the eurodollar COT data says that we should expect a major top in August 2015, and so there is not all that much time left for the RASI to get back up above +500. An upturn from this oversold condition should be able to produce a marginally higher price high, but if it cannot produce a RASI reading above +500, then we will know that the end has arrived for the bull market.”

Effron: M&A Activity Looks A Lot Like 2007

In a recent interview on CNBC, Blair Effron, co-founder of Centerview Partners and one of Wall Street’s biggest dealmakers, highlighted the similarities between the current M&A environment to that of 2007.

Currently, M&A activity is at its highest level since 2007 with global volumes hitting $2.9 Trillion since the beginning of 2015. According to data from Dealogic, that is a surge of 38% as compared to the same period in 2014.

Importantly, Effron also notes that the high valuations paid for M&A deals are, in large part, being driven by the current low interest rate environment.

Of course, with low interest rates, that means the majority of those deals are being funded by debt issuance. via WSJ:

“According to Dealogic, the Americas accounts for 83% of global acquisition related bonds, with a record $241.7 billion issued so far this year, compared with just $62.6 billion this time last year. In Europe, 38% of all high-yield bond issuance in the first half of the year has been related to M&A activity, according to Credit Suisse.”

That is an interesting point since that is the same argument for high stock valuations, stock buy backs and dividend issuance and the housing market. Given that the vast majority of analysts currently believe interest rates are on the verge of rising, logic would suggest that such will likely be a negative for the bullish mantra.

While we have seen this same game play out repeatedly before, this time is surely different…right?

It’s time to pay attention boys and girls – I have a sneaky suspicion things are about to get very interesting.

Have a great week.

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.