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Market Outlook: July 12, 2019

July 12th, 2019

 

2019-07-12

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Economy

The economic numbers continue to be mixed, with the bond market pricing in three rate cuts in 2019.  The most recently released numbers show an increase in employment as well as hotter than expected consumer and producer inflation.  The market is pricing in a 100% chance of a rate cut in July, a 65% chance of a cut in September, and a 45% chance in December.  Fed Chair Powell’s recent statements indicate that the July cut is likely despite the stronger employment and inflation readings.

There are many signs that a recession could happen in the next six to twelve months based upon continued slowing of leading economic indicators.  However, with the Fed beginning a monetary easing cycle while lagging indicators (like employment) are still strong, we certainly could avoid a recession.  Manufacturing is already in recession territory, contracting based upon PMI readings, but given that the services sector is still expanding (and a significantly larger portion of GDP) the overall economy could keep GDP positive.

Bond Market

Over the past several weeks, the trend in yields at the middle and longer end of the yield curve has been down, inverting the yield curve below short-term rates.  However, with the Fed likely cutting rates at the short end, yields have been ticking up in the middle and longer end of the yield curve.  This is leading to a potential un-inverting of the yield curve as bond investors grow slightly more bullish on the economy.

Negative bond yields in Europe have grown slightly less negative in recent days.  Economic numbers for Germany, France and Italy have all come in stronger than expected in recent days, giving bond investors there hope that the stagnating socialist economies might show some life.

Stock Market

After the big sell-off in May where the market was down 6.5%, the market recovered 6.8% in June.  So far in July, we have seen the market move 2.1% higher to new all-time highs as investors are viewing the anticipated rate cut as a fix to the slowing leading indicators.

This may be a temporary thing since second quarter earnings begin being reported next week and there have been a significant number of companies pre-announce that their second quarter and balance of the year likely would not meet earnings expectations.  It will be a struggle for investors to continue to push the market higher on the hopes that a rate cut will stimulate the economy adequately to change the trajectory of corporate earnings versus what they companies are seeing in actual financial results and sales trends.

Trends and Technical Analysis

The S&P closed yesterday at 2,999.91, trading up about 19% for the year.  It has continued to make new historical highs over the course of the rally from 2016 to date.  We are in a sustained bull market from the 2009 lows of 666 to the todays high of 3,006 (as of this writing), with the long-term (yearly) bullish trend intact.

The monthly bullish trend came into question in May, with the month ending lower than the preceding month.  However, the June month-end was higher than May as well as April, meaning that if July closes higher than June our monthly bullish trend is intact.

We have two levels of technical resistance that we need to get through to confirm that this move higher can be sustained and that it would be safe for investors to add equity exposure.  There is a key Fibonacci Retracement level at 3043 and an upper trend channel line at 3067 on the S&P 500 Index, that if both are broken signals that a move higher to the 3,113 pivot point resistance level is possible.

If we see market weakness based upon corporate earnings disappointments, there is lower trend channel line technical support at 2,832 as well as 2,792 pivot point support level.  Additionally, the 50dma is sitting at 2,891 and the 200dma is at 2,780, both of which are strong support levels.  As long as these levels of support hold any downside price movement, the market will be in technically neutral territory until we see if July closes above or below June.

Macroeconomic Issues

The macroeconomic  issues discussed in the previous Market Outlook continue to be of concern in their current and potential impact to the economy and financial markets.  They are, in short:

  • Tariffs hindering economic activity and increasing inflation
  • Earnings estimates are being cut
  • Personal, corporate, and government debt bubble
  • Government Debt Ceiling on September
  • Fiscal Policy limited due to high levels of deficit and debt plus the tax cut has already been implemented
  • Growing acceptance of Modern Monetary Theory, negative Fed Fund rates, and pegging of bond market yields
  • Illegal Immigration putting pressure on viability of social safety net
  • Legal Immigration system needs overhaul to focus on increasing the number of visa going to skilled workers
  • Demographics in the western world are deteriorating, with few than required young people than needed to sustain social programs and economic growth
  • A Solar Minimum Cycle of Sunspot activity leading to cooler and wetter weather, brief extreme heat waves, reduced crop productivity, volcanic and earthquake activity
  • Leading economic indicators flashing warning signs of recession

Strategy Summary

With the stock market at its all-time high, and the various technical indicators we follow telling us that the market is over-valued, caution is warranted.  However, stock markets can continue to move higher for longer than makes sense.

In recent weeks, we have raised cash by booking profits on holdings that our analysis showed were over-valued compared to their discounted cash flow fair value.  We invested that cash in bonds and in gold miners to hedge against a prolonged downturn in the market, along with cash equivalents.  This allowed us to outperform our benchmarks in May as the market corrected as we anticipated and again in June as the market recovered.

In early June, the Federal Reserve announced additional monetary stimulus was back on the table and that they would be ending their policy of Quantitative Tightening in the Fall.  This caused the correction to reverse and stocks to go higher.  We have reduced the duration in our bond hedges and have marginally increased our equity exposure by adding to defensive stock names as well as higher growth names that sold off in May.

Now that we are back at all-time highs, we need to examine our cash/gold/bond hedges.

  • If the market can close above the resistance levels discussed earlier and sustain those levels for at least three trading days, we will add additional equity exposure in client accounts
  • We will keep a normalize amount of cash equivalents on hand along with our bond and gold positions.
  • We added to our precious metals hedge by adding some silver to client accounts via the SLV ETF. Silver has not participated to the same extent in the move higher by gold prices and has the added benefit of industrial uses in case the fed rate cuts start to stimulate the cyclical areas of the market

With the stock market signaling that recession is off the table and the bond market giving trying to un-invert, we are in a difficult investment environment given the deteriorating fundamentals in the economic leading indicators.   The Fed’s anticipated rate cuts may in fact positively impact these fundamentals, but until they do we have to stick with what is known.  Based upon this, caution is still warranted in equity portfolios at the present time, but taking out overhead resistance would be a good start to a sustained move higher.

Stocks, Bonds and Gold Soar Higher – Which Is Correct?

June 20th, 2019

NY Fed

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Investment Strategy Executive Summary

With the stock market at its all-time high, and the various technical indicators we follow telling us that the market is over-valued, caution is warranted.  However, stock markets can continue to move higher for longer than makes sense.

In recent weeks, we have raised cash by booking profits on holdings that our analysis showed were over-valued compared to their discounted cash flow fair value.  We invested that cash in bonds, some longer duration, and in gold miners to hedge against a prolonged downturn in the market, along with cash equivalents.  This allowed us to outperform our benchmarks in May as the market corrected as we anticipated.

The graphic above (courtesy of the Zero Hedge Blog and Real Investment Advice) shows the NY Federal Reserve Bank’s Recession indicator.  The current reading is where we were exactly 12 years ago prior to the 2008 recession and stock market crash induced by the sub-prime bond market disaster.  It graphically illustrates why we need to be cautious at the current time.

In early June, the Federal Reserve announced additional monetary stimulus was back on the table and that they would be ending their policy of Quantitative Tightening in the Fall.  This cause the correction to reverse and stocks to go higher.  Even though we were at Max levels of Equity underinvestment, the bonds and gold both continued to move higher in anticipation of lower Fed Fund rates.

Now that we are back at all-time highs, we need to examine our cash/gold/bond hedges.

  • If the market can close at a new all-time high and sustain it for three trading days, we will invest some of the cash we have on hand in a beta driven strategy of buying the SPY. We will set stop losses for that position and raise them as the SPY moves higher in order to capture what could potentially be a blow-off top prior to a recessionary bear market.
  • We will keep a normalize amount of cash equivalents on hand along with our bond and gold positions.
  • If gold moves above its long-term resistance level as represented by 130 on the GLD and sustains it for three trading days, we will add to our gold miners positions, buying the GDX with a similar trailing stop strategy as the SPY.
  • If we see any corrections in defensive equity companies, we will likely swap some higher beta holdings in tech and biotech – particularly if they are overvalued compared to DCF FV – in anticipation of a potential recession but without increasing overall equity exposure.

With the stock market and the bond market giving us two different forecasts of the future, we are in a difficult investment environment.  Historically, the bond market has won the forecasting contest, but you cannot use it as a timing mechanism.  We will continue to be cautious, but with the strategy outlined above, act opportunistically based upon sound investment management techniques.

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Market Outlook   –   June 20, 2019

Economy

The economic numbers continue to be mixed, with the bond market pricing in two rate cuts in 2019 and a third in 1Q2020.  The most recently released numbers show a major drop in the manufacturing index but stronger than expected retail sales numbers.  I am writing this prior to the Fed meeting on Wednesday where many anticipate the first rate cut, but my best guess is they will not cut but say some soothing words to make people believe they will cut in July.

Bond Market

Over the past several weeks, yields at the middle and longer end of the yield curve have dropped materially.  Investors are looking at the weak economic data and driving down rates; many are also predicting recession odds are rising.

The bond market is pricing in two rate cuts in 2019 and a third in 1Q2020.  I am writing this prior to the Fed meeting on Wednesday where many anticipate the first rate cut, but my best guess is they will not cut but say some soothing words to make people believe they will cut in July.

Post-Fed Meeting, the 10-year treasury yield dropped below 2% for the first time in three years and the Yield Curve inverted even further with the Fed not cutting rates but indicating there will be cuts in July.  The Fed Fund Futures are now pricing in a 100% chance of a cut in July with another 65% chance in September and another 45% chance in December.

Stock Market

After the big sell-off in May, the market fell further in June before rebounding by 180 S&P 500 points, or 6.5% from the June low.

In May, the market peaked at 2,954.13, up 25% from the Christmas Eve low of 2,346.58.  Unfortunately, we closed May at 2,752.06 below the 12-month moving average and down 6.7% from the high and below the previous three months closing lows.  This indicates a potential change in trend that would need to be confirmed by a June close below the May close.

In June so far, we saw the market trade at 2,728.81, below the May low and below the 12-month moving average, but it has since rebounded by 6.5% and is now trading above the May close.

There are three possible outcomes to the month of June:

  • If we can close June above the May low but below the May high, this could just be a consolidation of the December to May rally, with potentially higher prices ahead.
  • If we can close June above the May high, then the rally from the December lows is still in place and May was just part of the ebb and flow of the markets.
  • If we close June below the May close and below the 12-month moving average, then we are looking at a change in trend with lower prices likely ahead.

The first level of resistance at 2,849.65 was broken above and the market has stayed above it, which is quite bullish.  The second level of resistance is at 3,192.44, well above the May high.  If we can break above the second resistance level and close June there, then the rally is certainly back on.

Post-Fed Meeting, the market rallied, and as of this morning we are threatening to close the day at a new all-time high.

Given our defensive stance, I have a plan to deal with this intermediate move higher in the markets – see the summary at the end for details.

Macro Issues

Tariffs: Tariffs are by their nature negatively impact corporate profits, are ultimately inflationary as companies raise prices to maintain profits, and generally disruptive to global growth.   While it is positive that the potential punishment tariffs on Mexico have been sidelined, the tariff war with China continues.

Earnings Estimates:  Corporate earnings before tax (Operating Earnings) have been flat since 2011, with EPS showing growth due to the financial engineering of stock buybacks.  However, 2019 has seen Operating Earnings fall even while valuation multiples have expanded.   Since the December low in the stock market, P/E multiples have expanded by 300 bps.  Investors are now paying very expensive prices for earnings that are at risk of falling further if the current economic weakness expands.

Debt:  Personal, corporate, and government debt is exploding worldwide.  It is a very worrisome situation, particularly if we are headed into a weakening economy.  If unemployment begins to increase materially, a larger than reserved percentage of personal debt becomes uncollectable.  If corporate profits continue to weaken, the corporate bond market and other lenders will experience write-offs greater than anticipated.  If unemployment increases and corporate profits fall, government tax revenues will suffer and additional debt will need to be issued to sustain our government’s unsustainable level of spending.

Government Debt Ceiling:  September 30th marks yet another opportunity for a government shutdown over the corporate debt ceiling.  We will be facing a $4 trillion continuing resolution to fund the coming year’s expenditures along with a $1.5 trillion anticipated deficit.  At some point, the global debt bubble will explode.  The fight over our debt ceiling could be a catalyst for that or it could be a non-event as the politicians try to kick the can down the road for future elected officials to deal with.

Fiscal Policy:  There do not appear to be any fiscal stimuli on the horizon to give the stock market and the economy a boost.  Tax cuts are behind us and the unacceptably huge budget deficit does not really allow for aggressive government spending.  There appear to be no tailwinds that will push us higher, if only temporarily.

Is the Fed Changing the Game:  There is a movement out there to accept that Modern Monetary Theory, negative Fed Fund rates, and pegging of bond market yields will allow the economy to go on into the future with no major economic disasters.  Modern Monetary Theory says that the government can continue to spend without regard to debt levels because the Fed will buy up all the debt, much like has happened in Japan.   In this way, we can spend the $92 trillion required to implement the Green New Deal and other socialist ideas.  In order to keep the debt service on all the new debt reasonable, both negative Fed Fund rates and setting fixed bond yields for government debt will ensure a low and positive yield curve.

Many economists are arguing strenuously against this, but many politicians and liberal economists are promoting it.   With the budget deficit at nearly 5% of GDP, I do not see how bond investors will stand for these actions without crashing the bond market first.

Immigration and Demographics:  As the G20 continues to age demographically with a birth rate below the replacement rate, their economic dominance declines over time.  To combat this, a country needs a sound immigration policy to bring their population growth back to the level where economic growth can be sustained at a reasonable level.

 

Weather:   We are currently in a Solar Minimum cycle of Sunspot activity.  These cycles last several years and impact the weather patterns on Earth in a few key ways:  the climate gets cooler and wetter, winters are longer and summers are shorter.

We can see this playing out right now with its impact on our Agriculture in terms of the reduced growing season from late planting due to the wet weather.

From a historic standpoint, insects, bacteria, and fungus that normally do not live at various climate zones are seen and attack crops, much as China is seeing today.  Here is an excerpt of the news report:  “A crop-eating pest first detected in China about five months ago is spreading rapidly and could hurt production of key crops critical to the populous nation’s food supply, according to the U.S. Department of Agriculture.  Damage from the so-called fall armyworm, which gorges on corn, soybeans, cotton, rice, and dozens of other crops, could force China to import more corn, rice or soy to makeup for the shortfall..as authorities expect it to expand to all provinces in coming months.”

From a historic standpoint, diseases that you thought we under control begin to proliferate.  The black plague came about during a solar minimum, while we have ebola once again proliferating out of control in Africa and measles gaining traction in the states even though a small minority of children have not been vaccinated against it.

From a historic standpoint, earthquakes and volcanic activity also increase.  It was during a Solar Minimum in 1465 that a volcano erupted in the tropics spewing so much ash into the air that the skies in Europe were darkened for years, leading to the mini Ice Age.  The impact of the mini Ice Age was reduced agricultural activity, increased disease, and European exploration of foreign lands and migrations of Europeans leaving Europe in search of land to farm and exploit natural resources.

Recession:  Many of the recession indicators published by the Regional Fed Banks and other entities are showing an increasing likelihood of recession in a range of six months (or sooner?) to two years.

Based upon this, lets look at the components of GDP to see what we believe.  Here is the normal calculation of GDP:   GDP = Personal Consumption + Investment + Government Spending (not including transfer payments) + Exports – Imports.

  • Personal Consumption (69% of calculation): this is typically the last item to turn down (ignore government spending which never turns down); at the moment it is in a debt-fueled growth move higher
  • Investment (18% of calculation): Housing and Business Investment in Capital Equipment are the two big factors here.  Housing has turned down at the national level (although lower rates are helping to stem the drop).  We need to watch Business Investment which usually trails Housing in movement.  If Business Investment drops then we have a problem.
  • Government Spending (17% of calculation): always growing and currently accelerating in a debt-fueled rage.
  • Exports – Imports (-4% of calculation): Tariffs are negatively impacting this at the present, even though the theory is that they will fix the imbalance over time through fairer trade deals, the short term impact is negative.

Personal consumption is by far the biggest component of GDP, and it continue to move higher as consumers continue to buy on credit and increase balances.  As long as employment stays relatively strong, and consumers can service their debt, this component should be solid.  However, if businesses lose money on tariffs and start to downsize, employment could suffer.

Business Investment as measured by Core Capital Goods Orders has been sluggish for a year.  It has neither grown nor shrunk markedly, meaning corporate CEO’s are cautious about the future.

Government Spending always increases, even net of transfer payments.  However, if we begin to see weakness in employment and corporate earnings, that spending will have to be funded by even more debt issuance.

Net Exports have been negatively impacted by the tariffs as China has curtailed its purchases of our goods in response to tariffs.

Based upon these issues, keeping an eye our for a potential recession is a necessary and prudent thing at this time in the battle.

Here Is What The Indicators Say

April 1st, 2019

2019-03-31

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The graph above shows the percentage performance of the S&P 500 over the past year.   If you were someone that did not panic in the November/
December sell-off, and held onto your investments, you are up about 8% over the past 12 months.

However, I like to analyze various factors that go into the markets movements to give me a feel for where we are going and what the investment strategy should be to best address where it is going.  So, I thought I would share with you some of those factors and what they are telling me:

 Momentum

  • 7-Day Relative Strength Index (70/30): nearing over-bought levels and rising (67.92)
  • 14-Day Relative Strength Index (80/20): rising (63.95)
  • Volume-Weighted Relative Strength Index (80/20) – shown as MFI below: rising (65.63)

2018-03-31 2

Breadth

  • McClellan Oscillator (50/-50): rising out of negative territory (7.92)
  • McClellan Summation Index (500/-500): weakening but still overbought (874.59)

2018-03-31 3

Note:  The top green and red graph is the Summation Index

Investor Sentiment

  • VIX Volatility Index (12/22): low volatility (13.74) equating to investor over-confidence

2018-03-31 4

Trends

  • Moving Average Convergence/Divergence: positive trend but weakening, with black indicator line below red trend line
  • Price/Momentum Oscillator: positive trend but weakening, with black indicator line below red trend line

2018-03-31 5

Participation

  • Percentage of S&P 500 Stocks Above 50-Day Moving Average (70/30): over-bought (71.80)
  • Percentage of S&P 500 Stocks Above 200-Day Moving Average (70/30): Positive (58.60)

2018-03-31 6

Based upon the indicators above, I expect that we are nearing a top in the market and should be rolling over.  We may have some continued upside as the computerized trading systems try to break through the all-time high, but the resistance is strong overhead and the indicators are mostly pointing to a weakening market.  Figuring out the indicators is never just a black and white decision, there are always nuances to it, plus they are just indicators and not commandments.  However, by and large they provide information that is critical to staying on the profitable side of the stock market.

As a result, we have been raising cash and will likely continue to do so as the market rallies toward the all-time high (if it does).  Risk Management is a key part of active investment management, and right now the risk is to the downside.

–Mark

Signs Of A Slowing Economy

March 22nd, 2019

Sentiment

Graph above courtesy of sentiment.com

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I wanted to share with you the current investment strategy activity as its been presented to our board of directors.  It includes some strategic changes based upon the technical indicators we follow and changing fundamentals of the economy.  The graph above shows you how investor sentiment has moved into the zone where we normally see stock prices pull back.

‘With the stock market approaching its all-time high, and the various technical indicators we follow telling us that the market is over-valued, breadth is weakening, momentum is waning, sentiment has gotten complacent, and the near-term trend appears to be rolling over to the downside, we have begun to book profits in positions that have moved above their calculated Intrinsic Value and/or positions that have significant gains since the January lows.  We have moved client portfolios up to maximum cash levels as outlined by their individual investment policies.  This is consistent with our view that the economy has begun to slow over the past three months and that corporate earnings growth has slowed significantly now that the impact of lower taxes is built into quarter-over-year-ago-quarter estimates.

 

With the Federal Reserve on hold with further interest rate increases questionable, plus the flattening of the yield curve with the spread between 2’s and 10’s at just 14bps, we have lengthened durations in bond portfolios and moved client portfolios up to maximum fixed income allocation as outlined by their individual investment policies. We have closed our positions in adjustable rate and floating rate government bonds, reduced our allocation to short-term fixed income corporate and government bonds, and increased our intermediate term holdings.  Additionally, we have moved a small percentage of the bond portfolio to long-term treasury holdings as a hedge against the downside risk in the stock market.  In accounts that allow both mutual fund and individual securities, we re converting mutual funds to individual bonds to lock in current rates for income clients.  This is consistent with our view that the economy has begun to slow over the past three months and that we risk an inversion of the yield curve that often presages a recession.”

10-2

The graph above shows the spread between the 2 year treasury yield and the 10-year treasury yield.   It has moved below the 14 basis points discussed above down to 13 basis points.  That means if you are a treasury investor, you are only paid 13/100’s of one percent more to tie up your money for 10 years than 2 years.  Because the yields are being crushed at the longer end of the maturity offerings, you are paid virtually the same amount of money on either maturity.

When the longer term maturities really fall like we have seen with the 10 year treasury yield, that is indicative of a slowing economy where investors a driving the yield down with demand for that maturity in spite of the shorter term paying the same return.  They are willing to do that because of the safety factor of being in a US Treasury Note and the opportunity to make capital gains on the principal because they believe yields will continue to fall (as yields fall, other investors are willing to pay you more than you paid for your note thereby providing you with capital gain income if you sell to them, which is a strategy the big bond investors like mutual funds and pensions use to enhance their returns).

Now is a time for caution, and we are positioning client portfolios accordingly so that when we get a correction we have cash on-hand to reinvest at lower prices.

–Mark

4th Quarter Strategy Implementation & 2019 Forecast

January 7th, 2019

2018-12-31

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Stock prices were pummeled in December – the worst December ever recorded for stock price performance.

Stock markets dropped last month based upon the ongoing tariffs, weak Chinese economic data caused at least in part by the tariffs, the Federal Reserve rate hike and announcement of three additional rate increase projected for 2019.

Despite these market moving items, other economic reports for the month were positive.  The manufacturing and services sectors of the economy both continued to growth. Retail sales were higher. Housing starts and existing home sales were both positive in November. Inflation was steady with the rate remaining at 2.2%.

With the broad market decline, the standard playbook for a distressed market kicked in:  large cap and higher quality stocks had relatively lesser declines on average than other types of stocks. Besides company quality and capitalization, price gain (i.e., momentum) and higher dividends yields were also favored by investors and performed better on average.

The worst performing companies had high betas (i.e., more historic volatility than the market) or were value stocks with factors such as price/sales, price/earnings and price/cash flow (i.e., value and momentum are typically opposite investing strategies).

No industry group had positive average price gains for December.  Driven by declining oil prices, most of the worst performing groups were in the oil and gas sector. Drug manufacturers and drug stores – typically a defensive area for investors to be when the market is in turmoil – also acted badly in December.

To recap our investment strategy implementation during the quarter, we began to raise cash in client accounts in August as the market was flirting with all-time highs.  We sold all companies whose current prices were above their intrinsic values as determined by a discounted cash flow analysis.  We also sold companies that had higher debt burdens or lower cash levels than industry standards.  This raised cash in client accounts that we could use for buying power if/when prices headed lower.

October 3rd was a seminal day in the markets as the Federal Reserve stated firmly that it planned on raising interest rates at least four more times.   This shook investors and they began to take profits and the stock market decline began in earnest.

As stocks that we liked fell in price, we would add shares, as is standard practice in order to lower our cost basis.

As the market decline continued, we used this opportunity to buy higher quality and larger capitalization stocks since, from a historical perspective, they perform better during turbulent markets.

We also added to health care companies – particularly those in cancer research that have products in the FDA approval process showing successful trials – given the historically defensive position healthcare companies have been treated by investors.

As the market continued down, we opportunistically started positions in certain high growth tech companies that have secular tailwinds but whose prices were down significantly from their highs several weeks prior.

For our Dividend Income clients, we followed a similar path, weeding out higher beta and lower quality companies with prices above intrinsic value and added to large cap companies with strong balance sheets and safe dividends.

As we got closer to year-end, and the negative impact of December was realized, we made tax loss sales in order to offset the gains we posted raising cash in August and September.  Many of the stocks we sold are on our re-purchase list because they are companies we want to own.   However, based upon tax law, we cannot repurchase them until after a month has passed.

As we enter 2019, we anticipate a rally in the first few weeks, but a potential lower low (i.e., a low in the market below that we saw in December) in March.  However, the news last week from the Federal Reserve that the 2019 rate increases are not a certainty may have made the December low the bottom for this correction.  We will just have to see what happens with the economy and corporate earnings announcements in coming weeks before we will know for sure.  If we do experience a lower low in March, then I’d expect a rally into the Summer.

There are a number of people forecasting a recession in the second half of this year.  I think it is too early to have a strong opinion one way or the other based upon the change in the Fed’s interest rate increase stance.   We do know that they have drained a significant amount of liquidity from the economy (see the chart of the Monetary Base – courtesy of Dennis Gartman and Doug Kass – at the top of this blog post ) but we do not know if it is enough to cause the economy to go into recession.

We also do not know the extent of the negative impact of higher interest rates on corporate earnings.  When 4th quarter 2018 earnings are announced beginning next week, we will have a better idea on this, but if significant, could drop GDP growth from the 3%+ level to 2% or below.  This could then be the beginning of a trend toward negative GDP growth that would define a recession.

One thing we do know is that the large GDP growth percentage in the prior quarter came from companies building inventories and not from increasing sales.  Typically, if inventories are building from sales that did not grow at an anticipated rate, this will also lead to a decline in GDP in subsequent quarters.

Longer term, the large debt levels for the State and Federal Governments, corporations, and individuals will be a big problem, negatively impacting the economy for a generation.  When you add in the off-balance sheet future liabilities for governments and corporations you are flirting with disaster – particularly with the next big issue likely to negatively impact the economy and markets, severely underfunded pensions at both the government and, to a lesser extent, corporate levels.  The demographics of our country, with the ratio of people receiving benefits to those providing funding to pay the benefits in a continual decline, will be very difficult for state governments to address without negative implications for their citizens.

It is easy to freeze up when stocks are going down in price – we don’t stop managing portfolios just because the market is turbulent.  We continue to watch the data and implement an investment strategy that will be defensive when needed and opportunistic when available.

Volatility Roils The Stock Market

November 13th, 2018
spx 2018-11-13
S&P 500 Index Annotated
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It has been a couple of weeks since I posted something on the blog related to the direction the stock market was headed. If you recall, on that last post I noted that we were due for a bounce higher off the October lows – which we got – and a potential retest of those lows before heading higher – which we may be in the process of achieving right now. After a retest, I noted there was the potential for a move back higher going into year-end.
 
The graph above is a version of one that I have had on the blog previously during times of higher volatility. I thought it would be interesting to look at it again when I was reading Lance Roberts blog and he showed his version of it. Lance goes into additional detail on small caps and mid caps, while I am going to stick with the large cap S&P 500 Index. Lance also uses fewer indicators than I do, but its remarkably similar.
 
Before I get into the nitty gritty of the chart above, here is a little background:
>This is a 20 year monthly chart of the index with four indicators and a trendline;
>The green circles represent times when the index moved above or below the 10-month trendline (called a trend change), but only three of the indicators confirmed a change in trend;
> The pink circles are times where there was a trend change and all four indicators confirmed it; and
> The red squares are times when there was a trend change but only two indicators confirmed it plus there are red arrows showing the indicators that contradict it.
 
For an indicator to confirm the trend change, it must cross either the limit line (as with the Williams % Index, the McClellan Summation Index, and the Rate of Change of the VIX) or cross an indicator trend line (as is the case with the MACD). In my system, the greater the number of confirming indicators, the more intense the move up or down in the market will be upon change of trend.
 
The trend change with the green circles is easy to see and can reliably tell you that you need to either get more aggressive in your investing because the market has changed to an intermediate trend higher or more conservative because the market has changed to an intermediate trend lower.
 
You will notice the two green arrow on the lower left. The one furthest left shows a move of the indicator above the upper blue limit line, but a move below it prior to the other indicators showing that there is trouble brewing and forecast a downturn in the trend. The second green arrow shows you that when the other indicators confirm the trend change, this one had already moved below the limit line.
 
That downturn ended up being the NASDAQ dot-com crash and the 911 market crash – if you had followed what the indicators were telling you, then you would have gotten conservative by raising cash so that you had liquidity available to buy quality companies (hint: NOT pets.com which is one of the more famous dot.coms to go bust).
 
PetsIndicators are not perfect. The dot-com crash was indicated by the change in trend, but the 911 terrorist attacks happened without warning and there was no possible way for the indicator to show that dire of a situation was at hand. This should have been a situation where we used a pink circle, and if it was some other economic event that had some warning we likely would have seen it in the indicator.
 
The pink circles show you when the trend change was confirmed by all four indicators – and when that happens – a fairly infrequent occurrence – you should be prepared for a potentially major move that takes the trend materially higher or lower. We discussed the dot-com/911 crash above that should have been circled in pink, but you also see the subprime mortgage crash of 2008 circled in pink along with the subsequent recovery that has led to a nine-year bull market with minor corrections along the way.
 
The red boxes denote trend changes with only two confirming indicators. These tend to be less severe than either those with three or four confirming indicator. I’ve added red arrows to show the non-confirming indicators to show that they did not cross their limit lines when the trend change happened. You might be able to discern that the trend changes are short-lived and shallow in these cases compared to the pink and green sets which have larger and longer moves.
 
So, what does this tell us about right now? On the far right of the chart I’ve used red boxes to show where we are now (in retrospect, I should have used another color or shape to separate them from the two sets of red boxes to their left). You can see that we had a trend change on the price graph, with the black index line crossing downward over the red trend line. We also had a confirming signal in the upper-most panel showing the Williams % Index crossing below the upper limit line and the MACD crossing below its red trend line. However, the Summation Index (the red and black area graph) has moved back into positive territory (just barely) and the Rate of Change on the VIX never was able to cross above the blue limit line.
 
[If you want additional information on these indicators, you can find it below the video below]
 
Based upon the readings as they stand right now, it looks like the current correction should begin to head higher again after a potential retest of the lows from October. The key index price to watch is 2603.54, which was the low in the month of October. If we can close out November without breaching that low, then we have made the first monthly “higher low” and that could lead to a rally into year-end. If we breach the October low in the next two weeks, then we are likely headed back to the February lows of 2532.69 on the index. If that doesn’t hold, then we are looking at 2380 as the next support level on this index which would put us squarely in bear market territory. If we do rally into year-end, we have several layers of resistance at 2751.71, 2761.98, 2822.44, 2899.89, and 2939.86.
 
If you listen to the investment gurus that appear on TV, most are predicting a year-end rally. I don’t know exactly what they base that on – they don’t ever disclose the indicators they follow nor how those indicators have acted over the years – but let’s hope they are correct and we are on the road to higher stock prices. Investor sentiment is negative at the moment, but until we get three or four of the indicators to confirm the trend change, it appears to be a normal pull-back at the present time. If we see further confirmation of a correction, I will let you know here on the blog.



–Mark
 
Indicators:
 
Williams % Index: a momentum indicator that tells us whether investor buying is increasing or decreasing. When investors are committing money to the market, that is the time to get more aggressive as they are likely to be driving prices higher.
 
MACD: A momentum indicator based upon two trend lines, when momentum is slowing the trend is weakening and visa versa. This is a very traditional indicator that is widely used and consistently helpful in providing a buy V sell signal.
 
Summation Index: a breadth indicator that shows the cumulative difference between stocks going up V stocks going down in price. In a downtrend, if the cumulative difference turns positive, that means in spite of what is happening in the index, individual companies are starting to come out of the correction and the index should follow suite soon. The opposite is true in an uptrend when the cumulative difference turns negative.
 
50-Day Rate of Change of the VIX: the VIX is a volatility indicator based upon the buying and selling of options. I use the derivative Rate of Change to smooth out the daily gyrations and to show the velocity of the volatility in terms of whether it is increasing or decreasing. The limit line is subjective but over the years I have grown comfortable with the level I use to tell me whether to get more conservative or more aggressive.

Rising Yields Take Toll On Stocks

October 11th, 2018

S&PDouble click on any image for a full size view

As always happens, rising yields have finally started to matter to the stock market.

What I wanted to discuss in this blog post is to what extent damage has been done, is there more to come, and what are we doing based upon the analysis.

If you look at the S&P 500 graph above, you will see that I have annotated it.  It is those annotations that I want to focus our analysis on so that we can develop a thesis for action.

Let’s start with the blue arrows on the price graph.  The lines around the price graph are trend lines based upon the 50 (solid green), 200 (solid purple), and 250 (solid red) day moving averages.  The dashed lines represent a band of +/- 10% around each of those trend lines.  The S&P 500 tends to move between the bands around the 250 day moving average.  These act as significant support and resistance levels to prices on the index.    You can see that I have a blue arrow pointing to the price line where it bounced off the dashed red line at the top when the market peaked in Jan/Feb this year and fell back to support at the purple 200 day moving average line.

The other moving average lines also act as support and resistance to prices on the on the index – I’ve marked several other blue arrows to show you how it happens.

What I want to focus you on is the last arrow on the right.  That is where we are today and you can see that the price has bounced off the 200 day moving average – and so far the 200 is holding.  I don’t have an arrow pointing to the peak price on the graph on September 20th, but you can see that prices never moved up to the top of the red dashed line – meaning they were never as extended as they were in Jan/Feb.  Part of that is the slope of the move up to both peaks – in the Jan/Feb peak, you can see prices moved up faster and the line is much steeper than the move to the recent peak.  From a technical perspective, that is a healthier move higher and more sustainable than the steeper/faster move in prices.

However, on the downside, I want you to look at the green 50 day moving average line and you can see that for three days, it held the price decline, but when it broke, you see the big move down yesterday (the long red thick straight line next to today’s much smaller/thinner red line).  The long red line represents a big move in prices yesterday (down 3.4%) and the thickness represents huge volume (the highest of the year).

What we want to focus on is whether the purple 200 day moving average line can hold and the market can stabilize, or will it break and we are left with the 250 day moving average as our last resistance before a significant correction ensues.

In writing this blog over the years, I’ve written about my Trendline Rule of Three.  When a support or resistance trend line is broken for less than three days, then you can consider that it held.  But if that line is broken for more than three days or three percent, then you must begin to look at the next trendline for your support or resistance.  In our discussion of the green 50 day moving average above, after three days, it was broken for greater than 3% meaning it is no longer in play and our hopes rest on the purple 200 day moving average holding and stabilizing the market.

But, since hope is not an investment strategy, we must look at supporting evidence to draw a conclusion.  Things like:

> price oscillators to gauge whether we are over-bought or over-sold,

> monthly price levels to confirm changes in trend,

> investor cash flow coming into or out of the market,

> volatility readings, and

> the health of the financial markets overall.

Price Oscillators

Lets focus on the two green boxes.  The uppermost one shows the relative strength index and the significant move below the 30 indicator line tells us that we are severely over-sold at the current time.  The lower one shows a similar reading below the 20 and 15 indicator lines.

Both of these price oscillators are short term indicators, but they are saying that we will be having a near-term bounce higher in prices soon.

Neither of these indicates how high the market will go back up on that bounce.  Just remember, 3.5% above current levels is the green 50 day moving average line that will act as resistance to any move higher.  So you have to assume that any move higher will be limited to 3.5% or less on the first attempt to move back above the 50 day moving average.  Does it have to be limited?  No, but the odds are greater that it will be since the resistance is there.  In most cases, to break above a resistance trend line, it takes a few attempts and even a retrace back to the lower support level (currently our purple 200 day moving average line).

Our conclusion is that we are due for a short-term bounce higher in stock prices in the near future.  It may be limited to 3% or so and it may retest resistance of the 200 day moving average line.

Monthly Price Levels

We look at monthly price levels to confirm either a continuation of a trend or a change in trend.

Last month we had a high on the index of 2940.91, and we closed positive for the month.  This month, we have broken beneath last month’s low 2864.12. We now need to close beneath 2864.12 on the last trading day of this month to imp give us a reversal of the bull market uptrend.

Our conclusion is that since we are trading below 2864.12 now, this indicates we need to be cautious with our investment activity, but not take any action to prematurely sell significant amounts of our stock holdings.

Investor Cash Flow

Let’s look at the Red box on the money flow indicator.  You can see that in Jan/Feb, cash flow into the market reach unsustainable readings, indicating that investor enthusiasm and euphoria got too high which always precedes a drop in stock prices.  The pink arrow to its right shows you that there was never the excess cash flow indicative of investor euphoria.  That supports our analysis above when examining the price line that we had never gotten as extended on prices as we did in Jan/Feb.

I also want you to see that we do not have a reading below the 20 indicator line telling us that lack of cash flow has reached unsustainable levels, meaning this intermediate term indicator says it is not yet time to be a buyer.   A reading below the 20 line (and particular the 10 line which isn’t labeled) is one of those situations where, if you are an investor that wants to use margin, you would have a fairly low risk entry point to buy stock on margin.  Clearly we are not there yet, so going all in on the market and using margin to buy stocks in the current sell-off is a dangerous prospect.

Our conclusion here is that from an intermediate term perspective it is not time to be either a buyer or a seller.

Volatility Readings

The black line superimposed over the green area graph is the VIX Volatility Index.  It represents investors buying options to protect against a significant correction in the market.  You can see the purple and pink arrow pointing to the black line graph.  Back in Jan/Feb, this line went from under 10 to above 35.  Under 10 is an indication that the market has too much enthusiasm and that raising some cash is warranted – over 35 is an indication that there is too much pessimism and that a buying opportunity should come soon.

The pink arrow shows you where we are today.  The steep increase of the past two days coincides naturally with the sell-off.  However, you can see that we have not risen above the level of the sell-off last April where the 200 day moving average resistance line held at a higher low than the Jan/Feb correction.  We can also see that the line never got below 10 after the Jan/Feb correction, never indicating a significant correction was coming.

Our conclusion here is that volatility has returned, but the VIX is not currently telling us that the sell-off is likely to turn into a full blown correction.  That can change in an instant, but right now the odds are against it.

Financial Market Health

The green area graph in the bottom panel represents the TED Spread.  The ted spread is the difference between interest paid on dollar denominated bank deposits in Europe versus the USA.  The concept is that the difference widens during times of financial market stress and narrows during times of relative calm in the markets.

I’ve drawn a purple downward sloping arrow from the peak of the green area graph  in April to today’s level.  Back in April, we were all concerned about the health of some of the European banks who were under-capitalized but had loan losses that would cause the banks to go under.  Due to the interconnected nature of the financial system, a major European bank failing would have world-wide repercussions on the financial system, and potentially could take down other banks, including those in the USA.

That peak on the graph coincided with the April sell-off in the market, but as Germany stepped in an recapitalized the failing banks, the crisis was averted and the financial system stress abated.  You can see that I have circled in purple the today’s level, which has been holding steady at a low level during this sell-off.

Our conclusion here is that the Ted Spread is indicating that at the current time there is not some macro economic issue that would impact the global financial system causing the stock market to drop significantly.

Conclusion and Strategy

Based upon our reading of the trend lines, price levels, and indicators, the current sell-off should be contained to either the 200 day moving average or the 250 day moving average.  We will likely see a move higher to the 50 day moving average and a retest of the 200 day moving average while the market consolidates this move lower and looks for a reason to either break above the 50 or below the 200 – and since we are entering earnings season, the results being better or worse than expected will probably be the determining factor in this movement.

From the conclusion above, our strategy is to be cautious but not panic and sell prematurely in this sharp sell-off.  We want to wait to see if the 200 day moving average holds as resistance, and if not, whether the 250 day moving average holds as resistance. We also want to end the month above 2864.12 on the S&P 500 Index, which is between the 50 and 200 day moving averages.

We are, however, selling some shares of companies whose price is currently greater than their fair value.  This will give us some cash to reinvest in companies that are both undervalued and that have sold off greater than the broader market.  We have been making those sales, and when we determine if the 200 holds, that will be our indicator to begin buying.

In an uptrending market, we would hold onto those shares and not sell them as the earnings growth anticipates higher fair market values ahead.  However, given uncertainty, we must stick to our discipline and act prudently for clients.  The companies will move into the bull pen of companies we have owned in the past that we want to own in the future based upon valuation and earnings growth.

Reading the market is never easy and it is always a best guess proposition based upon your reading of the price action and the indicators you trust.  I have been at this for 35+ years, and by writing this blog, I am hoping to share some of the knowledge I have accumulated and inform you of what we are doing with client money and why based upon our analysis and strategy.

As things change, I will be back here on the blog with updates for you – let’s just keep a positive outlook that it will be because of higher prices.

–Mark

Yields Are Rising

July 12th, 2018

Treasury 2 yr

Double Click on Image for Full-Sized View

The graph above is of the 2-year treasury note yield. At 2.58%, it is at a 10-year high – and looks like it could continue to rise.

The stock market has had a rocky start to 2018. One of the big reasons is rising interest rates. There is a trade-off between stocks and bonds – as bond yields fall, stocks become more attractive to investors. This is based upon a couple of reasons: (1) lower interest rates mean that corporations borrow at lower rates, and the difference between the higher and the lower rates equates to increased net income for shareholders, which makes stock prices rise (all else being equal) – so rising rates mean just the opposite, lower earnings and lower stock prices; and (2) when valuing stocks, you are really looking at a discount of a company’s future earnings – those earnings are discounted using current short term treasury rates, so falling rates will yield a lower discount and produce a higher valuation – while rising rates yield a higher discount and produce a lower valuation.

As an investment manager, we watch treasury yields very carefully. Rising yields means rising risk – the risk that your investment portfolio will go down in value. Above, we discussed how rising yields impact stock prices, but they also negatively impact bond prices.

As yields rise, the value of bonds goes down. Think of it like this: you bought a 2-year treasury last year at a yield of 1.35%, but today you could buy one yielding 2.58%. The yield has almost doubled over the course of a year, so if you want to sell that bond to someone else, your bond yielding 1.35% with a remaining life of 12-months provides less return than the current bond yielding 2.58% with 24-months remaining life. You would have to sell your bond at a discount so that the yield moves from 1.35% to the current yield on a similar new bond with 12-months remaining life. Today, a 1-year treasury note yields 2.36%, or a full 1% above your bond. That is a big discount, or loss in value from its face value, that you would have to take to sell the bond today.

Rising interest rates are bad for both stocks and bonds as shown above. So what does an investor do? Sell everything and move to cash?

No, part of managing investments for clients means that you have to work hard to make money even at times when extraneous forces are presenting headwinds to stocks and bonds.

As far as stocks go, you have to find ways to deal with the two issues discussed above: earnings and valuation.

To deal with the earnings issue, you need to focus on: (1) companies that have no debt (not always possible) or at least companies that have a lower level of debt than their industry average; and (2) industries that do not need to borrow as much as other industries to operate their businesses. Reviewing ratios of debt to equity for individual companies, and comparing them to other companies in their industry, will help with the first issue above. Over-weighting your industry allocations to industries with little borrowing needs, like biotech and technology, while under-weighting industries with heavy borrowing needs, like manufacturers, help with the second issue.

As far as bonds go, you need to focus on building a ladder of individual short-term bonds and CD’s (say one to three years in duration), short-duration mortgage bonds that repay principal along with their interest payments, and adjustable rate bonds (we focus on mutual funds for these last two) all are good hedges against rising rates. The short-term ladder allows you to hold your bonds to maturity (since selling early can cause losses due to the discount to face value as shown in the discussion above) and then reinvest your proceeds in higher yields. The mutual funds are defensive by the nature of their investment portfolios – you just need to be very careful when looking at a mortgage bond mutual fund to make sure the average duration is short. Additionally, if rising inflation is the proximate cause of the rise in yields, mutual funds that focus on TIPS (treasury inflation protection securities) can be a successful investment as well.

For the classic rock fans out there, here is a classic: the Animals playing House Of The Rising Sun

For those who are fans of today’s music, here is a cut from Jurassic World: Rise by Skillet

–Mark

 

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