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Lower Highs and Lower Lows

SPX 2016-04Its been a few weeks since the last post on the blog – the market has meandered up and down and we are just now seeing the pattern that is developing.

In the graph above, you can see the formation of a series of lower highs and lower lows with investors unable to move the market to a new high.

From a technical standpoint, this is not a good sign for the market.  But lets take a step back and remember what chart reading is really all about.  The charts are just graphic representations of investor behavior and sentiment.  This chart shows that there was positive sentiment that lead to a new high almost a year ago.  Since then, investors have been in a tug of war with part of them in a glass half full mood and part of them in a glass half empty mood.

The glass half empty crowd:  (1) sees a stock market that is overvalued at 25 times earnings, (2) sees corporate earnings that have steadily been falling over the past year and a half,  (3) sees a slowing economy with the manufacturing sector already in recession and the service sector bouncing on either side of zero growth, (4) see a Federal Reserve that is in a rate increase mode, even if that mode is projected to be slower than originally forecast, and (5) believes we are headed into a recession later in the year.    Their view is that the market needs to correct so that valuation comes in line with these headwinds.

The glass half full crowd:  (1) sees the US economy being stronger than any of our trading partners, (2) sees a potential for strengthening of the Chinese economy, (3) believes that the steps taken in Europe to stimulate its economy should begin to produce dividends, (4) sees the dollar weaken against foreign currencies, which should be a positive for corporate earnings, and (5) sees a Federal Reserve that is putting the brakes on rate increases.  Their view is that the market can push to new highs.

When you look at the graph, you can see that the investment crowd with a negative view is winning this battle.  They have been able to drive prices down, then those with the positive view jump in to buy the dip.  Unfortunately for them, they do not have enough strength or conviction to drive prices higher.  You then have another selloff to a lower level before the dip buyers jump back in but lose steam before moving to a higher point.

Given the forecast for falling earnings and the current valuation at 25 times earnings compared to the historic average of 15 times earnings, caution is warranted.

Based upon this, we have adopted a conservative strategy in our portfolio management.  There is a time to be aggressive and a time to be conservative, and given the fundamental landscape for earnings and the slowing economy now is a time to be conservative.