I get asked constantly if I am still bearish as the market continues to move higher and higher. My answer is yes, but with one caveat -- I have been reluctant to make a call on the top. The one exception was my call on April 11, which was a good call for about 15 days, producing about a 3% gain from peak to trough before turning back higher and taking out the April 11 highs on Friday.
Friday's spike on a very inconsequential jobs report provided more evidence of a market that wants to go up no matter what. I have argued for several months now that the market is climbing higher based on the mistaken belief that the Fed's QE program is actually doing something positive for the economy but that is only partially true. Stocks have gone up for the most part because of corporate profits and the fact that GDP growth has been positive.
If I know that stocks are not significantly over priced based on trailing earnings and reasonable multiples one might ask why I remain bearish? A follow-up question is how badly am I getting crushed? I will try to answer both questions in this article and maybe I will be able to convince you my logical is not irrational.
Let's start the discussion by looking at GDP and the S&P 500.
Click to enlarge images.
There are those that argue GDP is not a good indicator of stock price and I tend to agree -- at least in the short term. However, over a longer time span GDP should serve as an indicator of stock price for the simple reason that it represents the measure of economic activity in an economy -- in other words, it should be predictive of the top line sales of companies in the aggregate. The correlation coefficient of the two arrays -- GDP and the S&P -- is a respectable .83 suggesting that GDP is in fact relevant in predicting price over time.
The chart above is useful in that it shows that stock price tends to lead GDP as evidenced by the period in early 2009 when stocks moved higher well ahead of GDP. It also shows that stock price tends to be much more volatile than GDP and tends to overreact in both directions. More importantly it shows that relative to GDP stocks are not significantly overpriced today although the divergence from the trend line is at its widest point since coming out of recession in 2009.
Another chart that I use to predict trend shifts is my trade structure grid chart. Here is a chart of the S&P 500 going back to the first quarter of 2000.
The bold red line is a best fit trendline through the data points, indicating a market that is not showing much of a trend at all with a slightly downside bias -- an indication that we remain in a secular bear market. The trend lines connecting the peaks and the troughs show the much talked about megaphone pattern. I use this chart to determine trend shifts. Most of those who follow me understand the rules I follow but for the rest here is how I use the chart to predict direction change. When the close value moves above or below the +2 or -2 standard deviation values, respectively, and thereafter produces a countertrend move sufficient to push in the opposite direction by a full standard deviation, I assume a trend shift has occurred.
The buy and sell points using these rules are noted on the chart above. Occasionally the chart gives me a head fake but generally when the market moves significantly above or below the outer bands and then reverses by a full standard deviation it signals a trend shift. The chart above shows that a trend shift has not yet occurred although one of the two conditions for a trend reversal has occurred -- the close is now significantly above the outer band and indicating the most overbought condition since the Feb. 2, 2009, low.
In order to get a sell signal using the chart above the market would need to push below the +1 standard deviation level that is currently at 1451. However, the +1 standard deviation band is shifting higher at the present and moving into any pullback that might occur. In other words if the market rolls over and moves back to the +1 standard deviation line the band line will continue to move higher thereby compressing the time and the distance needed to get the sell signal.
Typically, using the monthly chart the turn points have a particularly high probability of predicting the peaks and troughs within one standard deviation. The most recent rally -- fueled by QE bulls -- has produced two head fakes, as indicated on the chart above. It is indeed rare for this to occur, but it is also rare for the Fed to be buying $85 billion a month in assets and backstopping sell-offs.
The following table shows the buy/sell points and overall gains using the long-term monthly trade structure grid chart:
625 position open
The overall gain using the strategy was 2153 using Friday's price to calculate the gain to date on the current long trade. The two false signals reflected above produced losses of 150 and 181 points for a total of 331 points. The overall gain is 1822 over 13 years or 140 points per year on average. Using the trend line value as a rough average of the S&P 500 over the period the strategy has averaged a respectable 11% per year over 13 years. The table above makes the point that trading the swings is much more profitable over time than a simple buy and hold strategy. There is no entry point that one could have used over the last 13 years that would have produced the magnitude of returns or the consistency of returns that the strategy referenced above has produced.
I read an article the other day that made the point that the difference between a professional trader and an amateur is that the professional always has an exit strategy. In other words the professional acknowledges that there comes a point where he must concede that he was wrong and exit a losing trade. As far as I am concerned no trade should be entered without first having a predetermined risk and a predetermined profit objective. I never enter a trade without first establishing that risk/reward structure. Furthermore, I never enter a trade unless that risk/reward structure is at least 1:2 -- in other words, I must see a return of at least twice the level of my predetermined risk.
So that brings me to my bearish stance -- a stance that I have maintained since September of 2012 when the S&P 500 was trading at 1475. Here is my point: I am a fundamental analyst for the most part but also recognize that the depth of my understanding of the economy can result in a lot of calls that are very premature. What I see from a fundamental perspective is that we remain in a secular bear market and I believe we are making almost no real progress toward reaching escape velocity. What others see is a market fueled by QE and therefore the market must go up. Not to worry that QE is doing nothing at all to increase money velocity, improve unemployment, induce inflation or produce any real escape velocity GDP growth. None of that matters to those who are pushing stocks to all time highs on the back of Ben Bernanke and his money printing.
A Bear Trade Isn't an All-In trade
Here's the point: A bear trade in stocks is a more risky proposition than a bull trade. Most of the time the stock market is moving higher -- even in a secular bear market. There have been four cyclical moves since the start of the century as reflected in the chart above -- two bull moves and two bear moves. The magnitude of the moves are roughly the same in the cyclical bull and bear markets but the time spent in bull cycles is 132 months and the bear cycles is 33 months. In other words about 80% of the time the market is going up and 20% of the time it is going down. Keep in mind that these ratios apply even in a secular bear market.
Additionally, it is very difficult to call a top in a bull market. Fighting momentum is a tough play and it takes a lot of conviction to stay short the market when it keeps moving higher. I knew that in September of 2012 when I took my first short positions. On the other hand my trade structure grid chart allows me to see with some clarity the outer bands of the potential trading range and therefore I am able to set realistic risk/reward levels.
At the present time the downside objective on the chart above indicates that within the next nine to 16 months we will hit the lower band -- we always do by the way at some point. That lower band is 1132 at the present but it will swing lower when we finally start down as the mean value will turn down and pull all the other bands with it. That said my downside objective is at least 1132 or at least 479 points from Friday's close.
When I established my first short trades the S&P 500 was at 1475. At that point my downside objective was 1031 and since I was at the upper band of the chart I saw almost no risk. The market did peak at 1475 and moved lower to 1343 but then moved back up finally taking out the 1475 high. Not knowing where we would top I committed to adding to my shorts in equal quantities at each 25 point interval on the S&P 500. My original trade structure had a profit objective of 444 points. By adding to the trade at 25 point intervals my overall average is now 1537 on 6 times my original position with a profit objective of 1132 or 405 points. In other words even though the market has moved higher so has my average price and even though my profit objective has also moved higher by about 100 points my overall profit on the trade will be 2430 points compared to my original trade profit objective of 444 points.
There are two things to keep in mind with this strategy. One -- as the sub-heading says -- a short side trade is not an all in trade. My recommendation is to employ about 20% of your total portfolio to the trade and to scale into the trade by adding equal amounts to the trade at successively higher prices pulling the overall average and the size of the trade up. At the present under this strategy I would have expanded my positions to a total of 30% of portfolio value but that still leaves 70% in cash. The bonus here is that I suspect when we do start the next cyclical bear move we will overshoot to the downside and the current level of 1132 will begin to move lower so that by the time we do achieve a trend reversal the downside will be close to the 2009 lows of 670.
Assuming that does occur the trade will produce an average of 867 points profit on 6 times my original position size or 5202 point total profit. Here is the math on the trade assuming an original portfolio size of $100,000 and using SPY as a trade vehicle. A total commitment of 30% would be $30,000 and allow for a position size in round numbers of 200 shares at the 153.70 average. The gain on 200 shares would be 86.70 per share or $17,340 -- a 17% gain on total portfolio value. Assuming the cycle trend shift occurs at the 1132 price level the gain would be 40.50 times 200 or $8,100 -- an 8.1% gain on total portfolio value. Keep in mind that represents a gain on cash committed of 27% under that scenario and a gain of 57% on the best case scenario.
At the present my loss is $7.70 on average on 200 shares or $1,540 and my profit objective is $8,100 under scenario one and under scenario two it is $17,340 -- a profit/risk ratio of 5:1 and 11:1, respectively. The truth is I am personally playing the market a lot more aggressively and not trading SPY. I am currently long three leveraged inverse ETFs and also long volatility with (NYSEARCA:UVXY). In addition, I have leveraged these positions to some degree with calls so I expect a total return when the bear cycle starts of much more than the numbers reflected above. Additionally, I am willing to risk 15% of total portfolio value before electing to exit the trades and I am a long way from that level at present. In fact, my loss to date under this scenario is only 10% of the total loss I have allocated before surrendering and exiting the trade.
As a side note one of my readers made a comment on a recent article that I was employing the Martingale double up strategy and that could not be further from the truth. At no time do I hold a trade that doesn't offer at least a 2:1 profit to risk ratio and that is rare -- I prefer at least a 3:1 or 4:1 trade structure. That should be evident by the profit to risk ratios reflected above that haven't changed significantly from the time I first entered the short side back in September. Additionally, I don't expect to win every trade and have set my total risk at 15% of portfolio value.
Fundamentals Matter in a Bear Play
There is one major caveat to this strategy and that is the fundamentals. As I stated above, the long-term bias in stocks is up and most of the time the market is moving up -- about 80% of the time since the turn of the century and in a secular bear market at that. Recognizing that, an investor or trader better have a good handle on the fundamentals as they do matter. The trade structure grid chart has proven to me that sooner or later the price will move to the -2 standard deviation band. That said, the -2 standard deviation band can move substantially higher than one might expect in a long-term secular bull market, meaning that a trader can get crushed waiting for the return to the bottom of the grid if that low ends up being substantially higher than the high at the time you initiated the trade. In fact, there is a scenario where you can never recover your losses, and therefore a fixed-risk cap must be employed and it must be a relatively small percent of total capital.
My strong suit as an analyst is that I have a pretty good grasp of economic theory and a very good grasp of monetary policy and the structure of the banking system. I know for example that QE is not inflationary unless the private sector banking system elects to expand M2 through loans and that requires two things -- qualified borrowers interested in borrowing money and a banking system inclined to lend it. Neither of these conditions is present at this time and in fact the tendency has been to hoard cash and deleverage -- a situation that creates deflationary pressure in spite of the magnitude of the Fed's money print.
That is what has occurred since the recession. The reason we are at all time highs on stocks has to do with the fact that companies have cut costs -- mainly labor costs -- and the government has subsidized GDP through massive fiscal stimulus that has driven the debt to GDP ratio to a level in excess of 100%. This fiscal policy has reached a point where it is no longer sustainable, yet without massive fiscal stimulus GDP will contract.
The consequence of that is top line sales will begin to fall and there is no way for companies to offset the impact of shrinking sales with further cost cuts - at least cuts of a substantial nature that will allow them to increase margins to offset the shrinkage in top line sales. We are beginning to see this with first quarter earnings as top line sales have missed estimates in more than half of the earning reports to date -- actually, around 60% have missed -- in spite of the rather modest estimates. That means one of two things happen -- either stocks sell off or P/E multiples expand. Multiples don't expand in a stagnant economy meaning that stock prices will decline from present levels in the aggregate.
But the problem is much deeper than many realize. Our one world economy today is interconnected and maintaining a competitive advantage requires an aggressive attempt to devalue the sovereign's currency and as each major economy attempts to gain that advantage the others react with their own initiatives. The effect is that currencies don't really end up being devalued at all as they are priced relative to each other. The one exception is the eurozone. The EU countries don't have a sovereign currency to devalue and they have a central bank with very limited powers. The structural arrangement of the EU is such that the central bank can't independently just create new money by purchasing Greek bonds for instance. The constraints imposed on the ECB are much more demanding than they are with the Fed or the Bank of Japan.
The consequence of this very flawed structure is that the EU is in recession and deflationary pressures are being felt as the recession worsens. As one of the three major economies in the world, this contraction is being felt in all economies as the EU represents a huge consumer pool. In other words, the contagion effect will be felt globally and the odds of avoiding a deflationary recession are very small. In fact, as I see it the probability of a global recession is almost 100% in the near future.
We can cheer on the Fed or the BOJ for a while but the truth is cash is being hoarded by all and the massive money printing is simply being held in reserves -- both at the domestic level by individuals and companies and also as a form of insurance for sovereigns who hold high levels of reserve currency assets as a form of protection. These structural flaws will be dealt with in time, and it is my opinion that at some point in the near future we will see a new monetary system emerge that will finally correct the inherent flaws in our current system and put us on a real growth path but that is a subject for another time.
So there is the logic I have employed -- for a little over 7 months. And no, I am not getting crushed trying to fade the rally as I am a strong proponent of money management and recognized from the outset that I could be a little premature on my timing. I admit that I didn't think I was this premature, but life goes on and as far as I am concerned my call is still the right one and my gains will be sizable and well worth the time invested.
There are those who will argue that I would have been better off to simply go with the trend and ride the Bernanke bull for all it's worth. To those who say that I ask: What is it worth? How much more do we have left on the upside, and did you know we would reach these levels when we were fighting the "fiscal cliff" back in December? I sure didn't think so.
Furthermore, will you recognize the end of the cyclical bull when it happens? Or will you just see the first sell-off as a buying opportunity? What happens when the market doesn't rally off the dip the next time? Will you just continue to buy as the market marches lower? You know at some point that is going to happen -- it always does. Bull markets don't last forever. There are as many market strategies as there are traders. No one does it exactly the same as another. As for me, I see no logic nor do I see any long-term gain in taking a buy and hold position in a secular bear market and that is still where we are today. On the other hand I see no problem playing the bull cycle in a secular bear market. To me the strategy defined above is a good one -- not perfect but a good one.
In this article I have defined the rules and provided the information needed to create structured trades that define risk and reward objectives within the context of a statistically valid framework. The grid chart gives me comfort in that I have a reasonably good idea what the outside parameters are at all times. The chart is not infallible and I recognize that. That is why money management and predefined risk levels are essential. As I stated above, a professional always has an exit strategy and the approach I employee always has that risk predefined.
I have been asked time and again if the reason I am so bearish is due to the fact that I missed the bull rally. The answer is yes -- I missed a part of it but that is not why I am bearish and I did get the majority of it. I will also miss a part of the bear move as well as I was premature. In other words, I can't pick the exact top of a market. I also can't pick the exact bottom of the market. I am content to take a good piece of each move and over time I will do a lot better than the buy and hold traders. I will also do better than the short-term traders that move in and out of the market attempting to catch the smaller swings within the larger trend. Such strategies usually fail over time as a few misses can eat up a lot of wins and the transaction costs can become quite a burden over time.
There are many who just can't see this market pulling back to the levels I have referenced here. A move to 1132 seems out of the question for many at the moment and a move to 700 seems totally unrealistic. The trend line on the chart above is at 1200 and it hasn't shifted much at all over the last four years. At some point a reversion to trend will occur -- it always does and it almost always overshoots. The funny thing about the human psyche is that it has a difficult time taking a contrarian position. It just isn't a comfortable place to be I guess, but the truth is that contrarians are always right at some point. A sentiment shift will occur, and the fact that we have moved to the outer extremes of price and beyond two standard deviations from mean suggests a market that has finally reached an overbought situation.
The odds are high that Friday was a near-term peak. It could end up being the cycle high but that is not as certain. One thing I am certain of: The fundamentals simply don't support a blow off top that moves much higher than Friday's close. Evidence of the anxiety in the market today is reflected in the fact that investors have created a mini bubble in defensive sectors such as consumer staples. That is not the kind of back drop one needs for a major leg higher or a blow-off top.
Risk vs. reward matters. And so do the fundamentals as well as price. As I see it the risks of holding longs at these levels and under the existing economic back drop is very high and the reward is very low. The fundamentals are signaling a slowdown at a time when prices are at all time highs and the market is clearly overbought. Cyclical bull markets always turn into cyclical bear markets. More important, though, is that both cyclical bull and cyclical bear markets tend to overreach in both directions. In other words, this bull market will end and the next bear market will -- in all likelihood -- go much further on the downside than most think and probably a lot further than it should.
Disclosure: I am long TZA, FAZ, TECS, UVXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.