Market Outlook: Time to Assume a Defensive Position

It seems as if the spring rally has probably exhausted itself. And it is about time given the extent and rapidity of the move. The MSCI World Index increased by 45.2% from its March lows until the early June high and the MSCI Emerging Markets Index by a staggering 68.9%. Both these indices have only had one down-week since the advance commenced in early March.

Leading markets such as Russia (+137.0%), India (+89.5%), China (+54.7%) and Brazil (+50.4%) significantly outperformed laggards such as the Dow Jones Industrial Index (+27.5%) and the S&P 500 Index (+39.9%), although all markets recorded very respectable returns. The major U.S. indices have gained for 12 out of the past 14 weeks.

Click here or on the table for a larger image.

Source: Plexus Asset Management (based on data from I-Net Bridge)

Focusing on the U.S., the S&P 500 Index (911) has backed off resistance at its January high (935) and is less than five points away from breaking down through the key 200-day moving average (906) - broken to the upside only two weeks ago.

Importantly, short-term oscillators such as the rate-of-change (momentum) indicator is on a knife’s edge of giving a selling signal, i.e. crossing through the zero line in the bottom section of the chart below. Also note the negative divergence between the Index and the ROC line - typically be a warning sign that a near-term trend change will take place.

Source: StockCharts.com

The venerable Richard Russell of Dow Theory Letters fame said:

In order for a counter-trend rally in a bear market to be sustained, it requires steady or rising buying power plus short covering. Lowry’s Buying Power Index has been declining steadily since May 8. At yesterday’s market close, this Index (demand) was only 24 points higher than it was at the March 9 lows. Furthermore, volume is drying up.

This is extremely negative action. Whenever buying power contracts during a rally in a bear market, the prevailing primary bear market forces immediately take over. For that reason, unless the trend of declining buying power soon halts and reverses, I believe that the March 9 lows will be attacked and violated.”

For more about key levels and the most likely short-term direction of the S&P 500, Adam Hewison of INO.com prepared another of his popular technical analyses. Click here to access the short presentation.

What about valuations? In order not to work with notoriously unreliable forward-looking earnings estimates, I prefer using Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), or normalized earnings as they average ten years of earnings. This measure provides a good picture of the market’s value regardless of where we are in the business cycle. On this basis, the multiple increased to 15.8 during the rally compared with a long-term average of 16.3. This represents “average” value at best.

I have argued in my post of two days ago ,”Have stock markets run away from valuations?“, that based on the historical relationship between the Purchasing Managers Index (PMI) and stock market movements, the S&P 500 seems overpriced under all scenarios over the next few months and only reaches positive territory again in August under the “very optimistic” scenario and in November under the “optimistic” scenario”.

It is difficult to envisage how much of a pullback we might see. I would be surprised if the retreat is not at least 10%, but do not exclude a bigger and longer correction than what many pundits are expecting. As this juncture my advice will be to assume a defensive position in your investment portfolio.

Comments

[Larry House:]

Sound advice.

Jun 18 10:05 AM

[Mad Hedge F...:]

I agree. It looks like the worm has finally turned. Hedge funds that rushed headlong into piling on new risk positions as recently as last Friday are now unwinding them today just as fast. All last week the smart money was selling to the late comers, newbies, and wanabees. The Viagra is starting to wear off. It’s time to take short term trading profits on crude (USO), commodities (DJP), all stocks (SPX), emerging markets (EEM), short Treasury bonds (TBT), all currencies (FXE), and junk bonds (JNK, HYG). I love all these things long term, but suffer from a short term tolerance for paid. When the best case scenario is sideways, I’m outa there. Look for decent bounces in risk reducing positions like the dollar ($USD), short dated Treasury securities (CSJ), and defensive sectors like utilities (IDU). It has been obvious to me that all of the good, long term holds were rolling over on shrinking volumes right at 50 or 200 day moving averages, since last month (see “Sell in May and Go Away” at madhedgefundtrader.com...). All of a sudden burgers on the back yard BBQ, booking campsites at Big Sur, and visiting those long lost, but nearby relatives looks like a better choice. I’m having a “staycation” this year to save money. Instead of Italy’s Amalfi Coast, you’ll find me dining at my local cheapo Italian restaurant with the nice Roman mural painted on the wall, the red checked tablecloths, and the plastic grapes draped over the doors. Please pass the parmesan cheese!

Jun 18 11:10 AM

[Missing_Link:]

I'm not a follower of the NeoWave theoy, but it looks like they agree:

www.emediawire.com/rel...

PS For heaven's sake, Mad Hedge Fund Trader, learn to use carriage returns! The "Enter" key is your friend :)

Jun 18 02:47 PM

[Riles:]

Agree with all the above, except, for Mad Hedge Fund Trader, CSJ is not a Short Term Treasuries fund, that would be (if Barclay's) SHY. CSJ is Barclay's ST Bond fund, quality averaging just an A.

Jun 18 03:12 PM

[willydo:]

I thought this was an excellent article. Not a lot of wiggle room, just the facts and straight forward prediction. I think Prieur is right on with this analysis. Thanks for following and cutting through the BS.
It is somewhat hard to imagine that the markets will turn down just as all of them have crossed their 200 MA and the ECRI is definitely pointing to the end of the recession in a few months. But I guess the market got ahead of itself; that's what I make of it.
Willydo
Tucson Arizona

Jun 20 08:44 PM