Market Fails To Breakout

| About: SPDR S&P (SPY)

On Tuesday, I updated last weekend's analysis, stating:

"On Monday, the market did indeed break above 2100 as suggested. That rally higher was driven by Yellen's comments that suggested no rate hike coming in the months ahead. However, while her comments were certainly dovish, the markets had already been pricing in a "no rate" hike scenario during the last couple of weeks as the economic data continued to crumble.

This was most clearly seen in the collapse of the dollar on Friday as the extremely weak employment data killed rate expectations reversing recent currency flows in expectations of higher yields.

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While the jobs report was clearly a disappointment, it is only one data point in a series of developments which suggest that economic deterioration is much more substantial than most of the bullishly biased individuals believe.

As Ed Harrison at Credit Writedowns penned last week:

"My worry is that the data are showing end of cycle weakness. And given the fact that this cycle is already seven years long, I believe it is more likely that we are near the end of cycle than we are near the beginning.

If in fact, we are near the end of the cycle, we are also in the unfortunate position of having no counter-cyclical monetary policy space and limited political fiscal space. That means no yield curve steepening. Instead, we will see flattening. And the distress in high yield will be acute. Bond yields may rally but I don't see equities benefiting since earnings are already in decline. Instead, there will likely be a wholesale flight to safety and crisis. To the degree that the Fed decides to hike into this weakness yet again, we should expect the credit situation to be worse.

We are muddling along at stall speed. 100%. And this could continue. But the data are increasingly suggesting it won't."

While job growth certainly deteriorated over the last several months, the reality is that job growth is ALWAYS a lagging indicator relative to the rest of the economy. Why? Because labor is expensive. It is expensive to hire, expensive to train and expensive to terminate. Therefore, companies tend to hoard required labor as long as possible, which is what creates drops in unemployment claims to low levels at the end of an economic growth cycle.

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However, there are many other areas of the economy that are also sending extremely clear signals that something more important may be afoot.

As Michael Lebowitz penned this morning:

"Commercial and Industrial (C&I) loan delinquency rates, have a strong historical correlation with employment. C&I delinquency rates have risen over the last year and a half, in-line with the decline in corporate profits, to levels last seen four years ago. While the overall delinquency rate is still relatively benign, it is increasing sharply. Another important observation about the delinquency growth rate is that delinquencies tend to trend in one direction for long periods. Note: C&I loans are loans to corporations and businesses and not individuals. Data on these loans are reported on by the Federal Reserve.

The graph below, courtesy of Cyril Castelli of R-Cube, highlights the relationship between the rate of change in C&I delinquencies and employment. The delinquency rates are inverted to better highlight the correlation."

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As revenues and profits decline, the ability to repay loans becomes more difficult. Of course, that same lack of revenue, which leads to rising delinquency rates, certainly does not foster a hiring spree for companies.

Furthermore, a look at capacity utilization and productivity also suggest that something is indeed amiss, economically speaking.

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Of course, eventually, when consumer demand (70%ish of economic growth) slows enough, so does freight and trucking demand.

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Of course, the problem with economic data is the markets, can ignore the data for quite some time, as they have been as of late. As John Maynard Keynes once quipped:

"The market can remain irrational longer than you can remain solvent."

However, what is crucially important not to forget is that eventually price does revert to reflect reality, and not the other way around.

Profit Recovery Hopes May Be Disappointed

The reason I addressed the data above is to give you a bit of perspective regarding my argument about the expected "profits" recovery in the second half of the year.

Just last week, Richard Bernstein stated the following:

"Earnings-driven bull markets seem to be the norm during the year following a profits recession trough.

Our earnings forecast for the four-quarter period ending June 2017 is roughly $115. The current S&P 500 (NYSEARCA:SPY) PE multiple based on trailing reported GAAP earnings is about 24. If history were to repeat, then the multiple could compress by 2 multiple points during that period, which would give one an expected S&P 500 level of about 2500 (115 x 22 = 2530), or about 20% expected return."

That's a bold estimation.

But here is the problem. First, it assumes that Bernstein's earnings forecast are correct.

November 2015:

"If one thinks the Fed will wait to raise rates (as we do) and if one thinks that the profits cycle will trough by year-end 2015 (as we do), then it follows that 2016 might be a good year for US stocks."

Not so much.

Earnings estimates for 2016 have been on the decline since last year, and as usual, have continued to be overly optimistic. Given the weakening economic backdrop, as discussed above, it is quite likely that current estimates will once again prove to overly optimistic as well.

However, let's set estimates, and all the inherent "bullshit" that goes along with Wall Street estimates, and look at valuations.

Multiple contractions are far more ominous over longer periods of time. As shown in the chart below, the 5-Year CAPE (Cyclically Adjusted P/E) is far more sensitive to bull and bear markets in equities.

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Post WWII, the 5-year CAPE ratio has been more of a leading indicator of market returns in the future. However, this is the inherent problem of Wall Street analysis, which touts investing for the long term, but then discusses potential returns over the next 12 months.

Another way to view this data is by looking at the deviation of the CAPE-5 ratio from its long-term average. Currently, at 41.11% above its long-term mean of 15.8x, the historical analysis suggests that future outcomes will likely not be palatable.

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Here is the point. While markets can remain irrational in the short term, historical analysis suggests the next few years will likely be either disappointing or potentially destructive.

Oh yes, about those earnings estimates. I wouldn't really base my investment decisions on their accuracy.

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Rates Suggest Negative Revisions Ahead

Despite rumors to the contrary, since 2013, the bond bull market remains alive and "kicking." This is no surprise as I have written many times in the past, as interest rates, and ultimately bond prices, are a direct reflection of real economic strength and inflationary pressures.

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Currently, as shown in the technical chart below, despite the recent disjointed rally in the S&P 500, the bond market has been suggesting a more bearish posture. As shown in the chart below, interest rates SHOULD have rallied (pushing bond prices lower) as money rotated from the SAFETY of bonds into equity-related RISK.

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That didn't happen, which suggests the current RISK-ON rally may be a bullish trap.

Furthermore, the recent decline in rates likely suggests a much weaker economic environment than is currently expected. The last time that rates were this low, and potentially heading lower, was during the economic slowdown in 2012 which boarded on recession.

In 2012, the Federal Reserve was in extreme accommodation mode, profits were growing, and multiples were expanding. That is not the case today.

The takeaway of all this is the risk to equities may be higher than currently expected. If rates, economic data trends, and valuation reversions are sending the correct message, the forthcoming negative revisions to the underlying data will derail the current bullish thesis of a profits recovery in the making.

"When reward is at its pinnacle, risk is near at hand." - Jack Bogle

THE MONDAY MORNING CALL

The Monday Morning Call - Analysis For Active Traders

Market Fails To Breakout

Okay, so let's get to what you really want to know. On Friday, the market failed to hold its breakout of 2100, as stated at the start of this missive, which keeps the market confined to its longer-term bearish trend.

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As I stated last week:

"With the market now overbought on a WEEKLY basis, there is little "fuel in the tank" effectively to substantially drive prices higher in the short-term. Therefore, with risk outweighing reward at the moment, a more cautious stance to portfolio management should be considered."

That overbought condition and downtrend resistance remain this week and are confirmed by the daily price chart as well.

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As shown in the top part of the chart above, when the markets are as overbought as they are now, it has generally been at, or near, a short-term peak in the market.

The short-term outlook suggests more vulnerability to selling. Importantly, the markets must hold support at 2080, the short-term moving average, or 2040, which is the recent bottoms of what currently appears to be a potential topping process.

The failure of the markets this week to break and hold above 2100 keeps portfolio allocations at current levels. As shown below, the downtrend resistance on a weekly basis also coincides with 2040, reinforcing the importance of that support level. Stop-loss levels are current set at 2020, and portfolio hedges will be added with a subsequent break of 2000.

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Portfolio Management Rules

It is important to understand that as a portfolio manager, I am truly neither bullish or bearish. I follow a very simple set of rules which are the core of my portfolio management philosophy, which focuses on capital preservation and long-term returns.

The fundamental, economic, and price analysis forms the backdrop of overall risk exposure and asset allocation. However, the following rules are the "control boundaries" for all specific actions.

  1. Cut losers short and let winners run. (Be a scale-up buyer into strength.)
  2. Set goals and be actionable. (Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  3. Emotionally-driven decisions void the investment process. (Buy high/sell low.)
  4. Follow the trend. (80% of portfolio performance is determined by the long-term, monthly trend. While a "rising tide lifts all boats," the opposite is also true.)
  5. Never let a "trading opportunity" turn into a long-term investment. (I will just hold it until it comes back.)
  6. An investment discipline does not work if it is not followed.
  7. "Losing money" is part of the investment process. (If you are not prepared to take losses when they occur, you should not be investing.)
  8. The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets.)
  9. Never, under any circumstances, add to a losing position. (As Paul Tudor Jones once quipped: "Only losers add to losers.")
  10. Market are either "bullish" or "bearish." During a "bull market," be only long or neutral. During a "bear market," be only long or short. (Bull and bear markets are determined by their long-term trend, as shown in the chart below.)
  11. When markets are trading at or near extremes, do the opposite of the "herd."
  12. Do more of what works and less of what doesn't. (Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing winners and adding to winners.)
  13. "Buy" and "Sell" signals are only useful if they are implemented. (Managing a portfolio without a "buy/sell" discipline is designed to fail.)
  14. Strive to be a .700 "at bat" player. (No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  15. Manage risk and volatility. (Controlling the variables that lead to investment mistakes is what generates returns as a by-product.)

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As stated above, the long-term price trends determine a bulk of portfolio actions. Currently, the bullish trend from 2009 remains intact. However, a violation of 2000 will negate that bullish trend and require portfolios to be either "neutral or short." Importantly, until that violation occurs, portfolios can, and should, be either long or neutral.

This is why currently, portfolio allocations remain long 50% equity, which is where they have primarily been since May 2015, when I reduced allocations from a 100% allocation to risk. Since that time, reduced allocations have not impeded portfolio returns, but has significantly reduced overall portfolio volatility.

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Furthermore, as stated above, by focusing on "risk controls" in the short term and avoiding subsequent major drawdowns, long-term returns tend to take care of themselves.

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It is through following these basic rules that, with the markets overbought, underlying fundamentals and economics deteriorating, and profits still weak, some portfolio actions should be taken to reduce, not eliminate, overall risk.

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Hedge portfolios against major market declines.
  3. Take profits in positions that have been big winners
  4. Sell laggards and losers
  5. Raise cash and rebalance portfolios to target weightings.

Of course, everyone approaches money management differently. I am simply sharing my process, and I hope you find something useful in it.

S.A.R.M. Model Allocation

The Sector Allocation Rotation Model (SARM) is an example of a basic well-diversified portfolio. The purpose of the model is to look "under the hood" of a portfolio to see what parts of the engine are driving returns versus detracting from it. From this analysis, we can then determine where to overweight sectors which are leading performance, reduce in areas lagging, and eliminate those areas that are dragging.

Over the last several weeks I have been discussing the move of RISK-based sectors which have outpaced performance relative to SAFETY. Starting three weeks ago, that level of outperformance began to fade rather significantly, suggesting the risk-based rally was coming to its inevitable conclusion.

This past week saw a continuation of that relative rotation from RISK to SAFETY as performance improved in bonds and areas that benefit from lower rates.

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Health Care and Financials continued their relative improvement last week, but Discretionary lost footing and has slipped very quickly from its previously leading position. While Energy, Basic Materials, Mid-Cap, Small-Cap, and International continue to provide leadership, relative outperformance has weakened markedly.

LEADING: Energy, Materials, Mid-Cap, Small-Cap, and International

IMPROVING: Financials and Health Care

LAGGING BUT SHOWING IMPROVEMENT: Utilities, Gold, Bonds, and Staples

LAGGING & WEAKENING: Discretionary, Technology, Industrials, and REITs

The sector comparison chart below shows the 9 major sectors of the S&P 500.

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The sell-off on Friday was most clearly seen in the Discretionary, Health Care, Energy, and Financial sectors. The one-day reversal was not enough to severely change the short-term dynamics of the market, but the failure to close above 2100 is enough to raise warning flags.

Staples, Health Care, Industrials, and Utilities are pushing extreme overbought territory, which suggests some profit-taking would be wise. As I stated last week:

"Furthermore, the large advance in Health Care is likely complete for now which suggests some profit taking and rebalancing in the sector."

The same can be seen in Small-Cap and Mid-Cap stocks, where the advance has gone too far, too fast in a catch-up rotation move. Bonds also paced a tremendous move last week as money rotated from equity risk to safety.

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Gold is the clear loser for now, as the "reflation trade" is still currently alive and well.

S.A.R.M. Sector Analysis and Weighting

The current risk weighting remains at 50% this week. The failure to maintain the breakout above 2100 holds allocation changes for now. With technical underpinnings still "bullishly biased," we want to give the markets the benefit of the doubt for now.

It will require a move to new all-time highs in order to safely increase model allocations further at this juncture.

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Relative performance of each sector of the model as compared to the S&P 500 is shown below. The table compares each position in the model relative to the benchmark over a 1-, 4-, 12-, 24-, and 52-week basis.

Historically speaking, sectors that are leading the markets higher continue to do so in the short term, and vice-versa. The relative improvement or weakness of each sector relative to index over time can show where money is flowing into and out of. Normally, these performance changes signal a change that last several weeks.

As stated above, Bonds, Staples, and Utilities had the biggest performance improvements last week.

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The last column is a sector-specific "buy/sell" signal, which is simply when the short-term weekly moving average has crossed above or below the long-term weekly average. The number of sectors on "buy signals" has improved from just 2 a few weeks ago to 19 this past week.

It is worth noting that ALL 19 sectors are now on bullish buy signals. As stated above, the technical underpinnings are bullish and should not be lightly dismissed. It is just highly unusual for such to be the case at a time where economic and fundamental weakness is so prevalent. In other words, this is a clear sign of market exuberance in the making.

The risk-adjusted equally weighted model remains from last week. No changes this week.

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The portfolio model remains at 35% Cash, 35% Bonds, and 30% Equities.

As always, this is just a guide, not a recommendation. It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance, time frames, and goals.

For longer-term investors, we need to see an improvement in the fundamental and economic backdrop to support a resumption of the bullish trend. Currently, there is no evidence of that occurring.

THE REAL 401(k) PLAN MANAGER

The Real 401(k) Plan Manager - A Conservative Strategy For Long-Term Investors


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NOTE: I have redesigned the 401(k) plan manager to accurately reflect the changes in the allocation model over time. I have overlaid the actual model changes on top of the indicators to reflect the timing of the changes relative to the signals.

There are 4 steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.

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Breakout Fails

As discussed in the main section of the newsletter, while the technical underpinnings have improved over the last few weeks, the failure of the market to breakout about 2100 keeps allocation models on hold this week.

With technical buy signals currently in place, it suggests that allocations should be moved up to 75%. However, given the inability to rapidly change allocations in many 401(k) plans due to trading limitations, I would rather wait for a clear breakout above resistance and a re-establishment of the "bullish trend" before taking on additional equity risk. Also, as we head into the seasonally weak time of year, combined with what appears to be a rather volatile presidential election, some extra levels of precaution seem prudent.

Therefore, there are no changes to the 401(k) model this week, as risk/reward is still not balanced enough to justify taking on additional model risk.

For longer-term investors, the markets have made virtually no progress since January 2015. Therefore, there is little evidence to suggest stepping away from a more cautionary allocation... for now.

Current 401(k) Allocation Model

The 401(k) plan allocation plan below follows the K.I.S.S. principle. By keeping the allocation extremely simplified, it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can; however, statistics show that simply adding more funds does not increase performance to any great degree.)

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401(k) Choice Matching List

The list below shows sample 401(k) plan funds for each major category. In reality, the majority of funds all track their indices fairly closely. Therefore, if you don't see your exact fund listed, look for a fund that is similar in nature.

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