June Rally Complete - Summer Decline Coming?

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 |  Includes: GLD, SPY
by: Lance Roberts

On May 18th we published "Risk Ratio Indicating More Correction Coming" wherein we stated:

The current market correction should not come as a surprise to any one. There has been consistent and substantial evidence that the rally that began last October was unsustainable. We discussed the coming correction beginning in March. The question now is becoming whether the current correction is over or is there more to come?"

The reality was considerably more drubbing through the end of the month. We suggested that individuals who had not taken action of reducing exposure during our previous writings should hold positions, rather than panic selling, and wait for a June bounce.

We then wrote on June 6th:

Last night on the radio show I said that the market would likely get a very strong bounce today due to the hints that QE 3 was on the way as Jon Hilsenrath of the WSJ hit the wires last night stating 'Disappointing U.S. economic data, new strains in financial markets and deepening worries about Europe's fiscal crisis have prompted a shift at the Federal Reserve, putting back on the table the possibility of action to spur the recovery.' I said that the first target would be a bounce to 1313 and then our targets set out in last weekend's missive of 1337, 1351 and 1364.

The purpose of this brief history lesson is to put into context our analysis of why we suspect the June rally is now complete and that the continuation of the summer decline will likely occur without some intervention in the near term.

Click to enlargeIn each of the past two summers the market has experienced an initial very sharp decline which took the markets from extremely over bought to extremely over sold as was the case in May. This temporary washout allowed for a bounce back to previous resistance levels where investors, previously trapped in the decline, begin liquidating out of the market as we expected for June. It was at this point that the markets retraced, and set new lows, as concerns over a weakening economy, lack of liquidity and the Eurozone crisis continued to plague the markets.

Click to enlargeIt was at these very distraught levels, where negative sentiment raged and stimulative programs were introduced, that rallied markets out of their respective downtrends. With the markets recently hitting our projected retracement targets we suspect that we have reached the near term conclusion of the anticipated June rally. The question now becomes what is likely to happen in July and August? If past is prologue - the prognosis is not good.

The reasons for a renewed decline in the market are many:

  • The European recession is slowing economic growth in the U.S. - the only real question is how much - how fast?
  • The "fiscal cliff" will have to be dealt with - but when and will it be too late?
  • The debt ceiling debate is approaching, again.
  • Emerging markets are slowing putting additional pressure on the U.S. economy.
  • Economic indicators are beginning to signs of increased weakness.
  • The Eurozone crisis continues with no real solution in site.
  • Corporate earnings guidance likely to disappoint
  • Market valuations and price targets are still very optimistic.
  • Sentiment is still bullish overall with few signs of investor fear.

All of these issues, and many more, currently put equity investors at risk, and with no current stimulative support from the Fed, the potential for further deterioration in the market remains high. This is why we have recommended holding higher cash levels than normal. There will be a better risk/reward entry point ahead, however, now is not likely that time. With our "sell" signals currently still in play it has paid to remain cautious since our initial recommendations back in April.

Sell Off Targets And Allocation Model Update

The bottom of the next decline will likely be between August and September with a potential of reaching 1200-1250 on the S&P 500 (NYSEARCA:SPY). If this occurs, and I suspect that this will coincide with the initiation of a new round of bond buying (QE3) which will provide investors with the best risk/reward opportunity to increase equity exposure for a rally through year end.

Click to enlarge

As we discussed in the Technically Speaking section the weekly newsletter "Sell Targets And Global Bailouts" we stated:

The most likely scenario is that the June rally will give way to at least a retest of the May lows, if not setting new lows, in the July-August time frame. Momentum is negative, there has not been a substantial level of fear in the market and negative headlines from the U.S. economy and the Eurozone are likely to continue to stoke investor fears.

Furthermore, many of the key indicators that we watch are still playing out very similarly to the past two summers.

"The two blue boxes are the relevant time frames for our discussion. In both periods:

An April-May sell off was met with a June rally.

The two major moving averages (dashed blue line and solid red line) crossed over into a major SELL signal post the June rally.

Major sell signals are almost always met with a fairly severe sell off historically speaking. This is akin to the 'death cross' of the 50-200 daily moving averages and should NOT be ignored.

The sell-off last summer post the 'death cross' was sharp and took the market down to much lower levels.

The current rally could very likely perform similarly given the amount of stresses that currently plague the global environment and economies.

The market currently remains on confirmed sell signals on multiple levels which further confirms our cautious stance.

In our update of our Risk Ratio analysis on May 18th we laid out the following course of portfolio actions at that time. The "sell targets" identified were met with the anticipated June rally:

Liquidate weak and underperforming positions as the market approaches the 1350 and 1360 levels.

Rebalance winning positions by taking profits and resizing positions back to original weights at the 1350 and 1360 levels respectively.

Look for rotation into precious metals (NYSEARCA:GLD) as a "safe haven" investment which is currently very oversold.

Short duration fixed income is still an alternative as rates will likely remain under pressure from the rotation out of stocks.

Be careful with dividend yielding stocks - while they will likely hold up during a correction they are already overbought in many cases.

Our call to buy bonds over the past month has played out well. They are currently overbought and extended. Hold current positions but be selective on new additions at this time. Wait for a move in interest rates to 2.2% on the 10-year treasury before aggressively adding more.

Hold cash for a buying opportunity when the next "buy" signal becomes apparent.

Click to enlargeThese instructions are tied to our asset allocation model which we post and update each week in the newsletter. From last week's missive:

On Monday it is important to move to the recommended allocation following the guidelines that we have laid out previously:

Sell laggards and losers and remove them from portfolios entirely. (weed the garden).

Harvest profits in winners by reducing weights back to original purchase sizes. (harvest the bounty).

Reweight portfolio allocations to align with recommended target levels - 35% Cash, 35% Fixed Income and 30% Equities. (prune the garden)

The reason I am reiterating these instructions is that the market remains on a sell signal and the June rally took the markets back to an overbought condition within a negative market trend. The rule in a negatively trending market is to sell rallies.

Hindsight Is 20/20

One of the more interesting comments I have received as of late was "The problem with your analysis is that like stock prices, you only can identify peaks or troughs in retrospect." That is exactly the point. Our goal as investors is not to try and "predict" market action as that leads to speculative risk taking. Our job is to identify changes in trend and then react accordingly. In this manner we control risk to principal. What is most detrimental to long term investing success is NOT the missing out of an advance in the market but the capturing of a decline. Replacing a lost opportunity is easy as there is "always a bull market somewhere," however, replacing lost capital destroys your most precious and limited asset - "time."

As investors we are generally left to our own devices to determine when it is "... a time to reap and a time to sow." Whether you are a trader, or a long term investor, the idea of portfolio management is the same. A portfolio, like a garden, will prosper only when it is cared for by weeding (selling losers), watering (making consistent contributions) and pruning (taking profits). A well-tended garden will produce bountiful harvests while an untended garden will eventually succumb to the weeds.

If all else fails just remember Buffett's Investing Rules:

1) Never Lose Principal

2) Refer To Rule #1

Disclosure: I am long GLD.