Risk Reward Shows Market In The Toilet For 2015

Summary

• We have consistently referred to four specific pillars that assist us in analyzing and prognosticating the market - sentiment, breadth, liquidity and valuation.
• Currently all four areas are in the 'crapper', so to speak.
• Here we delve into all four pillars in order to provide our readers with an in depth intermediate-term analysis of what to expect during the first half of 2015.

SENTIMENT

Ned Davis Research has created an intricate survey to gauge 2015
expectation of S&P 500 performance. 25% of managers polled predict
the market will be up 0-20% over the next 12 months. This suggests
complacency, as there are just too many bulls in the marketplace.

This indicator, created by Goldman Sachs, was recently highlighted on zerohedge.com. The sentiment gauge is currently 100% bullish, which is extremely negative from a contrarian’s point-of-view.

The next chart, created by SentimenTrader.com, averages the percentage of respondents who are bearish on stocks. They tracked
surveys going back at least 25 years recorded by Investor’s Intelligence, AAII, Market Vane and Consensus. The results show that in the 1,428 weeks of data available, only 27 weeks showed a figure of 25% or less. Clearly, this is a period of uncommon “un-bearishness.”

Such readings have historically been present several quarters ahead of
major corrections. Thus, market timing is often an exercise in patience. For instance, warning signs for the 2008 crash appeared as early as 2004-2005.

The Dumb Money indicator includes the equity-only put/call ratio, the flow in and out of the Rydex series of index mutual funds and small speculators in equity index futures contracts. “Dumb Money” sentiment is presently at a 5-year high, which is extremely negative.

This chart, produced by Chartcraft and calculated every Wednesday, polls newsletter writers for their current bullish or bearish prognostications. The indicator is currently positioned at a 41.5, which is extremely bearish. Since such a large percentage of the members polled are bullish, we view this as bearish due to its optimistic reading.

The infamous Investor’s Intelligence bulls/bulls+bears indicator includes data from Investor’s Intelligence-Chartcraft. Marty Zweig, a well-known market participant who is now deceased, tweaked the gauge. The current reading is at a 17-year high, which is a level not seen since the summer before the crash of 1987.

BREADTH

The NDR Volume Demand/Supply spread is used to judge underlying
supply and demand trends. Over the last 18 months, the market
has continued to hit higher highs. Concurrently the indicator has been
very weak, tracing out a series of lower highs. This is a nasty looking
negative divergence.

The number of negative divergences has piled up, suggesting that investors should be wary in the coming months.

The Hi-Low Logic Index, created by Norman Fosback, is a proprietary indicator that judges the difference between the numbers of 52-week highs and lows in the market. This tool gauges internal weakness, and it is useful for spotting topping or churning. Low readings are bullish, while anything over 4.4 is negative. The current reading of 6.1 is at
an intermediate sell signal.

The 52-week lows are beginning to expand. Bob Dickey, the technical analyst at RBC, points out that the number of 52-week lows has been expanding even while the market has been hitting 52-week highs. This is yet another indication that the strength of the indices is being carried by a narrowing list of stocks.

The Hindenburg Omen is a combination of technical factors that attempt to measure the health of the NYSE and, by extension, the
stock market as a whole. The goal of the indicator is to signal increased probability of a stock market crash. It is extremely rare to witness as many Omens occurring together as have been seen over the past 50 days. The last time such a level was reached was
prior to the bear market in 2007, and the time before that was prior to the bear market in 2000. This table shows every time (since 1965) that 11 or more Omens were triggered within 50 days of each other.

LIQUIDITY

The Stock Mutual Funds’ Cash/Assets Ratio is hitting a 50+ year low.
This leaves little room for any large redemptions that may occur in the
marketplace. The ratio dipped as low as 3.5 in 2007, before the 2008
crisis hit. After the crisis, managers moved their cash allocation up to
5.3%. Seeing the ratio back below 2007 levels tells us that liquidity is
running at low levels. Managers have scant reserves left to fund any future allocations or redemptions. The tank is empty.

Because margin debt levels have reached record highs, it has become increasingly important to look outside the box for various tools in order to analyze and properly understand the situation. These two charts, produced by crosscurrents.com, are excellent tools for this purpose. Both charts analyze the same data-margin debt and mutual fund cash. Even though the data is manipulated differently in each chart, the output remains the same. Clearly, the marketplace is leveraged to the hilt.

Household financial assets as a percentage of disposable income have increased sharply since 2008. When analyzing this chart, one can see that current investment levels relative to income are sharply higher than those of 2000 and 2007. Not only are investors taking on more risk, but this data also suggests that the market has become very overowned. Media outlets have popularized the theory that the public has failed to become heavily involved in this market. However, this data proves otherwise.

VALUATION

The S&P 500 Median Price/Sales Ratio is the highest in history, trading at over 2. This is in “nosebleed” territory.

This graph exhibits the difference between the high-yield energy market and the general high-yield market. As one can see, spreads have exploded as energy prices have crashed. Since the environment
has changed, the creditworthiness of the energy sector has been called into question. With the general spreads trading at 40-year lows, it would not be a reach to see the entire high-yield sector exhibit
a similar move relative to government yields.

EXHIBIT A

EXHIBIT B

The Emerging Markets Currency Index has basically been in free fall for the past year. This index just breached the low of 2008, and it could easily be the “canary in the coal mine.” The US Dollar hasn’t only been strong against the Euro, Yen and the Aussie. It has also absolutely hammered some of the emerging market currencies in recent months. The obvious one that comes to mind is the Russian Ruble, but many others have also suffered to a lesser extent. The equal-weighted emerging market currency index is currently breaking below its 2002 and 2009 bottoms. This has significantly impacted
GEM equities (and ETFs such as EEM), when priced in US dollars.

CONCLUSION

Risk is running very high and the momentum indicators are beginning to wane. Commodity prices are in free fall in some cases, and long-term interest rates continue to trend lower. These negative economic developments are deflationary, which augurs poorly for the stock market. Simultaneously, a plethora of indicators are also flashing warning signs. Our subscribers received a notice on December 15, advising them to add 10% to their short position. We are currently at 50% short.

Disclaimer: Lamensdorf Market Timing Report is a publication intended to give analytical research to the investment community. Lamensdorf Market Timing Report is not rendering investment advice based on investment portfolios and is not registered as an investment advisor in any jurisdiction. Information included in this report is derived from many sources believed to be reliable but no representation is made that it is accurate or complete, or that errors, if discovered, will be corrected. The authors of this report have not audited the financial statements of the companies discussed and do not represent that they are serving as independent public accountants with respect to them. They have not audited the statements and therefore do not express an opinion on them. The authors have also not conducted a thorough review of the financial statements as defined by standards established by the AICPA.

This report is not intended, and shall not constitute, and nothing herein should be construed as, an offer to sell or a solicitation of an offer to buy any securities referred to in this report, or a “buy” or “sell” recommendation. Rather, this research is intended to identify issues portfolio managers should be aware of for them to assess their own opinion of positive or negative potential.