Tug Of War Under The Surface Of The Market: Is A Resolution Coming?

by: Jim Sloan


There is a tug of war under the present market between bond proxies like REITs and cyclical stocks which benefit from a strong economy such as banks.

My SA portfolio including stocks owned, sold, or for possible future purchase also serves as a helper in reading what is going on under the surface of the market.

As I wrote on SA, I recently (July) sold REITs and cautiously bought banks; daily REIT/bank comparisons provide interesting insight into the overall market.

While economic indicators are mixed, I tilt cautiously toward the view that the economy is improving; the REIT/bank battle should give early warning if I am wrong.

A Jesse-Livermore-type insight: cheap stocks which stop going down in a market decline are falling into the hands of fundamentalist owners.

About a half dozen stocks may tell you all you need to know about the current market. They may also reveal the direction of the economy. And they all come up every day on my Seeking Alpha Portfolio. Throughout the recent trading range and breakout attempt these half dozen stocks have been engaged in a tug of war - a battle to the death. A definitive outcome of that war may settle things for a while.

The tug of war is between stocks that are expensive but considered to be safe and stocks which are cheap but under a cloud. A handful of groups are decisive. On the one side are consumer staples, REITs, a couple of stalwarts like Johnson and Johnson (NYSE:JNJ), and utilities - all expensive, but considered safe.

On the other side of the rope are financials, industrials, energy, and housing-related - all cheap but unloved. Other major areas of the market - technology and health care, for example - stand apart from this fundamental conflict because driven mainly by their own particular issues.

Just two of these groups tell me almost all I need to know about what is going on under the surface, and both are well-represented in my Seeking Alpha portfolio: REITs and banks. In this article on July 30 I wrote about my shifts out of the former and toward the latter. The descriptive words "out" and "toward" are accurate. I was much more forceful in selling REITs than I was in buying banks, at least initially. I largely got out of my REIT positions, which had done very well for me over a year. The lone exception was Omega Healthcare (NYSE:OHI). I "phased" into banks, initiating positions in Bank of America (NYSE:BAC) and Citigroup (NYSE:C) and adding as market action reinforced my initial opinion. For a more detailed rationale, see this article.

Now I get a quick snapshot of the market every morning just by glancing at REITs and banks. These two groups each serve as a synecdoche for their side of two binary market views: hold bond proxies as the economy weakens, hold early cyclicals as the economy strengthens. Over the course of the past ten weeks a struggle between these two groups has been the actual major story of the market. The ultimate outcome will likely resolve several major questions about the economy and the next important move in the market.

Why REITs And Banks?

REITs seem to me the best proxy for the proxies - the bond proxies, that is. They are the new utilities, and I sometimes fear the new "widows and orphans" stocks for the safe yield seekers. Like utilities REITs are sensitive to interest rates in two ways. As stocks bought for yield, they compete with bonds for those seeking higher income through regular payouts. They do well when low rates persist across the range of bond yields. The second way they benefit from low rates is possibly even more important: they are heavy consumers of capital, thus very dependent for growth and payout upon low cost of capital. This is driven both by ability to borrow cheaply and ability to issue shares at high price-to-FFO.

Higher rates will pummel both REITs and utilities from every direction, both undercutting the stock price and raising borrowing costs and thus the cost of capital from all sources. It will be a vicious circle. Increased cash flow from price increases or economic growth won't do much to mitigate. Economic growth, higher inflation, and higher rates do nothing good for them.

In late July I was much more confident and decisive in selling REITs than I was in buying banks. My judgment at the time was that REITs had pretty much had their run, a quite nice run from summer 2015 when I bought them. Some were up 70% or more. They had been cheap and unloved when I bought them (the taper tantrum) but it was impossible to argue that they weren't expensive a year later. I sold most of them within a day or two, writing options against Ventas (NYSE:VTR). I recently bought that option back cheaply, then picked an up day, and sold outright. That leaves the modest position in Omega Healthcare, and I ask myself every day if it is really still cheap or has something wrong with it.

Banks are pretty close to the flip side of REITs. Everything that hurts REITs helps banks, and vice versa. Pretty much, at least. Banks are capital providers, not capital consumers. Banks do well with an improving economy accompanied by not only rising rates but, especially, a yield curve with increasingly upward slope. A strengthening economy has this effect.

If the economy is going to get better, even by a modest amount, banks are going to be among the first and strongest beneficiaries. (There are others, of course. Many technical analysts use the ratio between consumer staples and consumer cyclicals - cyclical outperformance suggesting a stronger economy and better broad market prospects.)

A little inflation is also good. People want to buy things - to swap money for "things," just to draw the picture. Businesses want to produce more things which they can sell at higher prices, and they pay banks better rates on loans to ramp up production. Money is in more demand, and more customers will pay more for it. If the economy is going to get better, even at a modest rate, banks are going to be among the first and strongest beneficiaries.

All banks are currently under a cloud because of the Great Recession. Bank analyst Mike Mayo, the scourge of earnings calls leading up to the 2008 crisis, recently put my thoughts into words on a CNBC interview - the idea that there is a powerful psychological imprint from the crisis in the deep recesses of our collective unconscious.

Investors, regulators, and the general public are all ready to believe the worst about banks and ignore the positives. The fact is that banks are currently making very satisfactory profits, despite the tough environment, and because of their low book value BAC and Citi stand out for the financial engineering potential allowed by the recent Fed decision permitting significant capital return. Fears that the Fed will implement more stringent restrictions on capital strike me as overdone.

My buying of the banks did not immediately move to a scale matching my sale of REITs. Markets are about probabilities, not ironclad convictions. I think banks and certain other cyclicals are likely to do better than REITs and other bond proxies, but I'm not sure enough to bet the farm. In any case, the exchange is off to a very good start on both sides, with the decline in REITs over a couple of months being pretty spectacular.

None of the particular risks and opportunities of these two sectors is my primary subject, however. My subject is the interesting information the two groups convey every day as I look over my portfolio. REITs and banks, each as prime example of their associated groups, are telling the story of a war under the surface of the market - a war with important consequences which may be coming to its crisis.

It's The Economy, Smart Person, Not The Fed

Whatever you think of the Fed - and my view is the rather modest critique that they are currently suffering from weak leadership - it is not hard to understand their reluctance to take action. Both sides of the argument have their points. Economic indicators are, in a word, mixed. This is common when changes are on the way, but what kind of changes?

For those who want to do their own assessment of the economy, you can get the basic data and some solid and fact-based interpretation by reading two other SA authors. The posts by Doug Short come in clusters almost every day and provide the basic charts and data of economic (as well as market) activity. Doug is not bearish, exactly, in either the short or the intermediate term, but several of his economic indicators seem to be weakening to a degree. For the longer term, almost all his data suggests that the market is significantly overpriced.

The other side is well expressed by Jeff Miller (who also happens to be a fan of Doug Short). Jeff focuses on two or three important economic developments in each of his weekly posts and has a point of view one could broadly describe as "steady as she goes." He likes the job creation series and see it as basically okay. Together these two writers provide a solid, balanced, and fact-based picture and about as much data as the ordinary head can absorb.

Which leaves the one remaining prognosticator on the economy: the market itself. The tug of war currently going on under the surface of the market may provide the single best advanced early warning - a tell for both the market and economy.

What To Watch For And How To Interpret What You See

I'm a value investor. I try to buy things that are cheap and avoid, or sometimes sell, things that are expensive. I don't generally pay much attention to technical analysis with one exception. The exception is technical analysis grounded in the business fundamentals. I agree with classic Dow Theory that a market bottom is defined as a time when selling is exhausted and buyers emerge to purchase stocks for their business value. I also believe that rotation among sectors, if strong and persistent, often conveys important information.

At any given moment some market sectors are cheap, some are expensive, and some are in the indifferent middle. I like to buy cheap stocks in cheap sectors, and ideally sectors where market action has begun to improve. I sometimes buy three or four stocks in a sector which seems to have good fundamentals and good market action. The list of my current holdings is often concentrated in a few sectors, aside from a few more or less permanent positions. Mature bull markets often have wide dispersion. Only market bottoms sometimes converge in panic selling to provide a moment where you can throw money at the whole market.

Right now three sectors appear to be cheap, judging from some basic measures (PE, PB, or past history involving large price declines over the past few years). They are: financials, housing-related, and energy. Industrials may be on the cheap side of indifferent based on normalized earnings. I sold all my energy stocks on the first decline of the commodity and haven't bought them back because I can't reliably assess their future. I own the other three.

Consumer staples, high growth stocks, REITs, and utilities are expensive by the same measures that the above groups are cheap. I held quite a few of these until a couple of months ago but disposed of most of them either by outright sale or by writing deep in-the-money call options. I keep them on the screen in my SA portfolio, however. My portfolio on Seeking Alpha is thus composed of three different types of company - companies I own, companies I recently owned and disposed of, and companies I am watching to possibly buy under certain future conditions or at certain future prices.

The first thing I notice when I switch on the computer is the kind of day the market is having - a big up day, a big down day, or a mixed day with little movement. Then I start making comparisons of REITs and banks. Until some time in the spring, REITs and other bond proxies were very strong on up days, declined very little on down days, and were often up slightly on dull days. Banks were the opposite, indifferent on up days, down on down days, and often down on indifferent days.

My favorite of all days, I have to admit, is a day when the market is down big but my stocks are flat to up. It's like a secret signal from the market god that I am doing things right at that moment.

What I am going to say now is in the nature of the idiosyncratic observations of Jesse Livermore. Around the beginning of summer, banks began to perk up, first by refusing to go down on down or indifferent days. About the same time REITs and other bond proxies began to struggle to keep up on up days while participating fully on negative days. These modest relative movements under the market were beginning to tell a story. And let me add this: all of my stocks in a given sector perform similarly at least 90% of the time - deviating only on days when one of them has major particular news.

The story of the market action last spring, it seemed to me, was that the income-oriented TINA (There Is No Alternative) trade was fading. At the same time market movement based on a stronger economy was beginning to gain some traction. By late July I was increasingly convinced of this. When I glanced at other groups on a daily basis they confirmed the same thing. Industrials I own - Parker Hannifin (NYSE:PH) and United Technologies (NYSE:UTX) perked up in a way consistent with banks. So I sold REITs and bought or added to banks. I added modestly to housing, which hadn't yet really joined the pattern, but sold calls against Johnson & Johnson, again within a point or two of its high.

So far all but one of these related decisions have been profitable - thus "correct" at this point by the only criterion that counts. Housing-related buys are around break-even. I understand this by thinking that housing would suffer a more immediate bad consequence than banks or my particular industrials in the event of a weakening economy. They may likely be the best performers in the long run if it proves right to have been more bullish on America than the present majority. If so, it isn't too early to nibble.

Over the last week or two, I must say, the pattern has wobbled just a bit. On days when the market was weak, REITs performed well, but not spectacularly so. I read this to say that the basis for my first action continues in force: the bond proxy stocks have gone about as far as they can go even if conditions continue to be favorable.

The banks have bobbed up and down on rate news, company-specific news, and shifting economic projections. They have not given up the bulk of their gains, however, or fallen below major breakout points. So the relative out-performance remains in play, but needs to be watched. In yesterday's rout (Thursday, Oct 13, DJI down 200) REITs and JNJ outperformed weakly, but banks were down twice the percentage of the market - about 2% - before the afternoon rally in which they rose sluggishly.

My tendency is to think of this as a one-day correction to the trend, but if there are two or three more days like it, the change must be taken seriously. It would suggest that the economy may in fact be weakening, and possibly even sliding toward an early recession. Confirming action by industrials and builders over several sessions would make this more likely.

Today's action should take into account good bank earnings. An initial bounce should be discounted as a signal. Failure to rally within a few days would be a bad sign.


This is how I use my SA portfolio to watch trends and counter-trends under the surface of the market. It is helpful in timing and sizing positions, but it is no substitute for value and fundamentals. A couple of technical/fundamental principles of the Jesse Livermore type are worth remembering. When a sector as deeply loved as REITs were in July stops going up despite fine operating results, it has run out of buyers at the prevailing price. It's going down, possibly until the end of an economic cycle.

On the other hand, when a cheap stock in an unpopular sector stops going down more than the market or moves very little in a market wipeout, it has run out of speculative sellers and is mainly in the hands of owners who bought for the fundamentals - profits, cash returns, and future business prospects. If the market merely stabilizes, it may perform very well.

Try checking every day to see if your own portfolio is trying to send you messages. Good luck with your investing.

Disclosure: I am/we are long BAC, C, UTX, PH, OHI, JNJ.

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.