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Crisis And Opportunity With Markets At All Time Highs Part 3

|Includes: SPDR Dow Jones Industrial Average ETF (DIA), GLD, QQQ, SPY, USO, UUP
Crisis Opportunity

Signs that U.S. Markets Trade in Crisis Mode - Even at All Time Highs Part 1 By Dr. Van Tharp Trading Education Institute

Brexit . . . remember that little vote on the island kingdom 20 calendar days ago? That price drop is now an event distant in the rear view mirror - according to the market. The S&P 500 and the Dow Jones Industrial Averages just made new all-time highs.

Meanwhile, the more volatile Nasdaq and Russell 2000 indexes are many percent off of their highs. That disparity tells a big part of the problem. I've written many times before about the concept of "risk on" assets vs. "risk off" assets. With the risk-on Nasdaq and Russell short of their all-time highs, this current rally is rather upside down - as is 2016's market action in general.

This week we'll look at one sign that in spite of the all-time highs, this market is in crisis mode. (Next week, we'll look at a second sign.)

What is Crisis Mode?

First, let's define market "crisis mode". It's pretty simple - some analysts use this term for how the markets acted (and reacted) after the end of the Great Recession (2008 - 2009). Many observed a structural change in the way markets behaved after the crisis versus before:

Abrupt declines of greater than 5% (but less than 10%) were followed by a quick snapback; this strategy of buying all pullbacks was aided and abetted by the perception that central banks would continue to provide a safety net under the markets.

Correlation between geographic regions and asset classes grew to a very large extent and gave rise to risk-on (assets that move strongly up when markets are in a bull phase) and risk-off (assets that do better in bear phases).

We've seen another instance of a sharp decline (the two days after the Brexit vote) followed by a quick snapback.

SP500 Crisis Opportunity Chart

And now let's look at the first of two additional signs that we're still in crisis mode trading.

Sign #1: Defensive Sectors Lead the Way

In the risk-on versus risk-off paradigm, certain sectors have classically been associated with one side or the other. One of the classic pairs is the Consumer Staples sector (NYSEARCA:XLP) vs. Consumer Discretionary (NYSEARCA:XLY). You can see how these two sectors contrast by looking at their top holdings:

XLP's Top Holdings:

Everyday consumables - beverages soap, toothpaste, paper goods, etc.: Proctor & Gamble (index weight: #1), Coca-Cola (#2), PesiCo (#8) and Colgate-Palmolive (#10)

Tobacco: Philip Morris (#3) and Altria (#4)

Discount Retail & Pharmacies: Walmart (#5), CVS (#6) and Walgreens (#9)

XLY's Top Holdings:

Discretionary Retail: Amazon (#1), Home Depot (#2), and Lowes (#8)

Travel & Entertainment: Comcast (#3), Disney (#4), Priceline (#9) and Time Warner (#10)

Restaurants / Coffee: McDonalds (#5), and Starbucks (#6)

Recreational Wear: Nike (#7)

The idea why discretionary is the risk-on sector is pretty clear - when times are good, we spend more on leisure and discretionary retail. When times are not so good, money becomes tight and the last things to cut back on are staples and therefore this sector is the traditional risk-off choice.

Let's see where these sectors are in terms of year-to-date performance. This is what Stockchart.com calls a performance chart or a percentage gain/loss chart of the nine sectors classified by Standard and Poor's. Note that stockcharts.com uses the term "Cyclicals" instead of "Consumer Discretionary" for XLY:

S&P Sector ETFs

You can see on the chart that risk-off consumer staples have significantly outperformed their risk-on sibling - discretionary (cyclical).

In addition, I highlighted another risk-on/risk-off sectors pair in the chart: the traditional risk-on technology sector (bright green) and the very defensive, risk-off utilities sector (orange). In a flip flop of what you'd expect to find in a market making new all-time highs, we have technology in the bottom half of performers this year and another defensive sector (utilities) leading the way!

It's almost as if investors and traders are saying, "Ok, we'll buy because people are still jumping in at every dip, but we're going to buy cautiously…"

Sign #2

Next week, we'll look at second sign the market is in crisis mode - some enlightening market correlation numbers from one of the world's biggest hedge funds, Renaissance Capital. We'll see if we can draw some useful conclusions from that data.

Signs that U.S. Markets Trade in Crisis Mode - Even at All Time Highs Part 2 By Dr. Van Tharp Trading Education Institute

In the first part of this series last week, we talked about a market that keeps pushing higher but that also has the underlying characteristics of a market in crisis. We looked at the first sign that the market is in crisis and this week, we'll dive into a second sign.

Sign #1: Defensive Sectors Leading

We revisited the concept of "risk on" assets vs. "risk off" assets and one week later, we still see the broader S&P 500 and blue chip DOW stocks continuing to lead this rally. Meanwhile, the "risk on" Nasdaq and the Russell asset teams continue to lag during the big push up.

We also saw that traditionally, the defensive ("risk off") sectors in utilities and consumer staples are the leading gainers in 2016. For a quick read of that article and the charts showing this you can click here.

This week I want to highlight some work on market correlation numbers from Renaissance Capital, but first, a quick reminder.

What is Crisis Mode?

Let's revisit a definition for "crisis mode" trading action. It's pretty simple - some analysts use this term to describe how the markets acted (and reacted) after the end of the Great Recession (2008 - 2009). Many observed a structural change in the way markets behaved after the crisis versus before:

Abrupt declines of greater than 5% (but less than 10%) were followed by quick snapback; this strategy of buying all pullbacks was aided and abetted by the perception that central banks would continue to provide a safety net under the markets.

Correlation between geographic regions and asset classes grew to a very large extent and gave rise to "risk on" (assets that move strongly up when markets are in a bull phase) and "risk off" (assets that do better in bear phases).

Sign #2: Correlations Remain Sky High

Last week Neil Dutta at Renaissance Macro hedge fund sent out to clients a research piece about the high correlations between asset classes - which you would traditionally expect to be uncorrelated.

Here's the table that shows how low the correlations used to be even through the years leading up to the start of the global financial crisis in 2007:

Intermarket Correlation Ratio Data

After the Great Recession, these correlations went quite high, a common occurrence for corrections but - then those correlations stayed high for several years - which is very uncommon. Back in 2012, I wrote a series of articles about this very phenomenon where we dug into how markets had traded rather independently before the 2007 - 2008 crash but after the Great Recession, how they traded very similarly (or in a correlated way).

Dutta notes that we are still in the same boat. In his words:

"The global financial crisis started almost 10-years ago and while that may be a distant memory for some, it left a lasting imprint on the global economy. For financial markets, the behavior of asset prices continues to exhibit crisis rather than pre-crisis characteristics."

To his point, compare the correlations of those same markets in mid-2016:

Intermarket Correlation Ratio Data

Dutta continues:

"The one implication we would like to point is that because of the high correlations, market volatility in one country is more likely to be transferred to another and more quickly."

Next week, we'll look draw some conclusions and offer some guidance for dealing with this crisis mode market - that keeps making new all-time highs.

Signs that U.S. Markets Trade in Crisis Mode - Even at All Time Highs Part 3 By Dr. Van Tharp Trading Education Institute

Well, the market did drive up quite decisively to new highs after the recent Brexit drop but - not by much. The S&P 500 Index overshot its previous high from 15 months ago by only 1.9% and since then, we've been stuck in a tight (~1% of price) sideways box for nine trading days:

"But wait, D.R.", I can hear you say, "why do you say that the market has inched to new highs?"

Well, the market did drive up to new highs quite decisively after the recent Brexit drop but - not by much. The S&P 500 overshot its previous high from 15 months ago by only 1.9% and since then, we've been stuck in a tight (~1% of price) sideways box for nine trading days:

SP500 Chart Index

The Crisis Mode Signs

In the first part of this series two weeks ago, we talked about how this all-time-high market had some underlying characteristics of a market that thinks it's in a crisis. One characteristic of a crisis mode is leadership by "risk off" assets which have been outperforming "risk on" assets. Two weeks later, the current rally is still being led by the broad S&P 500 and the DOW blue chips. Meanwhile, the "risk on" Nasdaq and Russell continue to lag. At the sector level, we also see that utilities and consumer staples leading the market even though they are traditionally defensive ("risk off") sectors.

In Part 2 of the series last week, we looked at some nice work on market correlation numbers from Renaissance Capital. Their research shows that correlations across the spectrum of capital markets more closely resemble the "crisis mode" in 2008-2009 rather than the much lower correlations found during the 2000-2007 bull market period.

With today's market prices "at the top of the page" and the market trading defensively in many ways, let's consider one useful metaphor of what might be happening. And then we'll finish up this series of articles with some actions to consider moving forward.

The Status Quo and Market Capacitance

I was just talking with a friend and fellow stock market analyst about several aspects of the markets right now. We noted that market prices are staying near the top of the page even while yellow and red economic flags pop up all over the globe.

I talked about the central bank safety net narrative. The world's central banks have the conviction and the wherewithal to prop up markets in hopes that a real economic recovery will come along and save us - or at least investors and traders still seem to believe that.

Then we speculated about how long excess liquidity could really prop up the markets. At that point, our conversation turned to the concept of capacitance. In electrical devices, designers use capacitors to temporarily store electrical energy so that it can be discharged when needed.

This concept of capacitance applies to the financial markets as well. In early 2005 I wrote a six part series on the housing bubble and followed up in late 2005 with a four-part series about the same topic. In early 2006, housing prices peaked. The equity markets, however, lagged the real estate and credit markets. So much stimulus had poured into the financial system that it took a year and a half (or more) for it to work its way through the economy and manifest fully with the stock index peak in late summer 2007.

Now consider another period that showed the idea of stored financial energy - between 2011 and 2015. During that period, Europe's unity was coming into serious question and member country banks were in crisis (Remember Ireland, Greece, etc.?). In addition, China's growth continued to slow and their debt ratios worsened - even as the equity markets were in bull mode.

Fast forward to mid-2016 when one of the EU members has decided to actually leave the union and big bank troubles (OTCPK:ITALY) are making headlines again. Also, China's economy has gotten worse - even by their official government numbers. China's growth has slowed significantly and their debt figures far exceed anything we saw in the U.S. in the years leading up to 2007-2008. While these factors are worse now than they were in 2011-2015... the markets are trading at all-time highs.

So regardless of what signals we're seeing (or not seeing), recent history tells us the current upward momentum can continue for a long time in the stock market.

So What?

When defensive sectors like utilities and consumer staples lead the charge to new highs, I believe that the market is hoisting a yellow flag. BUT - prudence dictates that we continue to participate in the equity markets until price tells us that something is awry. Investors and traders can buy sensibly during pullbacks until we see major chinks in the narrative that "central banks are still in control".

Most importantly, know your stop loss point when you say "I'm scaling back" or "I'm heading to sidelines."

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