[“3 Things” is a weekly publication of ideas, usually contrarian, to provoke thoughtful discussions and decision-making processes. As a portfolio strategist, I am sharing things that I am considering with respect to current investment models and portfolio allocations. Please feel free to email or tweet me with your comments and ideas.]
Stocks: Is It Over Yet?
While yesterday’s suspension of trading on the New York Stock Exchange drew attention to the plunge in equity prices, the reality is that stocks have been in a correction since the all-time highs posted back in May. Of course, until yesterday’s headlines, you may not have realized that the correction was in process as it has been “as slow as a turtle running in peanut butter.”
As Michael Kahn wrote at Barron’s yesterday:
“After months of sideways action and false moves, the Standard & Poor’s 500 finally scored a true technical breakdown. It moved below the pattern that had held it in check since February, taken out the May low, and now dipped below the more important 200-day moving average for the second day in a row.
In technical circles, the positive reversal of fortune left sizable ‘hammers’ on Japanese candlestick charts. In candle-speak, the market is hammering out a bottom and after a two-month slide it did look that it was time for a rebound. But as with many chart patterns, confirmation in the form of upside follow-through was needed to prove that the market had found a floor. That was not to be”
The first chart is a DAILY chart of the S&P 500 index. The black dashed line is the 150-day moving average that has acted as primary support for the bull market advance (with the exception of the post QE3 end tantrum in October) since December, 2012. Importantly, after the markets failed to maintain its bullish consolidation (rising red dashed line) that began earlier this year, the subsequent breakdown found support at the long-term bullish trend. Unfortunately, the oversold bounce failed at the previous bullish consolidation support line, turned down and broke through the long-term bullish trend.
Unlike the break of the long-term bullish trend in October of last year, which quickly recovered and scored new highs, that has not been the case as late. Each attempt to break back above the long-term bullish trend has failed so far.
If we slow the price volatility down by looking at a WEEKLY chart, a very similar pattern emerges. The bullish market consolidation, long-term supports, and the recent breakdown are all evident. It is also worth noting that a majority of indicators are registering a “sell signal” which suggests that, at least in the near term, prices are likely headed lower.
As shown in both charts above, the 2040 level is currently acting as critical support for the market. If the bull market cycle is to continue, the market must hold that level and move to new highs very soon. Another failure at lower highs, as in June, will confirm the current downtrend and suggest lower price levels in the not so distant future. Michael makes a good point on this:
“In the past, any time the Fed assured the market it would not rush to raise rates, stocks benefited. Banks are telling us now that may not be true anymore. Weak fundamentals, rather than low interest rates, may be the driver over the coming months.
The question for investors is whether this is a correction or the end of the cyclical bull market that began in 2009. Unfortunately, the answer is still not known although it is very likely that cash should be an important part of any portfolio at this time.“
I agree with that statement. I am not suggesting that investors become overly defensive in portfolio allocations currently. The market is getting oversold on both a short and intermediate term basis which provides the “fuel” for a reflexive bounce. That rally should likely be used to rebalance portfolio allocations, reduce aggressive “risk” postures and raise some cash to hedge against further turmoil until markets provide a more stable investment environment.
At least things are starting to get interesting.
Like I Said, Rates Aren’t Going Anywhere
I have consistently pushed back against the mainstream notion that longer-term interest rates were going to rise simply because the economic underpinnings do not support higher rates. To wit:
“With economic growth running at exceptionally low rates, along with inflationary pressures and monetary velocity, interest rates will remain range-bound at low levels for quite some time. This is simply because interest rates are a reflection of the demand for credit over time, in weak economic environment higher rates cannot be sustained.”
“Therefore, the recent uptick, as recommended in last weekend’s newsletter, is now a buying opportunity for bonds.“
What perplexes me about the mainstream media is that while they focus on every facet of trading the market in stocks, they give little notice to the investing side of fixed income.
As investors, we buy stocks because we think that the overall market is going to rise. This is why we benchmark our portfolio to some nebulous index that has absolutely nothing to do with our specific risk tolerances, goals and, most importantly, time horizons. However, just a the stock market index is used to gauge levels of “risk” exposure in stocks, interest rates provide exactly the same analysis for fixed income.
The chart below, which I often discuss in the free weekly e-newsletter, shows the technical trading model for fixed income in portfolios.
The circles highlight periods when interest rates have become extremely overbought or oversold. Unlike the stock market, interest rates have an inverse relationship to bond prices (as interest rates rise, bond prices fall) therefore, when rates are overbought, bonds are oversold and should be bought.
Note: This analysis is less important if you are buying individual bonds and holding them until maturity. However, for the majority of investors that are using bond funds and bond ETF’s, this analysis becomes critically important especially in navigating a long-term sideways trading range for rates going forward. (Read this for reasoning why rates are stuck over the next decade.)
As shown above, the recent move higher in interest rates was simply a bounce from the extremely oversold levels witnessed at the beginning of this year when rates fell to 1.7%. However, despite the media’s ongoing calls that the “great bond bull” was dead, the reality is that rates completed a very traditional 61.8% retracement of decline from April of last year.
Given the current weakness in economic data, the overbought condition in rates currently, and the rising issues in China, it is highly likely that rates will potentially retest their lows by the end of this year. Regardless, investors need to start paying attention to the developing trading range of interest rates in the future.
Oil Prices & Energy Stocks
Besides interest rates, I also cover oil and energy prices on a regular basis in the weekly e-newsletter. Two week’s ago I stated the following:
“There are very few signs that the drop in oil prices, and subsequent pain to energy-related investments is over. As shown in the chart below, there is still a significant divergence between energy-related investments and the underlying commodity price. These two will likely reconnect at some point in the future as oil prices drop towards the high 40’s potentially later this summer.
Secondly, energy related investments have experienced the first of most likely several ‘dead cat’ bounces that will plague energy investments into the near future. There is still WAY too much exuberance due to “recency bias” to make energy a viable investment opportunity longer term. More pain in the sector will be required to flush out speculators before longer term investments can be made. There will be a good opportunity in the future, it most likely isn’t now.“
The chart below shows the previous high correlation, as would be expected, between energy stocks and oil prices. The divergence in early 2014 is what prompted my call then to begin reducing exposure to energy stocks. While energy stocks are attempting to complete a 61.8% retracement and hold some level of support, the gap between oil prices and energy-related investments has yet to be filled.
There is still a significant amount of unwinding left in the energy space as production is still far outstripping demand. If the collapse in China continues, it is possible that oil prices could drop into the low $40’s putting additional pressure on energy company related earnings.
Furthermore, exuberance is still high. Great buying opportunities come when the markets become convinced that oil prices and energy companies are “eternally dead.” We are not there just yet.
Just some things to think about.
Source: Street Talk Live