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Ready... Set...

Ready… Set….

 

     It’s been so quiet in the markets of late that we have had just about nothing to talk about, until now. As always, the Red Sky Report will let you know, what you need to know on a timely basis. So this is that time. By our measures, today’s selling marks the kickoff for a long overdue correction. What’s the downside risk? Is this just a correction or something worse? What are we doing about it? Read on.

 

Tracks and Warnings

 

     Regular readers are certainly aware of the tracks we have been following indicating a market that is rising on fumes, short on leadership, becoming more selective with several non-confirmations solidly in place. We talked about small caps lagging badly and now moving negative on the year while the S&P 500 and other capitalization weighted index moved up to almost 7% gains YTD. We talked about the final drop in volatility to dangerous levels on January 27th. We talked about the incredible one day wonder of $8 Billion flowing into a single ETF (SPY) representing the S&P 500 on March 1 marking an all-time record. When investors just push it all in on one day, we have typically seen a market peak. Indeed, the markets are still down from March 1st and now under some real selling pressure for the first time since elections last November. More recently and not discussed, is the sell signal we got on all high yield bonds and preferred securities, as well as a short-term buy in Treasury bonds on the day of the Fed Rate hike. One week earlier, commodities fell completely out of bed. And finally, investor bullishness has been sitting at an extreme (high) for over two weeks. Now, the stock market finally sees the first real selling pressure. With just one down day, we can not say with any real confidence if prices will continue to fall but the warning signs of the last several weeks are indicating the risk of a healthy correction is very real.

 

Measuring the Downside

 

Nod to Greg Morris for this educational riddle

This game costs $10 to play

You have a 1 in 6 chance of losing (pretty good odds)

You stand to win $1 Million


Do you want to play?

 

The Game is Russian Roulette. The downside is death.

     So the important and not so funny riddle is about understanding the risks of any venture, any investment. Looking only at the upside can be a terrible trap. For the $8 Billion of hard earned money that plowed into SPY at the very zenith of the market’s move to all time new highs, this one’s for you. 

     Take a look at the chart below which is a simple three-year price chart of the S&P 500 stock index. There is a purple curvy line that represents the long-term moving average of the index, a faster yellow curvy line, which represents the short-term moving average and several drawn white trend/support lines. What a mess! Let me explain.

  

chart 1 3.22.17

 

     Last Friday the S&P 500 index closed at 2,373. If we believe that a correction in prices is in the works and things come back to reality a bit, it would be very natural, normal and healthy for the markets to retrace back to the most recent support level of 2182 (-8%) or possibly the next layer down at 2129 (-10%). 2182 also represents the current uptrend line shown so that level seems to be the most logical for a downside target. Understandably, we might not like the sound of that as a correction of 8% would erase all the market’s gains thus far in 2017 and some of the gains in 2016! Having done this for nearly 25 years, I can tell you that the market regularly erases early gains or losses before establishing the real trend for the year. Remember how 2016 started? Down 10% by February 11th only to reverse and make an all time new high by July.     

     A pullback to either of those support levels would also negate of a lot of price appreciation that has been attributed to the new Trump administration, taking us almost all the way back to election levels. It seems pretty obvious to most that Trump’s promise to get things done, either will not happen at all or be made effective in watered down versions, only in future years. So logically, market gains made on unrealistic expectations of immediate change would be unwound right? 

     Either way, the market is beginning to discount (read- ignore) Trump altogether and focus more appropriately on Fed policy changes, rate hikes, currency moves and earnings. And to that end, the Fed has just completed their third rate hike. In the past, three rates hikes have spelled trouble for stocks but those rate hikes were historically from much higher levels. While I can’t imagine that short-term rates at 3% are a real headwind to borrowing, we’re also looking at a 2% US GDP number, which isn’t all that strong, to begin with. Time will tell but we need to keep our radar on watching for signs that a tighter Fed policy might be working its way into falling earnings and rising unemployment. It still feels too early and we really have very few signs of pending recession risk so far.

 

Bear Market?

 

     We don’t think so at this time but every bear market starts with a standard correction. It would be more likely that any correction now is just a healthy event followed ultimately by a move higher out to all time new highs around summertime or early fall. Then again, there’s a lot of uncertainty with Trump at the wheel, the Federal Reserve tightening and valuations at near record highs for US stocks.

 

Current Net Exposure and Selectivity Changes

 

     Consistent with our well-defined process, we have already cut our net exposure across our Tactical Equity models (Worldwide Sectors, High Dividend and New Power) by nearly 20% (to cash). In addition, in recent weeks, we have taken profits in some cyclical sectors, like airlines, and added to our defensive sectors like healthcare. Also, since valuations now strongly favor internationals over domestic indices, we hold a larger allocation to emerging markets, Asia, frontier countries and Japanese indices purchased with the proceeds of sales of US index funds.

     Our Blended Asset strategies (All Season, Gain Keeper Annuity, and Foundations) have similarly eliminated exposure to High Yield bonds, most pure-play commodities, and small caps and also sit with higher cash. For the first time in a while, we have also taken positions in the Barclay’s Aggregate bond ETF (AGG), the 10 year Treasury bond ETF (IEF) and Emerging Market bond fund ETF (EMB). All three bonds have been trading higher from an early buy signal on the day the Federal Reserve raised interest rates. These may be short term trades but it’s suddenly very nice to have some defensive ballast in our Blended Asset strategies.

     Income strategies (Retirement Income and Freeway High Income) moved largely to cash last week with the sell signal in High Yield bonds and also initiated some Treasury bond fund exposure.

     All in, we’re in a well-balanced position and have anticipated this selling pressure for several weeks. Once prices fall to where they want to fall, we’ll likely get back into the buyers’ seat and look for new investments hopefully from a lower level. But for now, we’re working to protect capital and protect our gains YTD. 

That’s it for today – Nice to finally have something to talk about!

 

Sincerely,

Sam Jones