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Signs of a Washout

These are the hard days for investors. We all want to pull the plug, sell everything, cut and run. Fear and doubt start to creep into our thinking, hourly, in the dark hours. I’m going to interrupt our 2016 Best Bets Series to provide a little emotional peace of mind.

 

You may have seen this headline come across your screen or email. It was an article provided by CNNmoney.com referencing some RBS broker’s very strong directive.

 

CNN: Sell everything! 2016 will be a “cataclysmic year,” warns RBS

 

Now, we know the history of headlines and we know the contrarian nature of sentiment and we also know that the average stock is already in a bear market (-20% or more from the highs). The last time I heard anything like this in headline fashion was August 24th, which proved to be one day from the lows last summer. Then, we had an indicator ripping around that talked of massive short selling in the markets and high likelihood of an imminent CRASH or Black Swan event. Strangely, I’m always thankful to finally see these headlines as they are typically associated with a short term low (+\- a week). Let’s see if the magic works again.

 

Other things I’m seeing during this very heavy and persistent selling cycle for global stocks. I’m seeing the energy sector give up, completely. Energy stocks are down another 10% in aggregate but select names like Marathon (MRO) and Anadarko are down 20-30% or more YTD. Losses in the energy sector as a whole from the highs are approaching -76%. If the history of bubbles and major asset class disasters repeats like we saw with semiconductors in the early 2000’s or homebuilders in 2008, energy will fall another 9% before finding a long term bottom. Note – the bottoming process can also take several years after the final low. The same thing is happening with select basic materials, with companies like Freeport McMoRan, the largest copper mining company in the world, now down -44% YTD. Arch Coal, one of the largest producers of coal in the world is filing for bankruptcy. Again, what we’re seeing is the end game phase for a generational grade commodity wipe out. Note, we don’t own any of these sectors or types of companies because they have been in downtrends for nearly two and half years. But someone does, a lot of someones, and they are capitulating in mass. Massive selling is a necessary ingredient to every tradable low in the markets and we’re seeing it happen now across multiple sectors and indices.

 

I’m also seeing some massive profit taking in last year’s winners like the FANG stocks. Regular readers might remember commentary on 12/3/2015 “There is no Bell” when we spoke specifically about the risks in Facebook, Amazon, Netflix and Google (FANG). At that time we sold 50% of our position in Amazon and Facebook retaining only our long term holding positions. Now, these stocks are down 13-15% in just a few days. I have no doubt, they will be names to own and love in years to come but investors need to understand that nothing goes straight up forever. These were our leaders in 2015, keeping “things” looking deceptively ok from an index perspective. Now these same names are leading to the downside tearing apart the same indices. Oddly enough the market indices are now doing worse than a lot of individual names and sectors YTD.

 

Also from the technical side of things, the market is working it’s way quickly back to the August lows. Honestly, we’re surprised it has gotten this far (down) in barely two weeks of trading. Nevertheless, the market is approaching a very strong level of support. We are agnostic about the prospects of that support level holding. I’ll leave those predictions to the “experts”. We are simply aware of the oversold nature of things and the fact that price support is approaching fast (S&P 1870). Also from a historical perspective, we know that the market’s reaction to the first rate hike by the Fed is almost exactly an average loss of 9%. As of yesterday’s close, the S&P 500 is down 8.91% from the highs. And here’s the good news. The average 12 month gain following those reactionary lows is 15% for the S&P 500 (Bespoke). These are just averages and historical probabilities, not rules or guarantees by any means. Anything can happen, I’m just offering some perspective here.

 

Developing Buy for Income Strategies

 

This is very early in the cycle to say this but I’m starting to see the signs of a developing buying opportunity in corporate bonds. Regular readers know that we have been largely in cash (80%+) since July of last year in our Retirement Income model, which tactically owns high yield corporate bonds. Tactical means there is a buy and a sell signal associated with price trends. Our other income model called Freeway High Income is designed for taxable accounts and has held a nice 50% allocation to municipal bonds (high yield and intermediate term), which continue to make new highs every week. Both models have been waiting and watching corporate bonds fall in prices and rise in yield for nearly eight months. One of our clients recently made the comment that they didn’t like the fact that the strategy was sitting in cash while she was paying management fees. We respectfully would argue that sitting in cash while our primary return generating asset class is falling in price is precisely what our clients pay us to do. We trade away the risk of capital loss during periods like this while watching daily for that best buy to develop. Everyday, the gap in performance widens simply by avoiding loss and we’ll finish the play by loading up on cheap corporate bonds paying 8-10% yields. That day is coming and it might happen sooner than we think. Here’s another tidbit. High yield corporate bonds have never put in two consecutive years of losses (ever). 2015 was a negative year for high yield corporate bonds. YTD, they are down another 2%. Here’s my recommendation. I would add money to either of our Income strategies now as I see the opportunity for a potential double-digit gain from these levels. I can’t say with confidence when we might see the actual buy happen but conditions are becoming ripe so the time to add money is now.

 

Adding money to a strategy should generally come from cash or other sideline money that is not invested or has been waiting patiently for an opportunity of some sort. Shifting strategies internally in your portfolio can make sense but only if you have found yourself uncomfortably overweight in stock strategies (by our prescriptions). If you don’t know what I’m talking about, please revisit the 2nd quarter, 2015 Change of Season’s update called “Best Fit. Otherwise, we’re generally going to argue that you sit tight with your current strategy allocations and avoid the trap of risk tolerance shifting just because the market is down.

 

That’s it for today – just some feel good info for another red market day

 

Sam Jones