One of the things I truly cherish about our methods and style is the flexibility it offers when market conditions change. Last week, I suggested the primary bull market uptrend was still intact and a strategy of buying short term dips was still a good one. One week later, I am staring straight at conditions that look like a significant market top is now behind. This is not a call to panic but to respect conditions as they are newly unfolding, gradually and with intentional subsequent action. Remember, Darwin’s rules of natural selection were not as much about survival of the fittest but rather the sustainability of those species which are most adaptive to changing environments.
Conditions Getting Worse
As you may know, our process that identifies opportunities, risk and ultimately our investment exposure, is largely driven by the weight of evidence presented by technical, fundamental and sentiment conditions. We are both “bottom up” and “top down” in our observations. The art of our practice comes from years of experience understanding how to read and interpret all of this stuff. For instance, during the early and middle stages of a new bull market, technical and sentiment type indicators are less important as rising and favorable fundamental evidence trumps all. At the later stages of a bull after years of rising prices and a fully recovered economy, we begin to pay more attention to technical and sentiment driven evidence. This is one of those late stage moments when we need to respect a significant technical breakdown. Here’s what has just happened with last week’s selling in bonds, stocks and commodities – a rare event by itself.
First, we saw several key indices like the Dow Transports, Dow Utilities and the NY Stock exchange, fail to make a new high with the rest of the benchmark indexes in late February. All are now headed lower below the late 2014 highs and did NOT confirm the recent new high in the Dow Jones Industrial Average. At the same time, we saw the 20 year treasury bond move from a leader YTD in price to a loss on the year sending long term rates to one of their highest levels in months. Also on the technical front, one of our longer term market momentum models just put in a double top and is heading lower toward a long term sell. A double top in this indicator has a very long history of preceding bear market declines (-20% or more) with a near perfect track record. Also, for those who care, breadth oscillators both daily and summation, have turned negative as of Friday’s close. Empirically, we also know that the US stock market has never managed to put together six consecutive calendar years of gains. 2015 is the 6th year of this bull market, which is on track to be one of the longest and strongest bull markets in history. While this will be one of the history books, that statistic was earned in the past. The question on everyone’s mind now should be how much of that will you keep? Remember – “Create Wealth, Defend It” is our company motto. Historically, since 1956 according to Jim Stack of Investech Research, every bear market has “repossessed” 50% or more of the previous bull market run. At the moment, a repossession of that magnitude doesn’t seem possible but who knows.
Second, from a sentiment perspective, the Nasdaq Composite did make an new high last Monday pushing it above the 5000 mark for a psychological victory – for a day. In doing so, sentiment figures blew out to extremes and investors capitulated on the buy side. Bearishness hit a very low level of less than 30% briefly confirming the bullish frenzy we have been looking for (warning shot).
Third, from a valuation/ fundamental perspective, we know that the market is and has been expensive but it has been something we have felt tolerant of as long as rates remain low. The S&P 500 index as a broad brush metric, is trading over 19 on a price to earnings ratio. This is about 17% above the long term average and nearly 30% above what many would consider a neutral reading. At the same time, we are seeing more evidence that corporate earnings from an absolute perspective may have peaked in the 4th quarter of 2014. So even while earnings are coming in ahead of expectations, their absolute levels are now declining. The rising US dollar is certainly a factor here hurting overseas sales. Remember, almost 50% of earnings in the S&P 500 come from overseas now! And now rates are rising and no longer supportive of that lofty valuation. Also in the fundamental front, we have margin debt for stocks that seems to have put in a peak and is also heading south as of the end of February. The massive carnage in the energy complex can be blamed but the staggering level of margin debt is right up there with all major market peaks in the last two decades. Also, continuing the discussion from last week, we are continuing to see a troubling string of weaker economic reports now. Last week 16 of 28 reports could be considered negative. I still believe this to be a short term thing but would also appreciate some stronger numbers about now.
Finally, we are also facing a less accommodating Federal reserve as they have clearly put an end to our own domestic QE measures and are now getting closer to raising the Federal Funds interest rates as the economy and employment picture threatens to bring inflation back. When the Fed plans to raise rates is hotly debated but it is not uncommon for the stock market to put in some sort of peak within 6 months of such an event. Importantly, these peaks in the past have not yielded painful bear market but typically 8-10% declines only. Real bear markets come in well after the Fed has raised rates sequentially. In light of that, all of these warnings may be just for the pre-rate hike correction and not a more protracted bear market (yet) giving us more reason to move sloooowwwwly.
With last week’s selling, many of the indicators we watch regularly took a decided turn for the worse adding negative input to our weight of evidence model. If prices are able to recover smartly and make a new high right away, then all of this negative evidence will dissipate for the time being. If not, the probabilities increase that a top may be behind us for much of the market. Again, please remember that bull markets do not end in spikey affairs. Bull market peaks tend to unfold over time with a long painful period of failures that form rolling, rounded top price patterns. We are seeing those rolls now so we want to start “unrolling” our exposure to the markets, selling weaker holdings to cash, increasing our alternative holdings that move counter trend to the equity markets while holding our winners for as long as they want to run. We hope to make this a gradual and graceful process, avoiding reactions or fear based decisions but selling individual holdings only as they cross below our stops. Remember, market corrections and bear markets serve a purpose. They offer smart investors, who have their emotional and physical capital intact, an opportunity to make a lot of money on the other side. We will be there ready to jump. Stay tuned and keep both hands on the wheel if you are managing your own money, this is not a time to get complacent.
Sincerely,
Sam Jones
