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Watershed Wednesday

Yes, they are already coming up with cute names for the latest round of panic in the financial markets – last Wednesday.  I think Watershed Wednesday is going to be an accurate title for its notable extremes in both bond and equity markets worldwide.  Will it prove to be the bottom?

Liquidity/ Short Squeeze Issues

For those in the trenches last Wednesday, it looked very much like we were going to see and experience another mini crash in the markets.  I’ve been through several and it had all the makings.  But as is often the case during bull markets, those extreme moments (at 13:00 hours EST), we saw a reversal and stocks rebounded smartly into the close.  Small caps even finished up 1% on the day!  It’s enough to really shake your tree, to the roots.  I spent the weekend in isolation from all news because I needed to get a grip.  We have known that the financial markets have been operating on a high level of margin debt and leverage since late 2012.  We have spoken about the heightened risks under these circumstances when the leveraged money tries to get unleveraged by selling anything they can – typically US equities and bonds just to cover themselves.  That’s exactly what happened on Wednesday and may very well prove to have been a watershed moment in modern history marking exhaustion and capitulation among the managed money crowd.  Did mom and pop sell?  Not so much sadly.  In fact bullish sentiment among the American Association of Individual Investors (AAII) actually went up on the week from 39 to 42%.  Of course, this makes me nervous now.    For this round of selling, it looks to have been much more on the “professional” side judging from the sentiment numbers and trade sizes.  Big money wanted OUT after taking a massive beating in energy, small caps, and all the other holdings that were already down 20,30 and 40% this year off their highs.  Make no mistake; the carnage in the global financial markets has been far worse than indicated by the S&P 500 or the Dow.  Here’s a snapshot of Bespoke’s sector breakdown showing percent losses from recent 52-week highs. 

How is the S&P 500 only down 8% from its 52 week high?  A small company called Apple.  Beware that in a different market, we might see just the opposite as Apple anchors the S&P 500 while specific sectors widely outperform.  I almost expect that event sometime soon.  Today, John Bogle wins.

Pouring gas in the fire, we also saw additional liquidity issues in the bond markets, especially high yield corporate bonds and the CDS (Credit Default Swaps) markets.  Meanwhile, the 10 year Treasury bond yield fell to its lowest level in a couple of years in a dramatic move that forced short sellers out of their positions.  Wow!  What a day when both short sellers (of Treasury bonds) and leveraged investors (of stocks) both got the squeeze of their lives.  I have no doubt that next month you will hear about multiple hedge funds that are now out of business and returning what’s left of their investor’s capital.  Is it all over? 

Was Last Week the Low?

You know me better than that.  Of course I’ll dodge that question but I’ll offer a few items to chew on.  If we focus less on noise and more on facts that will help us find answers, we see the following:

1. The markets are extremely oversold and due for a bounce of some sort = Good!

2. Small caps are rebounding along with several of the other most beaten down sectors like energy and materials = Good!

3. Bonds are seeing selling pressure and the US dollar is now headed lower = Good!

4. News headlines (Ebola, Russia, and ISIL) are terrible.  Potential relief rallies to follow? = Good!

5. Interest rates, cost of capital, analysts expectations and now stocks are all low, LOW and LOW going into earnings season  = Good!

6. Cash on the sidelines, Merger activity and buybacks are all high = Good!

7. Seasonality gets very positive in 11 days = Good!

8. No economic reports are even close to recessionary  = Good! (for stocks)

9. Consumer Sentiment just hit the highest level since July of 2007= Good!

10. Economic reports last week were still positively positioned but showing signs of some tiredness (1 month drop in general business conditions was ugly)  = Worrisome but not BAD yet.

11. Slow downs in Europe, China and South America are dragging down the US economy/ markets, messing with currency markets and this is all happening as we’re wobbling around on our new bike without training wheels (see illustration from our annual meeting below) = Bad!

So all things considered, this deep and scary correction in the global financial markets looks highly technical and less about the current conditions of company fundamentals or the US economy.  However, as we can see with little Sammy above, we’re not done with the pain of our Transition Year yet.  The market is going to fall down a few times (more) before getting the hang of life without the Fed (training wheels).  The crazies in the world want us all to believe that there is no life without massive infusions from the Federal Reserve.  Bunk!  QE and every act of the sort has been a unique experiment by the Federal Reserve only seen in the last five years.  We have seen massive bull markets and robust economic growth without Federal Stimulus in the past (50’s and early 60’s, 80’s and 90’s). 

Best guess in the short term, it would seem likely that prices will rebound smartly from this level, but fail to make a new high.  Sellers will want out again at a higher level and then we could see more chop lower into the first half of 2015 when the Fed finally does raise short term interest rates.  I do not see the ingredients in place for a massive and devastating bear market at this point.  I see a continuation of this corrective cycle giving opportunistic investors several chances to buy stocks at deep discounts.  This should be the first. 

Shifting Into Trading Mode

As I discussed at the annual meeting on October 9th, when the markets break trend to the downside and trade below the 200 day moving average, we change our tactical approach a bid.  Specifically, our focus orients more toward technical analysis of the markets, watching oversold, and overbought indicators and move more into a trading mode.  Last week we bought several market indices including small caps and other “rentals” for a hopeful rebound ride back up.  I don’t expect to be in these positions for more than two or three weeks.  On the sell side, we are planning to jettison some of our weaker holdings and get as defensive as market conditions dictate – again on a rebound.  At the next cycle bottom perhaps in early 2015, we might do it again.  Trading and paying attention to market internal indicators is going to be our MO until price moves and hold sustainably above the longer term trend lines and moving averages. 

Remain calm, turn off the TV and know that you’re in good hands.

Have a great week!

Sam Jones