There is probably one word that describes what I see happening in this market. That word is RESISTANT.
Buyers Still Resistant
After a very strong up week for stocks (nearly +5%), I was surprised to see the degree to which short term traders appear resistant to change their defensive positioning. We looked at the inflow and outflow numbers to and from short positions, current cash as a percentage of portfolios, as well as short term sentiment numbers. All three show a short term trader who is literally and figuratively not buying this rally as anything more than a rebound within a larger downtrend (or bear market). They might be right, but usually they are not. Short term trader activity and sentiment have long histories of being excellent contrarian indicators. The fact that they have not engaged with this rally so far, given all the short term positive technical reasons to do so – as of 2/11- means there is the real possibility that prices will continue to rise, potentially taking out the early February highs. On Tuesday, our Net Exposure screen suggested that breadth, volume and price patterns were strong enough to add back SOME stock exposure. We did so across the board but only by 5-10%. Current cash (and short term bond) positions are now roughly 30-35% of total portfolios, down from 40-45%.
Energy Stocks Resistant to Going Lower
Energy, and the pain surrounding this generational industry disaster, has been the subject of daily headlines for nearly six months. Most watchers out there figured that energy would have put in a cyclical low way back at $50-$60/ barrel. Now with the current price hovering at $30/barrel, even the strong willed and vocally provocative Middle East suppliers are buckling with talks of a cut backs in supply. Still supply is a problem and still global demand is in decline. I will volunteer that oil producing companies and countries don’t really know how to do anything but produce oil. Cutting supply down to sustainable or economic levels basically means shutting down your company or your country for a while. Expect bankruptcies, mergers, acquisitions and even more social unrest in the Middle East to follow. But, we are also starting to see select US based energy stocks show a little resistance to going lower. In fact, several are now positive on the year by 3-5%, paying some very nice dividends and have broken their intermediate term downtrends – to the upside. Given the previous comments, we might think this show of technical strength is transitory. But it is also widely known that energy stock prices will bottom and rise dramatically in anticipation of a final low in the actual commodity by as much as 9-12 months. The companies that are behaving well are those that are broadly diversified, have stronger balance sheets, some free cash flow and not exclusively living or dying on production. This week, we took a small entry level position in Schlumberger LTD (SLB) adding to our only energy stock Phillips 66 (PSX) in our Worldwide Sectors strategy for combined total of 6%. SLB is now up 3.81% YTD paying 2.76% in dividend yield holding steady with high free cash flow, very low debt to equity and a 9% 3 yr. average return on capital. They are well diversified and the stock is trading off its highs by 35%. And now, we have a constructive price pattern while it’s outperforming the S&P 500. This is not a recommendation to buy SLB but rather an opportunity to illustrate the types of situations that we find appealing for one of our stock strategies measuring both fundamental and technical evidence. PSX is still down slightly YTD (-2.14%) but holding strong in terms of recent price action. With a Price to Earnings ratio of only 9, a healthy balance sheet and positive free cash flow, we’re giving this one a little wiggle room from our purchase late last year.
Perhaps the most important thing to consider with the recent strength in select energy stocks is the psychological benefit to the broad market. Energy and the US stock market have shown very high correlations in recent months. A bottom in energy could easily be a catalyst for at least an intermediate term bottom in the broad US stock market. It’s too early to make that call for either side however.
The Fed Now Resistant to Raising Rates
A rate hike in March is off the table, probably June as well but we’ll see. As I’ve said before, the new Federal Reserve seems more reactive to outside pressures than other reserve boards in the past. They are working overtime to justify what we all see as a reactive policy. One month, they can only talk about rising stock prices, full employment and rising wage pressure (hikes). The next, we hear only about the rising risk of global recession (no hikes) and the impact of currency spreads on the foreign central banks. So for now, the Fed is going to be resistant to raising interest rates which will keep the US dollar down or under pressure. Why should you care? Well if you remember from the last couple updates, the rising US dollar has been cited by almost 70% of companies reporting this quarter as negative force behind declining profits and revenue. If the US dollar is not rising, then of course, we might expect stronger earnings and revenue in the next couple quarters. Even so, the current earnings season has not been as terrible as (we) expected. 75% of large cap companies have already reported for this quarter. I won’t say it’s been an easy ride for stocks but most of the damage to the markets was done in the January, well before the reporting period. All things considered, the Fed’s resistance to raising rates for the foreseeable future, should also be supportive for the stock market especially those sectors like materials, industrials, commodities and internationals.
Resisting the Urge to Get Bullish (us)
We see the discount in the markets. We see the support level still in place marked by the lows of last August and again this January. We see three consecutive days of strong volume with 80-90% of advancing issues. But it’s not enough yet to change the intermediate term trend of the global financial markets. In fact, even if prices do manage to rise above the late January peak (S&P 500 – 1940) the trend will still be negative. The S&P 500 would need to rise and hold above 2005 for anyone to even consider the possibility of a trend reversal. At this point, we are looking at the potential for a stronger than expected rebound rally within a larger and longer decline. Selling and buying pressure indicators are in bear market mode. Long term moving averages are falling with prices trading below, pulling then down. Margin debt is contracting from a multi-year high, small caps are still a disaster, we have almost no leadership at the sector level and investors are still very spooked. We remain resistant to the concept that this is just a correction but rather continue to expect to see a bear market in US stocks unfold before we get an attractive moment to become fully invested again. The downside risk in the S&P 500 back to a valuation level that is reasonable, is about 1550 by most measures. That’s a lot of air between here and there. While we do not see a longer term opportunity in the broad US stock market yet, we do find lots to get excited about in individual oversold stocks. So our strategy remains the same; Carry high cash while remaining active in our selection criteria with exposed capital. It’s just going to be that kind of year.
Signing off for the week – from the drippy world of Steamboat Springs, CO.
Sam Jones
