Breakout! Market Breaks Above 200-DMA. Is The Bull Back?

In this issue of “Market Breaks Above 200-DMA, Are All-Time Highs Next?”

• Market Breaks Above 200-DMA
• Are Bulls TOO Optimistic
• Technical Review
• Portfolio Positioning
• MacroView: CFNAI Crashes Most On Record, 
• Sector & Market Analysis
• 401k Plan Manager

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June 13th from 8-9 am

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Catch Up On What You Missed Last Week

Market Breaks Above The 200-DMA

In last week’s missive, we discussed how the market remained stuck between the 50- and 200-dma. At that time, we noted the risk/reward ranges, which encompassed a breakout or retracement within that range. (The chart is updated through Friday’s close.)

The shaded blue area shows the containment of the market between the two moving averages. With the market very overbought short-term (orange indicator in the background), there is downside pressure on prices short-term.

While the market did break above the 200-dma, such does not change the negative risk/reward characteristics of the market.

• -2.8% to the 200-dma vs. +1.7% to the March peak. Negative
• -9.2% to the 50-dma vs. 5.6% to February gap down. Negative
• -10.5% to the consolidation support vs. +10.1% to all-time highs. Neutral
• -19.7% to April 1st lows vs. +10.1% to all-time highs. Negative
• -27% to March 23rd lows vs. +10.1% to all-time highs. Negative

However, as stated last week, the break above the 200-dma is currently changing the complexion of the market.

“If the markets can break above the 200-dma, and maintain that level, it would suggest the bull market is back in play. Such would change the focus from a retest of previous support to a push back to all-time highs.

While such would be hard to believe, given the economic devastation currently at hand, technically, it would suggest the decline in March was only a ‘correction’ and not the beginning of a ‘bear market.'”

While the negative risk/reward dynamics are evident, the more negative outcomes are becoming less probabilistic. However, on a longer-term basis, a deeper correction becomes more possible, given the deviation in prices from the underlying fundamentals. 

Are Market Bulls Too Optimistic

Currently, the markets are rallying in hopes of a “V-Shaped” economic recovery, which will be supported by a COVID-19 vaccine and no second wave of the virus. If such is the case, then it is expected the depression level readings of unemployment and GDP will quickly reverse, supporting the stock market’s current valuations.

There are several underlying problems with this narrative:

1. There is a very high probability that as states reopen their economies, there will be a “second-wave” of COVID-19.
2. Out of the dozens of companies that are in the process of developing both therapeutics and a potential vaccine, the odds are incredibly high the vast majority, if not all, will fail.
3. Corporate profits and earnings were already struggling, heading into the recession. While they will rebound as the recession passes, they are unlikely to return to levels to support current valuations.
4. Unemployment will likely remain higher for longer than expected. Up to 50% of small businesses, which account for about 25% of all employment, are expected to shutdown. Consumption, which is where earnings and profits come from, will be cut accordingly. 

Currently, investors have gotten back to more extreme stages of bullishness as the market has relentlessly rallied from the lows. 

Valuations Matter Long-Term

However, the complete detachment from the underlying fundamentals is likely to weigh on the markets soon than later. Irrespective of Fed stimulus, valuations do matter over the longer-term time and will drive forward returns.

The problem is the valuation levels are worse than shown as earnings are still being revised lower, and will get worse. We know this because corporate profits were released this past week for Q1 and showed a record drop. That drop was for a quarter where the shutdown accounted for only 2-weeks of the reporting period. The decline in the second quarter will be materially worse as the entire month was lost to the pandemic.

Castle Of Sand

We can see the deviation between GAAP earnings and corporate profits if we use the data for first-quarter.

The shaded areas show the lag between the decline in profits and the decline in GAAP earnings. Over the next couple of quarters, profits are forecasting a much deeper decline for S&P 500 earnings. With estimates still in the $95/share range, we could see a rather substantial decline.

As stated, investors have priced in a “perfect” economic recovery story. Such leaves much room for disappointment as the deviation between what investors “expect,” and “reality” is at the highest level on record.

Historically, sharp declines in corporate profits are met by equally sharp declines in GAAP earnings.

While investors are “hopeful” this time will be different, the reality of 40-million unemployed, mass failures of small businesses, and a contraction in consumption, argues differently.

“It’s too ‘happy days are here again. It’s just not going to work like that. Not with 38 million unemployed. You can’t keep building on a castle of sand. I see a lot of quicksand underneath some moves. I wish we would just calm down and digest some of these things.” – Jim Cramer, Mad Money

Technical Review Of The Market

No matter how you want to slice the data, the markets are back to more egregious overbought conditions on a short-term basis. With the markets very overbought, and in a very tight ascending wedge, watch for a break to the downside to signal the start of a correction.

Also, with roughly 95% of stocks now trading above the 50-dma, such has historically signaled short-term corrections to resolve the overbought condition.

While much of the media has been talking about positive returns from stocks over the next 12-24 months, we could also have a 2015-2016 type scenario.

At that time, the markets climbed above the 200-dma, combined with a “Golden Cross” as the 50-dma also “crossed the Rubicon.”  While the media bristled with bullish excitement, it was quickly extinguished as the markets set new lows as “Brexit” engulfed the headlines.

Importantly, while concerns about a “Brexit” on the global economy were valid, “Brexit” never materialized. Conversely, the economic devastation in the U.S., and globally, is occurring in real-time. The risk of a market failure as “reality” collides with “fantasy” should not be dismissed. It CAN happen.

Lastly, speaking of the number of stocks above the 50-dma, that indicator is laid behind the S&P 500 in the chart below. Historically, whenever all of the overbought/sold indicators have aligned, along with the vast majority of stocks being above the 50-dma, corrections were close.

Such doesn’t mean the next great “bear market” is about to start. It does mean that a correction back to support that reverts those overbought conditions is likely. Therefore, some prudent risk management may be in order.

Portfolio Positioning For An Overbought Market

This analysis is part of our thought process as we continue to weigh “equity risk” within our portfolios.

Positioning, and the related risk, remains our primary focus. This past week made changes that reduced risk in our overall portfolio by taking profits out of the largest gainers and adjusting weightings in defensive holdings. The following is trade commentary provided to our RIAPRO subscribers (30-day Risk-Free Trial)

Rebalancing The Equity Portfolio

In the equity portfolio we have rebalanced our exposures to align with our Relative Value Sector Report:

We are taking profits in:

• AAPL – 1.5% to 1% portfolio weight
• MSFT – 1.5% to 1%
• CHCT – 1.5% to 1%
• MPW – 1.5% to 1%
• RTX – 1.5% to 1.25%
• ABBV – 1.5% to 1.25%

We added exposure to:

• UNH – 1.5% to 2% portfolio weight
• DUK – 1.5% to 2%
• AEP – 1.5% to 2%
• NFLX – 1% (Trade only – see Jeffrey Marcus commentary)

Taking profits in our portfolio positions remains a “staple” in our risk management process. We have also increased our treasury bond and precious metals to hedge our increased risk over the last two months.

We don’t like the risk/reward of the market currently, and continue to suspect a better opportunity to increase equity risk will come later this summer. If the market violates the 200-dma or the ascending wedge, as noted above, is breached to the downside, we will reduce equity risk and hedge further.

I will conclude this week with a quote from my colleague Victor Adair at Polar Trading:

“The growing divergence between the ‘stock market’ and the economy the past couple of months might be a warning flag that Mr. Market is too exuberant. The Presidential election is just over 5-months away with polls showing that Biden may be the next President. The U.S./China tensions have been escalating, and the virus’s first wave continues to spread around the globe. However, the ‘stock market’ continues to be pulled higher by a handful of ‘Megacaps.’ The late Friday rally after Trump’s ‘punish China’ speech shows ‘animal spirits’ are alive and well!”

I agree, and while such may be the case for the moment, markets like this have a nasty habit of delivering unpleasant surprises.

Pay attention to how much risk you are taking.

The MacroView

If you need help or have questions, we are always glad to help. Just email me.

See You Next Week

By Lance Roberts, CIO

Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders

S&P 500 Tear Sheet

Will return next week.

Performance Analysis

Will return next week.

Technical Composite

Note: The technical gauge bounced from the lowest level since both the “Dot.com” and “Financial Crisis.” However, note the gauge bottoms BEFORE the market bottoms. In 2002, the market retested lows. In 2008, there was an additional 22% decline in early 2009.

Sector Model Analysis & Risk Ranges

How To Read.

• Each sector and market  is compared to the S&P 500 index in terms of relative performance.
• The “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
• The risk range is a function of the month-end closing price and the “beta” of the sector or market.
• The price deviation above and below the moving averages is also shown.

Sector & Market Analysis:

Be sure and catch our updates on Major Markets (Monday) and Major Sectors (Tuesday) with updated buy/stop/sell levels.

Sector-by-Sector

Improving – Materials (XLB), and Energy (XLE)

This past week, the market finally broke out above the 200-dma. Materials continue to underperform due to a fragile economy, and there is no reason to maintain exposure to the sector currently.

We continue to hold our Energy sector (XLE) exposure, and we did add slightly to those holdings last week. We also are doing the same with our recent Real Estate exposures, which remain oversold on a relative basis.

Current Positions: 1/3 position XLE

Outperforming – Discretionary (XLY), Technology (XLK), Communications (XLC), and Healthcare (XLV), 

Previously, we added to our core defensive positions Healthcare, Staples, and Utilities. We continue to hold our exposures in Technology. This week we adjusted weightings in our portfolios to these areas specifically to alter our risk profile. These sectors are continuing to outperforming the S&P 500 on a relative basis and have less “virus” related exposure.

Current Positions: XLK, XLC, and XLV

Weakening – Utilities (XLU), and Staples (XLP),

After adding a small weighting in Utilities previously, we added to our positions in the equity portfolio this week. XLP is underperforming at the moment, but we continue to like the defensive qualities of the holdings, especially when a second wave of the COVID-19 virus occurs

Current Position: XLP, 1/3rd Position XLU

Lagging – Industrials (XLI), Financials (XLF), Real Estate (XLRE)

Financials continue to underperform the market. As we have said previously, Financials and Industrials are the most sensitive to Fed actions (XLF) and the shutdown of the economy (XLI).

Real Estate is lagging currently but remains a “risk-off” rotation trade, but is starting to show some relative improvement. If it turns up meaningfully, we will add to our current holdings.

Current Position: 1/2 position XLRE

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) – We continue to avoid these sectors for now aggressively, and there is no rush to add them anytime soon. With roughly 50% of small businesses expected to fail, there is significant risk in these two markets. Be patient as small and mid-caps are lagging badly.

The rally last week failed over the previous two trading sessions as expected. We expect to see further underperformance next week.

Current Position: None

Emerging, International (EEM) & Total International Markets (EFA)

Same as Small-cap and Mid-cap. Given the spread of the virus and the impact on the global supply chain, we continue to expect underperformance. There was a brief rotation rally last week like we have seen previously, that will likely fail next week. Continue to avoid these markets for now.

Current Position: None

S&P 500 Index (Core Holding) – Given the overall uncertainty of the broad market, we previously closed out our long-term core holdings. We are currently using SPY as a “Rental Trade” with the break above the 200-dma. We have stop set slightly below that support level.

Current Position: None

Gold (GLD) – Previously, we previously added additional exposure to IAU and currently remain comfortable with our exposure. We rebalanced our GDX position back to target weight previously.
We are also maintaining our Dollar (UUP) position as the U.S. dollar shortage continues to rage and is larger than the Fed can offset.

Current Position: 1/2 weight GDX, 2/3rd weight IAU, 1/2 weight UUP

Bonds (TLT) –

As we have been increasing our “equity” exposure in portfolios, we have added more to our holding in TLT to improve our “risk” hedge in portfolios. With the bond market oversold currently, we are looking at potentially adding more exposure next week.

Current Positions: SHY, IEF, BIL, TLT

Sector / Market Recommendations

The table below shows thoughts on specific actions related to the current market environment.

(These are not recommendations or solicitations to take any action. Such is for informational purposes only related to market extremes and contrarian positioning within portfolios. Use at your own risk and peril.)

Portfolio / Client Update

This past week, the market broke above the 200-dma, but it was overly convincing. We added a 5% “rental” trade to portfolios using SPY, which will increase to 10% if the market holds the 200-dma next week.

As discussed above, the market is extremely overbought. Still, there is some short-term upside as momentum continues to push stocks. The markets can “taste” all-time highs in the Nasdaq, which will pull the S&P 500 due to the largest cap-weighted names in both indices. As we head further into the summer months, the relative risk/reward ratio is not in our favor. (Please see the analysis in the main body of this week’s message.)

The economic data is getting substantially worse in “real” terms. Such is going to drag on earnings and profits, which the market will pay attention to eventually. While it certainly seems that no matter how dire the data is, the market only wants to go higher, such is also the trap. We are mindful of how markets work over more extended periods, but also realize performance is crucial to you. Therefore we continue to add exposure and balance risk as we can.

Changes

Our process this week remains the same. We continue to work around the edges to add exposure while managing risk. In the equity portfolios, we adjusted holdings, as noted in the main missive above, by taking profits and adding to defensive areas. Our additions of NFLX, and INTC, and increases in DUK and AEP, continue to balance risk appropriately.

We continue to hedge those increases in equity risk with additions to our bond and gold holdings. Our process is still to participate in markets while preserving capital through risk management strategies.

We realize there is more “trading” activity than usual as we work out way through whatever market is going to come. Is the bull market back? Maybe. Maybe Not. Once the bottom is clearly in, we will settle back down to a longer-term, trend-following, structure. Now is not the time for that.

We continue to remain defensive and in an excellent position with plenty of cash, reduced bond holdings, and minimal equity exposure in companies we want to own for the next 10-years. Just remain patient with us as we await the right opportunity to build holdings with both stable values, and higher yields.

Please don’t hesitate to contact us if you have any questions or concerns.

Lance Roberts

CIO