In this issue of “Market Holds 200-DMA, Bulls Remain In Control.”
- Market Holds Bullish Support
- From Bubble, To Bust, To Bubble
- The Problem With 2-Year Forecasts
- A Bearish Pattern Remains
- Portfolio Positioning
- MacroView: Rationalizing High Valuations Won’t Improve Outcomes
- Sector & Market Analysis
- 401k Plan Manager
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Catch Up On What You Missed Last Week
Market Holds Bullish Support
Last week, I updated the analysis on the break above the 200-dma, which changed the market’s complexion.
“If the markets can break above the 200-dma, and maintain that level, it would suggest the bull market is back in play.”
Then, in our Tuesday follow up, we discussed how the markets had pushed to more extreme overbought conditions and the importance of the market to hold the 200-dma on a subsequent correction.
“That correction came swiftly on Thursday. The surge in COVID-19 cases in the U.S. undermined the “V-Shaped” economic recovery meme. As we noted, the market had rallied into overhead resistance, and the correction found support at the 200-dma.”
As we saw in April and May after the initial surge off the March 23rd lows, the market has once again begun to consolidate its gains to work off the short-term overbought extension. With Friday’s sell-off, we can update our risk/reward range, which has turned more positive in the short-term.
- -2.9% to the 200-dma vs. +4.9% to recent highs. Positive
- -5.7% to the 50-dma vs. +9.1%% to all-time highs. Positive
- -11.2% to previous consolidation lows vs. +9.1% to all-time highs. Negative
- -15.2% to March bounce peak vs. +9.1% to all-time highs. Negative
However, the market reversal on Friday from a strong opening to a weak close, is a good reminder of just how volatile markets can be. Despite the technical backdrop becoming more bullish short-term, we hedge our portfolios against just this type of risk.
From Bubble, To Bust, To Bubble
In January and February of this year, we wrote articles discussing why we were taking profits from our portfolios and reducing overall portfolio risk. In “This Is Nuts,” we stated:
“When you sit down with your portfolio management team, and the first comment made is ‘this is nuts,’ it’s probably time to think about your overall portfolio risk. On Friday, that was how the investment committee both started and ended – ‘this is nuts.’
We discussed the overbought, extended, and complacent market over the last couple of weeks. Still, on Friday, I tweeted out a couple of charts that illustrated the excess.”
That was on January 6th.
Yesterday, I tweeted out some interesting charts:
— Lance Roberts (@LanceRoberts) June 19, 2020
— Lance Roberts (@LanceRoberts) June 19, 2020
Put/Call ratio is at the 19th most overbought day in 20 years.
Few days ever reached such an extreme level. This is even more extreme than at the stock market's top in *February 2020*
This is an important risk for equities – monitor carefully. pic.twitter.com/uV719FM0yx
— SentimenTrader (@sentimentrader) June 19, 2020
This Is Nuts
Our portfolio management meeting Friday morning started with “This is nuts.”
Importantly, I want to direct your attention to the Nasdaq, which is where portfolio managers have been stuffing cash.
There are several things to note about the chart above:
- Every time, and it is only a function of time, the Nasdaq gets extremely extended above the 2-year moving average, it reverts to, or beyond, that average.
- The MACD is more extremely extended currently than in the past 25-years.
- The current deviation above the 2-year moving average matches the extension seen in February before the collapse.
On the S&P 500, there are warning signs as well. As shown below, the number of stocks on “bullish buy signals” has reached an extreme weekly. Historically, such extremes have preceded short-term corrections and bear markets.
Also, as noted last week, the number of S&P 500 stocks trading above their 50-dma has peaked and started to turn lower. Such has always been a precursor to a short-term correction or worse.
At the moment, the over-riding investment belief is that markets can’t decline because of the Fed. However, all it will take is an unexpected, exogenous event to trigger selling and quick correction of 10-15% due to the current lack of liquidity in the market.
What could such an event be? I have no clue. The market has already factored that in a second wave of the Virus. However, one thing no one is currently expecting is for states to shut down commerce once again. I don’t think that will happen either, but you get my point.
Again, this is why we maintain our hedges.
The Problem With Two-Year Forecasts
As markets get overly bullish, extended, and exuberant, Wall Street tends to come up with new ways to “sucker,” I mean “rationalize,” investors into taking on additional risk.
One thing I had hoped for in 2018-2019 is that we would get a correction large enough to revert some of the excessive valuation levels which existed. Such would provide higher future rates of return over the next decade, allowing investors to reach their investment goals.
Instead, through the Fed’s actions, the correction was halted, and the “clearing process” was not allowed to occur. The outcome has been even higher levels of corporate leverage, and valuations remain grossly elevated on many different levels.
So, how does Wall Street justify “buying stocks” in the current environment of recessionary economic growth, high unemployment, and collapsing earnings? Easy, you just tell uneducated investors to use earnings estimates 2-years in the future.
“Yes, stocks are expensive based on current earnings, but cheaper using earnings in 2022.” – Wall Street
Faulty Analysis Leads To Faulty Outcomes
There are significant problems with this analysis. The first is that even based on 24-month estimates, stocks are still historically expensive.
Secondly, Wall Street is terrible at estimating forward earnings. Historically, forward estimates are about 33% too high before they are ratcheted sharply lower. So, even if you assume the stock prices don’t move over the next two years, as future estimates are lowered, valuations will rise further.
Using Wall Street logic, if you were buying stocks in 2018 using 2020 estimates, you grossly overpaid for value and wound up paying the price.
Lastly, think about the stupidity of the statement for a moment.
You are paying for earnings two years into the future. Such means that you will have NO appreciation in the price for two years to maintain the “valuation” of what you paid today. Furthermore, every year going forward will have to have higher earnings estimates than current just to maintain the same valuation.
Such is why valuations are so important. By overpaying for assets today, and locking in earnings 24-months into the future, you have guaranteed yourself a long-term period of low returns.
Do you now understand why Buffett is sitting on $137 billion in cash?
A Bearish Pattern Remains
In the short-term, however, the technical backdrop of the market keeps the bulls in control. The market had gotten overheated, but the correction over last week successfully retested the 200-dma.
However, on a monthly basis, there is still a more “bearish” pattern in the works. The broadening range of highs and lows, known as a “broadening” or “megaphone” pattern, is characterized by two diverging trend lines. As noted by Investopedia:
“Broadening formations occur when a market is experiencing heightened disagreement among investors over the appropriate price of a security over a short period. Buyers become increasingly willing to buy at higher prices, while sellers always find more motivation to take profits. This creates a series of higher interim peaks in price and lower interim lows. When connecting these highs and lows, the trend lines form a widening pattern that looks like a megaphone or reverse symmetrical triangle.
The price may reflect the random disagreement between investors, or it may indicate a more fundamental factor. These formations are relatively rare during normal market conditions over the long-term since most markets tend to trend in one direction or another over time. For example, the S&P 500 has consistently moved higher over the long-term. Therefore the formations are more common when market participants have begun to process a series of unsettling news topics. Geopolitical conflict or a change of direction in Fed policy, or especially a combination of the two, are likely to coincide with such formations.”
The Technical Chart
You can understand why there is a disagreement among investors given the current backdrop of a recessionary economy and a bullish stock market driven by the Fed. The ongoing “broadening formation,” which is typical of longer-term market tops, is coupled with a negative divergence in the Relative Strength Index.
Given this is a “monthly” chart, such doesn’t mean the market will crash tomorrow, if even at all. However, it is one of those warning signs which continue to suggest a bit of caution in portfolios is likely advisable.
Portfolio Positioning Update
With our portfolios almost fully allocated towards equity risk in the short-term, we remain incredibly uncomfortable. As noted on Tuesday:
“From a purely technical perspective, the bulls remain in control for now. Fundamentally speaking. However, we remain ‘bears.’ We also realize that with the Federal Reserve intravenously feeding liquidity into the markets, we need to participate. As we stated last week:
“As a portfolio manager, we buy ‘opportunity’ because we have to. If we don’t, we suffer career risk, plain and simple. However, you don’t have to. If you are indeed a long-term investor, you have to question the risk undertaken to achieve further returns in the market currently.”
As noted, fundamentals will eventually matter. We just don’t know when that will ultimately be the case. However, there are more than enough signs to know we are likely close to a peak:
- Wall Street firms using 2-year forward “operating (or B.S.)” earnings to justify valuations.
- Investors are chasing bankrupt companies.
- Companies rampantly issuing debt to shore up liquidity
- A complete lack of market liquidity.
- Investor over-confidence
- Retail investor exuberance.
- Overly estimated future earnings growth.
You get the idea.”
As I stated, we are participating, but it doesn’t mean we have to like it. We just have to respect the market for what is.
We continue to hedge our equity exposure with fixed income, dollar, and gold investments. While such hedging does reduce the participation of our equity portfolio short-term, it has mitigated the risk of sudden and unexpected sell-offs.
We are very confident we are not in a “no risk” market currently.
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
Sector Model Analysis & Risk Ranges
How To Read.
- The table compares each sector and market to the S&P 500 index on 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 table shows the price deviation above and below the weekly moving averages.
Sector & Market Analysis:
Be sure and catch our updates on Major Markets (Monday) and Major Sectors (Tuesday) with updated buy/stop/sell levels.
Improving – Materials (XLB), Industrials (XLI), and Energy (XLE)
While Industrials moved into the improving category, performance overall remains concerning with a failure at the 200-dma. Materials and Energy also corrected this past week. We had previously reduced our exposure to XLE two weeks ago. We recommend profit-taking previously, which worked well, and now we are looking for an opportunity to add exposure safely.
Current Positions: XLE
Outperforming – Technology (XLK), Discretionary (XLY), and Communications (XLC)
Discretionary, which had gotten very extended, and has corrected this past week. The sector is still very overbought, so more correction is possible. We suggested profit-taking in positions last week. The same goes for Communications, which has also had a major rise and is extremely overbought and deviated from long-term trends. Technology, unsurprisingly, moved back into the leading category as money is once again flowing into “big tech” to hide.
Current Positions: XLC, XLK
Weakening – Healthcare (XLV)
Previously, we added to our core defensive positions Healthcare, Staples, and Technology. We continue to hold these sectors as they have been outperforming the market overall during the correction over the last couple of weeks hedging other equity risks.
Current Position: XLK & XLV
Lagging – Utilities (XLU), Financials (XLF), Real Estate (XLRE), and Staples (XLP)
Financials continued to underperform the market. We had recommended taking profits last week, but we currently maintain no exposure.
Our defensive positioning in Real Estate and Utilities has lagged but remains part of the “risk-off” rotation trade. We see early signs of improvement, suggesting it is the right place to be. If it turns up meaningfully, we will add to our current holdings.
Current Position: XLRE, XLU, & XLP
Market By Market
Small-Cap (SLY) and Mid Cap (MDY) – We stated last week that both of these markets were extremely overbought and susceptible to a pullback. That pullback continued this week. Both markets violated important support. We maintain no holdings currently.
Current Position: None
Emerging, International (EEM) & Total International Markets (EFA)
Same as Small-cap and Mid-cap. As noted last week, “There was a brief rotation rally last week, which will likely fail in the next week or so. Continue to avoid these markets for now.” That rally appears complete for now. We will watch what happens next week.
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 DIA as a “Rental Trade” to pick up some bulk exposure for trading purposes.
Current Position: None
Gold (GLD) – We currently remain comfortable with our exposure through IAU. We are also maintaining our Dollar (UUP) position. No changes as these hedges are offsetting our increased equity risk.
Current Position: IAU, 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. However, with yields so low, and with the Fed supporting the mortgage-back and corporate bond markets, we swapped our near zero-yielding short-term Treasury funds for Mortgage-Backed and Broad Market bond funds with 2.5% yields.
Current Positions: TLT, MBB, & AGG
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
On Monday and Tuesday, the market rose sharply, holding support at the 200-dma. That hold of support confirmed the bullish trend of the market for now, keeping our portfolios tilted toward equity risk.
Interestingly, last week I made of our position in TLT:
“Not surprisingly, we were getting a lot of phone calls questioning our portfolio hedge in TLT, which was lagging as the market rallied. The surge in TLT during the vicious decline last week was a solid reminder of why we hedge.
Risk is what happens when things go wrong. As noted last week, I am willing to “lose a battle” short-term, to the “win the war” longer-term. After all, it is YOUR money we are putting at risk, and we take that responsibility very seriously.
Given the volatility of the market this past week, TLT, along with positions in the U.S. Dollar and Gold, continued to hedge risk against market volatility.
In both the ETF and EQUITY portfolios, we added a DIA rental position to give us both some broad market exposure plus some additional exposure to basic materials companies. DIA broke above the 200-dma and is playing catchup with the S&P 500. If the markets are going to move higher, DIA will give us some additional participation in the short-term.
However, we also backed up that increased equity exposure by making some swaps in our bond holdings. With yields so low, and the Fed active in the bond markets, we swapped out of our extremely short-duration Treasury holdings into Mortgage-Backed (MBB) and Broad Bond (AGG) market exposures. This move not only gives us some duration exposure to participate if yields fall further, which we expect, plus an increase in yield towards 2.5%.
We continue to hold our hedges for now as both UUP and TLT have begun to rally from deeply oversold conditions.
We continue to remain defensive, but we are nearly fully allocated to equity markets currently. While the Fed is active in the markets, we must participate, but that doesn’t mean we can’t do it with a bit of “risk” control.
Please don’t hesitate to contact us if you have any questions or concerns.
THE REAL 401k PLAN MANAGER
A Conservative Strategy For Long-Term Investors
If you need help after reading the alert; do not hesitate to contact me
Model performance is a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. Such is strictly for informational and educational purposes only and should not be relied on for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril.
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Lance Roberts is a Chief Portfolio Strategist/Economist for RIA Advisors. He is also the host of “The Lance Roberts Podcast” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, Linked-In and YouTube
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