Archives for September 2015

Are We There Yet?

This feels like a family car trip with one of the kids constantly asking, “are we there yet?”

Much of what I have to say remains the same. Stocks have almost perfectly followed my post mini-crash scenario since August 24 and they are now in the zone for a possible successful retest of those lows between now and say, October 15. With the major indices opening sharply higher today, talk will once again focus on IF we have seen the bottom and this is day one of the rally.

Last Friday, we faced a similar set up, but I opined that the odds did not favor a low. Today, with the S&P 500 and S&P 400 retesting their closing lows from August and the Russell 2000 undercutting it, the odds now move to 50/50 that the final low has been seen. Even money is not an investing bet I would normally take as I typically like the odds to be in my favor. With that said, I think it’s better to pay a little higher prices than buy right here without an edge. In the end, I still think that another selling wave hits over the next few weeks.

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Was That It?

At their worst levels on Thursday, the major stock indices were bludgeoned and downright ugly. The Dow was down to 16,000 and could have been cracked open like a coconut today had the bulls not mounted a very strong late day charge. The rally was somewhat impressive and leaves open the question of whether we just saw the revisiting of the August lows I have spoken about on CNBC’s Fast Money and written about here. With stocks looking up more than 1% at the open, it will be interesting to hear what gets circulated in the media.

My take is that the odds do not favor yesterday’s low as being the final chance to get on board the train to new highs. It was a nice reversal, but I don’t think price went deep enough nor shook out enough weak handed holders during the day. In short, the decline was too orderly. I think more work needs to be done on the downside.

Looking at the calendar, it’s not a usual time to see a final stock market bottom, but that doesn’t mean we can’t see a low now. Additionally, we typically see a little more time go by from the crash low (Aug 24). More than likely, after selling off in almost straight line fashion since the Fed decision last week, the stock market needs to bounce short-term before heading lower to what I believe will be the ultimate bottom. As I continue to write, I am keenly interested in which sectors lead and lag during the rallies.

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Market Behaving as Expected. Bottom Shortly.

In my last update, I opined that the Fed should not raise rates and that whatever they did, the market would end whatever move it was having and reverse in the other direction. First, I am glad that Yellen & Co. did not raise rates. That time will come, but it wasn’t last week. Second, stocks rallied nicely into the Fed meeting and in the moments after the announcement. However, it was the perfect “buy the rumor, sell the news” as stocks reversed sharply shortly thereafter and closed near the lows for the day. I totally dismiss that the market was disappointed by the Fed’s lack of raising rates. That’s preposterous. Stocks rallied into the announcement in the classic ” buy the rumor” trend. Friday was an ugly day for the bulls and after the typical post-weekend, feeble bounce on Monday, the bears are out in full force today.

None of this action should come as a surprise as I wrote about post-crash behavior many times here and in Street$marts. From its intra-day low on August 24 to last week’s peak, the Dow jumped roughly 1500 points, retracing about 50% of what it lost since its last all-time high in May. Stocks are now in the throes of the secondary decline to revisit the levels seen in late August. I expect that visit to be successful within a few percent and eventually lead to all-time highs again.

The stock market doesn’t look pretty now and I don’t expect that to change until after the bottom is reached over the next two to four weeks. There will be all kinds of reasons not to buy when it’s time. “The market has lost confidence in the Fed.” “China is having a hard landing.” “Global economic growth is recessionary.” And on and on and on.

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Market Reaction to Fed Announcement

The big lingering question regarding the Fed meeting after the decision is how to properly position portfolios. If you thought it was tough to get an edge on the rate decision, the markets’ reaction is even more so, which is why I would absolutely not advocate making wholesale changes ahead of the announcement. It’s one thing to flip a coin on the decision, but it’s a whole other thing to get the markets’ reaction correct as well.

The four possible scenarios are below.

Rate hike and rally
Rate hike and decline
No hike and rally
No hike and decline

Before pondering that, I saw a few Tweets that suggested Yellen could raise rates with dovish comments or leave rates alone and offer hawkish comments. And if the Fed doesn’t raise rates now, we will be having this same discussion before the December meeting. It’s enough to make you head spin!

Regarding stock market reaction, the very short-term sentiment indicators still have sufficient enough pessimism to support further upside. If I had to lean, that’s the direction the odds favor right now, but I certainly would not bet the farm on it. Good thing for me since I don’t own a farm!

The Fed trend also has a 70% upward bias for the day, but some of that fuel was likely used this week.

Should stocks spike higher on the news and follow through, I will view that as a selling opportunity rather than a momentum buying opportunity, which should be the minority opinion.

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Will They or Won’t They

I truly cannot wait until September 17th at 2:01 PM. At that time, the Federal Open Market Committee, aka, the Fed, will make a decision about interest rates. I don’t know anyone who isn’t completely exhausted from all of the Fed talk over the past few months. It’s enough already. How many times do we need to see “Countdown to the Fed Decision”, “Special Report: The Fed”, “Breaking News…”, etc. Are there no other business stories worthy of being discussed in the media?

Here’s the deal. Unlike almost every other interest rate cycle change, the odds of a rate hike on Thursday are really about 50-50. The Fed has laid the groundwork for the markets to expect a rate at some point since Ben Bernanke’s famous Taper Tantrum speech more than two years ago. However, something keeps getting in the way.

Should the Fed raise short-term interest rates?

The market has already done so on the 10 year treasury note to the tune of 37%. Yes, you read that correctly. The 10 year yield has risen from 1.675% in February to 2.30% as I type this. And that’s not counting the move from 1.40% back in July 2012.

Since 2008, my thesis has been and continues to be that the Fed should not raise interest rates until the other side of the next recession. This is your “typical” post-financial crisis recovery that’s very uneven. It teases and tantalizes on the upside and frustrates and terrorizes on the downside. Another recession, albeit mild, is coming over the next few years. That’s okay. We’ll get through it. On the other side of it, our economy should get back to trend or average GDP growth, not seen since pre-2008. This could also coincide with Europe getting its fiscal act together after another sovereign debt crisis.

Anyway, I don’t believe the Fed should raise rates and I will guess that they don’t raise rates today. Inflation is nowhere to be found. Rumor has it that the Social Security Administration is using 0% for the 2016 COLA increase to social security benefits. Yes, I know all about the conspiracies to limit COLA increases to help the budget, but just look around you. Transitory things like energy and grains have collapsed. Wage growth is woefully pathetic. Money velocity has been in the perfect downtrend since 1998.

While the dollar has been very stable for the past six months, that comes on the heels of a 20% rally (huge in the currency market) over the prior 9 months, which can be considered a quasi-rate hike. The very dovish IMF and ECB are begging and pleading on hands and knees for Janet Yellen to leave interest rates alone. Think of all that emerging market debt denominated in dollars that has been hammered by dollar strength and will likely get much worse. Think about the currency imbalances with the dollar appreciating so mightily. A rate hike here will not be good for our struggling trading partners in Canada and Mexico.

Why raise interest rates?

I have heard some pundits use the word “credibility”. The Fed needs to hike rates to either preserve or establish credibility. I am sorry, but that’s idiotic and doesn’t need any further rebuttal. Some believe that an unemployment rate of 5.1% represents “full” or “maximum” employment and that a rate hike is necessary to cool the jobs market. Another reason I totally dismiss as unfounded. How about the labor participation rate at 62.80%, a 38 year low?!?!

Finally, there are those who believe our economy is growing strongly enough to warrant a rate higher than 0%. To me, that argument at least has merit and I can’t easily rebut it. The recovery remains uneven, but GDP is growing. I wrote a strongly worded piece after Q1 GDP printed so poorly that I totally dismiss it as yet another bad seasonal adjustment and that I thought Q2 and Q3 would print between 2% and 3%. I was wrong. It’s even better. However, with that, let’s not forget that wage growth remains awful and inflation is non-existent.

Interestingly, while Fed members have given speeches all over the place all year, Chair Janet Yellen has been uncharacteristically silent of late. You would think that if the Fed was about to raise rates, Yellen would be stumping with at least some trial balloons or hints. The rate hike argument has persisted for two years and without it, there hasn’t been any negative consequences. Why not continue to wait…

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Follow Up to Post Crash Behavior

Last week, I wrote a piece here and in Street$marts entitled, Post Crash Behavior Leading to Dow 20,000. If you haven’t read it, I think it’s a worthwhile read (of course I do since I wrote it!) whether you agree with the content or not. Subsequently, I was really excited to join CNBC’s Fast Money to discuss my research. A few things I want to add.

I used the word “crash” very liberally in my study. After “bubble”, crash is probably the most overused word in investing. True, historic stock market crashes typically only occur once in an investing lifetime. They are such emotional affairs and require years of setting up. It’s that perfect storm. We saw one in 1929 as well as 1987. The rest are really just large declines that accelerated like a crash. You can call them crashettes or mini crashes.

As Mark Twain said a “few” years ago, history rhymes, it doesn’t repeat. No two market environments or rallies or corrections are exactly alike. The market does its best to confound the masses most of the time. I remember in 1998 that the NASDAQ 100 actually went from its August mini crash when Russia defaulted on her debt, straight back to all-time highs in September, only to see another mini crash in October when Long-Term Capital blew up. The masses were generally hopping on board the tech train until the tech wreck hit a few weeks later.

If you look closely at my study, 2011 looks very similar to 1998 and 1987 for the most part, but not exactly. 1989, 1994, 1997 and 2010 are not highly alike although 1989 and 1997 are the most alike of the group. 2015’s price decline is similar to 2010.

In the end, it’s much healthier for the stock market to thrash around for 4-6 weeks and test the mettle of both bull and bear. That kind of constructive repair from all the damage done during the decline would set the market up for a potentially powerful fourth quarter rally. I would be very concerned if stocks just took off higher from here without looking back.

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How I Can Best Protect My Investments as the Markets Tank

The following is an article I wrote for Crains Wealth last week.

Investors don’t plan to fail. They fail to plan.

Markets typically pullback every month. Most pullbacks are nothing more than innocuous 3% to 5% dips – short bouts of weakness followed by new highs. Every quarter or so, the shallow pullback deepens to a 6% to 9% drop. Occasionally, full-fledged corrections of 10% or more take hold. Every four to five years, a bear market hits that lops at least 20% off of the major stock-market indices.

When investors think about protecting their investments, they usually don’t worry about the small pullback, and many don’t really care about the deeper one. It’s the steep declines of 10% or more that tend to test the mettle of the average investor. I know from my own client base that I rarely hear from anyone who is concerned until they see a stock-market decline, usually one that exceeds 10%, make headline news.

Before the stock market begins to decline, investors need to have a set of plans designed to remove emotion from the decision-making process. Whatever that process is, it absolutely cannot be a subjective decision, since countless studies have shown that emotion-based investing fails in all market environments. Don’t wait until the stock market is in full decline before establishing the plan!

In my firm, we use time-tested, sophisticated, quantitative and technical models to determine risk/reward ratios, allocations, position sizing and our overall exposure to various markets. However, it doesn’t have to be that complex.

Simple systems include selling a certain percentage of a position when it declines by a predetermined amount from a peak. Others use the 50-day, 100-day or 200-day moving average to generate buy and sell signals. Momentum investing 101 has guidelines for buying or selling securities after the return over a certain period becomes positive or negative, in essence betting on the continuance of an established market trend. Dow Theory involves watching the industrials and transports make new highs or breach secondary low points to determine how to navigate the investing environment.

After the investing plan is created there are a several methods to protect investments once the situation has been triggered.

The first is the easiest and simplest; securities are sold to raise cash. The small downside is that it becomes a taxable event, but in my business, tax considerations are secondary to opportunistic capital preservation.

Another way to preserve your investments is to hedge. That means once your plan triggers to take defensive action you buy a mutual fund or exchange traded fund (ETF) that goes up when a given market index or sector goes down.

A more complex and sophisticated method to protect a portfolio from decline is to buy put options or sell call options against the position. In this advanced case, the purchase of put options is preferred if volatility is low or if he anticipated decline is substantial. Selling call options may be a better choice if volatility is high or if the forecast weakness is on the more mild side.

Finally, good old fashioned, non-correlated asset diversification may be helpful.

In a modern-day equity portfolio, a Treasury bond mutual fund or ETF will often rise when stocks decline. Additionally, the Japanese Yen typically behaves in a similarly contrarian way and can be purchased through the CurrencyShares Japanese Yen ETF (FXY). During other periods over the past 40 years, commodities and real estate investment trusts (REITs) have sometimes been non-correlated to equities, but that hasn’t been the case during this bull market.

The most important takeaway is to create a comprehensive plan in advance and stick to it, no matter how stressful market conditions become.

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Post Crash Behavior Leading to Dow 20,000

The day before Flash Crash II last week, I opined that the bottoming process could begin as early as last week. From my seat, it did. One week removed from the mini crash or crashette and stocks took it hard on the chin again. China was blamed, but that’s only a cover story and coincidence. However, unlike August 24, we did not see another Flash Crash. There was no panic. The selling was fairly orderly, which can be viewed as a good thing and a not so good thing. Volume was on the light side. Market internals were abhorrent.

In short, stocks are shaking out from mini crash type action according to history. Of all the declines since the bull market launched in 2009, including the 20% one in 2011, the current correction gives the bears the most ammunition to claim that a new bear market has started. But before you jump to conclusions, read on…

I remain steadfast that while the bull market may continue to be old, wrinkly and not exactly the pillar of health, it is nonetheless alive. That’s the same conclusion I have drawn during each and every decline since 2010. The final peak lies ahead of us and that’s very likely to be north of 20,000 on the Dow.

I know. I know. I am crazy.

Who in their right mind would forecast fresh all-time highs ahead, let alone Dow 20,000 with China imploding and global recession supposedly all but a certainty. And there is always a risk I am wrong, but I do love being in a camp by myself!

So getting back to the action since August 24, you can see a few different ways in light green arrows on the chart below on how this bottoming action may play out. I chose those paths by looking at other similar action. There weren’t many over the past 30 years where a bull market peak was so close. That was criteria number one. The bull market peak was within two months of the crash.

Defining the actual crash isn’t as easy. It’s easy to spot in hindsight and you can certainly feel it when it’s happening. It’s rapid downside acceleration without any intervening rallies that usually leads to a 3%+ down day at the end.

I am going to take you through each occurrence to compare and contrast starting with the most recent. The years will be listed on each chart along with the “crash”, one of the most overused words in investing lexicon, and then where the final bottom was before stocks took off again to the upside.

On the surface, 2011 and 2015 look very similar although the decline in 2011 was more damaging and deeper. It took roughly six weeks to bottom.

2010 is next. That’s where we saw the first Flash Crash which doesn’t seem all that bad on the surface. This week’s action looks very similar to the three day rally immediately after the Flash Crash. The final bottom was eight weeks later and at prices significantly below the crash, something very unusual.

1998 is next and that looks exactly like what we saw in 2011. In fact, I wrote an article after the crash in 2011 forecasting that the final bottom would be a mirror image of the 1998 decline. In both instances, the decline was more than 20% and the final bottom was six weeks after the crash.

1997 is below and that crash behavior doesn’t really behave like the rest. Stocks pulled back a little, but the crash was essentially a one day decline that was sharply reversed the very next day.

1994 is next and while the decline was not even 10%, the post crash action was very similar to most other periods. I marked the final bottom 11 weeks later because that was low from which stocks finally rallied, but you can certainly argue that it was right at the day of the crash.

1989 has some similarities to 1997 in that it was essentially a one day outlier decline based on the leveraged buyout craze imploding with takeovers in United and American Airlines falling apart with Donald Trump involved. The bottoming process was fairly quick and not very painful with the final bottom occurring roughly four weeks later.

Finally, the greatest crash of the modern investing era was seen in 1987. Similar to 9/11, most people remember where they were and what they thought as the day unfolded. I recall my father launching a new discount brokerage business that very day. While I thought the timing could not have been worse, he often said that it was perfect since none of his clients lost any money on that day as there were no clients yet!

As with most of the other crash periods, the final bottom was seen some weeks later, six in this case.

Crashes, mini crashes, crashettes are all very emotional events. The most panic is typically seen during the crash when the market makes its internal or momentum low. There is usually a rally and subsequent final bottom some weeks later. The only caveat I will add is that the more pervasive the sentiment towards this behavior, the more the market will morph and confound the masses.

As always, please do not hesitate to contact me directly by hitting reply to this email or by calling the office at 203.389.3553.

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