Stocks Turn Bearish

The investment environment continues to deteriorate despite the pickup in economic activity in the U.S. the last couple of years.  As the Big Four Indicators I highlighted recently show, the U.S. economy continues to move in the right direction.

Despite the U.S. economy doing well, international economies are performing poorly with few catalysts outside of fiscal or monetary policy to drive them higher.    Europe is in disarray and in a speech yesterday, China’s Premier Xi, signaled little trade flexibility.

In terms of Monetary Policy (central banks), we are in uncharted territory.  On the one hand, market intervention potentially provides a mechanism to avoid financial contagion.  On the other hand, it has added a lot of debt to the global economy and relies on globalization to keep the party going.  The US and Europe are looking to reduce their exposure to globalization trends.

In terms of Fiscal Policy (government revenue/spending), deficit spending is projected for many years which is a concern after a 9-year economic recovery.

Constant increases in government debt, whether through monetary or fiscal policy, are likely to be a fixture of the 21st century economy.  Investors should expect more market intervention going forward.  My job is to manage the effects it has on investments and purchasing power.  Right now, it is looking like global markets are bracing for another round of asset deflation.

The biggest telltale sign of concern about the potential for further asset deflation is not coming from stocks, it is coming from bonds.  With the Fed now selling $50 billion dollars’ worth of bonds every month through Quantitative Tightening (the opposite of QE), analysts expected yields to go up and bond prices to fall.  That is not happening.  Money is moving to the safety of the 10-year Treasury bond.  Money flows to 10-year Treasuries when it is concerned about asset deflation.  10-year Treasury bonds are again yielding less than 3%!  Yields on the 10-year would be moving higher, and prices lower, if the bond market was expecting economic growth to continue.

Markets are signaling a high likelihood of ongoing asset price weakness. With each passing day more assets are breaking-down through price support levels.   It is entirely possible all of 2017 gains will eventually be erased although stocks still hold on to most of them at this point.

For this reason, I believe it is a good time to be a bit more defensive and raise cash levels.  Once the market settles down, available cash provides the ability to purchase growth investments at potentially lower prices.  Even if you end up reinvesting at higher levels, that is a price worth paying if it provides peace of mind during a turbulent period in the global economy.

The Big Four Indicators (12/7/18)

The Dshort website (part of Advisor Perspectives) hosts an incredible about of economic and market data.  Periodically I feature some of their work, specifically The Big Four Indicators update.  Taken together, these four indicators covering income, employment, retail sales and industrial production are thought to be an excellent monitor of the overall health and direction of the U.S. economy.

Advisor Perspectives, Jill Mislinski, December 7, 2018

The recovery from the Great Recession has been slow but positive.  The most encouraging development recently has been the strength coming from industrial production (purple line).

The Grind To Lower Valuations

Let’s think about the future for a moment.  After all, that is what the stock market is doing constantly.  Up to this point in 2018, the stock market has had a very positive view of the future.  Why wouldn’t it?  Corporate sales and earnings growth have delivered in the strongest economy since 2008.

In addition to an economy that is strengthening, we are also experiencing an innovation renaissance.  Quantum computing, space exploration, and organ replacement are just a few of the areas announcing major breakthroughs.  If you spend any time following science and technology news, rarely a week passes without a new scientific announcement.  Contrast that with the DotCom crash of 2000 where we were at the end of the personal computer revolution of the 1990.  The future did not look very bright.

The most important market to watch right now, in terms of what the near-term future may hold for stocks, may be high-yield (junk) bonds.  Many commentators point to the increase of debt by corporations as a major risk for the economy.  So far it is holding up remarkably well which is not what you would expect if the economy was about to fall in to a recession.

At some point in the future we will see another credit event like the sub-prime debacle of 2008.  That is the nature of a credit-based global economy and it will likely trigger a deep recession.  Perhaps we are on the verge of such an event but the high-yield market does not seem to think so.  It is holding up remarkably well considering how much corporate bond doom and gloom is being reported.

Stockcharts.com, Dightman Capital

If there were serous concerns in the high-yield bond market you would expect a bigger sell-off, but instead high-yield bonds appear to have decoupled from stocks.

I shutter to think what the global economic environment would be like without the corporate tax, personal tax and regulatory reform recently implemented in the U.S.  But I digress, that is the past.  What is more important is will these policies allow the U.S. economic expansion to continue?

In its totality this selloff has the character of a grind down to lower valuations; not a panic selloff with no bottom in sight.  I think the biggest surprise of this market could be the Dow, S&P 500 and Nasdaq reaching new all-time highs before we actually experience the next recession.  There are many things that could go wrong but I continue to believe we are experiencing an adjustment in valuations that will allow this market to resume the bull market rally; not the beginning of the end of the this cycle’s expansion.

Are Cracks Forming in the High-Yield Bond Market?

While high-yields bonds (HYG) have held up better than equities, there are signs of cracks forming.

Negative developments at GE have caused some to speculate more highly leveraged borrowers are looking at downgrades.  The lower tiers of investment grade ratings currently represent a large number of bonds and if we see a series of downgrades pressure could mount on the corporate bond market, both investment grade and high-yield.

I am still viewing this entire episode as a cycle slowdown and not the end of the cycle.  The Fed will likely put the break on interest rate hikes in 2019 if credit markets continue to rumble.  The real estate market has already broadcast a slowdown and change in buyer behavior attributed to higher interest rates.  Weakness in the corporate bond market has their attention.  One aspect that may be overlook in the corporate market, however, is the impact of corporate tax reform on the ability of borrowers to service debt more effectively.

The U.S. economy is still doing well and there may be more to come if congress can get together on an infrastructure project.  Trade talk with China remains a risk but so far the impact to the U.S. has been limited.

I have set another alert for the high-yield market.  Should it trigger I will become more concerned about junk bonds rolling over which would likely represent a negative development for stocks.

Sellers Push Markets Lower; Most Stock Breakouts Hold

After a swift and intense decline in October, U.S. stocks are trying to rally but face renewed selling pressure in November.

One of the current challenges is the performance of international stocks.  The economic recovery and central bank policies of Europe, Japan and China continue to lag results in the U.S.  This divergence has created a significant valuation gap and instead of international stocks catching-up to the U.S., investors may be looking to revalue U.S. stocks lower.

Here is a look at the Price to Earning (P/E) and Price to Book (P/B) ratios of international (EFA) and emerging market (EEM) stocks compared to the S&P 500 (IVV).

IVV  P/E 23.29, P/B 3.33  (U.S. Stocks)

EFA  P/E 13.87, P/B 1.59  (Developed Country Stocks)

EEM  P/E 11.94, P/B 1.52  (Emerging Market Stocks)

State Street, BlackRock, Dightman Capital as of 11/12/18

As the data above shows, U.S. stocks are trading at a premium to the rest of the world.  The P/E ratios above are calculated using 12-month trailing earnings.  If 12-month forward earnings estimates were used the P/E ratio for US stocks would be significantly lower.  Strong earnings growth projection for U.S. stocks explains why there is such a large difference between trialing and forward P/E calculations.

The risk to U.S. markets is a reduction in the P/E and P/B ratios through lower stock prices despite a healthy U.S. economy and corporate earnings environment.  Stocks could trade down another 10-20% from current levels to narrow the gap but U.S. stocks should be able to maintain their independent valuation despite lower growth and valuations in other parts of the world.  This would be based on continued sales and earnings growth.  High growth environments are often reward with premium valuations.  In terms of opportunities in international stocks, eventually they may represent an attractive investment opportunity but as a group they appears to have more economic work to complete before they can stage a strong recovery.

Interestingly, leading growth stocks have held-up pretty well during the selling this past week with the number of stocks reaching new highs for the NASDAQ well above lows back in October.

It will be important for the New Highs-New Lows index to move back into positive territory.  The performance of leading stocks is an important sign of when to potentially take defensive action.  If high-growth stocks are holding up in a market correction, the likelihood of a bear market is lower.

End of This Cycle

Some commentators are suggesting we are at the end of this cycle.  However, they may be failing to recognize that in this cycle we spent the first 8 years in repair mode and only recently began a phase of strong economic growth.

Weak Credit Markets

Another clue to the health of the overall environment can be found in credit markets.  Some commentators have suggested the flat yield curve is a sure sign of a pending recession.  What they may fail to realize is this is a common occurrence for years leading up to a recession as short-term rates move higher while long-term rates remain somewhat anchored due to a deflationary trend cause by globalization.  We are only one-year into a rate rising process and remain at very low rates.  Some rate sensitivity has been reported which may help The Fed pause at some point in 2019.

High-yield bonds are holding up well which is something we would not expect if we were moving towards a change in the market cycle.

Mid-Term Results

The stock market had a strong day on November 7th and some observers believe there is a reasonable chance of an infrastructure bill passing which should be well received by the market.

Trade Negotiations

In terms of the international trade, progress has been accomplished.  However, China and the U.S. have very different approaches, definitions and attitudes on the subject which could mute economic growth next year if an agreement is not reached.

There are always risks and “what if” considerations when monitoring market cycles.  On balance I believe we are still in an expansionary phase economically which could last longer than many people anticipate.  There are risks and conditions could change quickly but in total I believe the current selling is corrective in nature, and even if we see additional declines, I believe stocks will resume the current uptrend.

Brutal Correction

Back on October 15th in market commentary I wrote, “A scenario is developing which could push stocks further into the red in the coming days and weeks…”

On October 20th I wrote, “I do not expect the current situation to resolve itself quickly.”

To be fair, the stock market could have moved higher from each of those dates, but it hasn’t, the selloff has intensified.  There is one primary reason I felt it could get worse before it gets better.  This is a mature market.  I don’t believe the I bull market is over.  I do believe, for it to continue advancing, values need to be reset and that is what is happening.

Those investors with more than a few years of investment experience know that periodically we enter into corrections and occasionally bear markets.  The difference between a correction and a bear market has to do with the degree of the decline.  Bear market also usually last much longer.

The primary culprit of the current sell-off is interest rate related.  The good news is that a statement by the Fed that they are going to review future rate hikes and reconsider their plans could stabilized the market.  This is likely to happen if the situation deteriorates any further.  A credit/consumption-based economy is very sensitive to interest rates.  Like a ballast, interest rates have the potential to tip the stock market if they rise to far too fast.  Several real estate reports have recently indicated a slow-down in activity being attributed to higher interest rates.

Corrections are a necessary part of investing.  They allow the market to reassess value.  Higher interest rates require future cash flows for stocks to be discounted at a higher rate causing them to be worth less. Once the market has revalued stock prices based on higher interest rates the bull market underway should continue.  A pause in rate hikes could make this process smoother.

It is possible we could see the situation deteriorate further.  If it does investors are best served to hold tight.  Often the market overreacts in this type of situation but eventually sprints higher.  You don’t want to be out of the market when that happens.

Of course, investments in money markets, bonds and gold can provide some refuge during difficult stock market conditions.

Triggered Alerts – 10.23.18

Marketsmith, Dightman Capital

Immediately at the open this morning I had two alerts trigger.  One alert was for stock based investment that was under selling pressure.  The volume of shares traded immediately at the open was much larger than normal.  Overall, the price was down around 2%; firmly below the 200dma (black line).  As I suggested in recent commentary related to the current selloff, the additional selling I thought had a good chance of materializing has arrived.

Marketsmith, Dightman Capital

The other alert I received this morning was related to gold.  The ETF GLD gapped up at the open and looks poised to continue climbing.  This is the type of action you look for from gold in a portfolio.  According to ETFReplay.com, the ETF GLD has a correlation to the S&P 500 ETF SPY of +0.08, which is only slightly positive.  Correlations have a tendency to change and right now gold appears to be delivering a negative correlation, which is what you what to see during a stock market selloff.

Evaluating Current Market Support and Breakout Levels

Stock market trading settled down this past week providing an opportunity to evaluate trading levels and set technical alerts for support and breakout points.

Below is a snapshot of a equity investment I follow closely.

As you can see in the chart, it has been seven days since the investment closed below the 200 day moving average (Black Line Below Price Bars).  During the last 5 trading days support has been held at this line.  Notice the investment has closed just above this support the last two days and at the bottom of the range of the trading range (Small Horizontal Line Across The Longer Vertical Blue & Red Lines Represents The Closing Price).  Volume has been heavy (red and blue vertical bars in the section below the price) which suggest sellers were met with an equal level of buying at these prices.

Marketsmith, Dightman Capital

The first support level for this investment is currently near the 200dma (day moving average).  There is also support at the bottom the price range where this investment traded below the 200dma.  It is too early to tell if we will revisit those levels again but so far buyers have been willing to come in and support a price above the 200 day line.  Continued support at the current price level would suggest the worst of the selling is behind us.

Trading this last week has also provided a potential break-out price level.  If the price of this investment moves above the trading level from 3 days ago, that would indicate buyers have regains some control which may indicate the worst selling from this correction is behind us, increasing the likelihood we rally into year end.

I do not expect the current situation to resolve itself quickly.  I believe investors are reluctant to come into this market because so many commentators are suggesting this is the beginning of the end of this bull market.  It believe they are wrong and those investors that take an overly defensive position into 2019 may be leaving money on the table.

We have two big dynamics at play that are supporting this market.  A strong U.S. economy, which we have not had since the Great Recession of 2008, and a technology renaissance touching a wide variety of industries.

Excellent Technical Analysis Example

There are a lot of technical indicators used by stock investors.  Some screens are so filled with colors, lines and data it tough to make heads or tails from what you are looking at.

It is helpful to remember there are only two data inputs.  Price and Volume.  Price determines the trade direction and volume establishes conviction.  Focusing on these two variables and adding a simple relative strength indicator can yield a great deal of information about the potential near-term price action.

Take the example below.  This is a high-growth tech stock that has delivered outstanding returns to investors over the last couple of years.  This stock when public in 2015.

Marketsmith, Dightman Capital

In weekly chart above we can see three different basing patters (identified by the green dots and curved line).  Two of these bases were consolidation types and the middle base was a cup w/handle type (the handle slopped upward which is a potential concern).  The most telling part of the current late stage base (also a warning) can be seen when comparing it to the prior consolidation base of about a year ago.

Notice how the current base is downward sloping (current price is near the bottom of the base range).  The base this stock produced over a year ago featured the price staying more in the middle and then upper range.   You should be able to see an upward sloping trend just looking at it.  The current consolidation is producing the opposite, a downward slope.

Below the price bars you see the blue relative strength (RS) line. The RS line measures the price performance of a stock with the price performance of the S&P 500.   If the line is trending higher it is outperforming the market.  For growth investors often a new high on the RS line is a bullish buy signal.  It is extra bullish if this line hits a new high ahead of the price.

In this example, the RS maintained an upward slope during the first two bases.  Now it is starting to exhibit a downward slope.  The red lines over the RS were drawn to show the change in slope.  Notice how in the first base the slope of the RS line initially weakened.  This is normal and to be expect as a stock rests.  It is possible the stock above will still move higher and the RS line will turn higher.  But, if the price of this stock moves below the bottom of the current base consolidation, that would increase the probability this stock is going to see weaker price performance in the near-term.