Back at the start of the third quarter in this year, our
valuation model selected the utilities sector as the sector with the most
value. There was a smaller position in the SPDR Utilities ETF (XLU) in the
portfolio that was added at the start of the fourth quarter 2014 that had
performed nicely versus the S&P 500. The addition to the position brought
the total portfolio weighting for XLU up to 25%. The latest movement in the
sector has us pleased thus far.
We initiated and added to the position based entirely on our
fundamental modeling but the recent technical action provides us with
additional confidence that we have made the proper adjustments.
XLU has been one of the strongest sectors over the past few
months rising almost 10% in that time span. Looking at the chart below we see
that both the RSI (5) and stochastics are signaling over-sold readings so a
near-term pullback should be expected. Depending on the magnitude of the
pullback, we are cautiously optimistic that this sector can continue to outperform
the broader index for some time. The longer-term trend seems to be
materializing and it is pointing to higher stock prices. The RSI (14) rose
above the 50 level and the weekly MACD line made a bullish pass through the
signal line. The EMA (20) approached the EMA (50) but never penetrated it to
the downside and is now rising again.
Almost two-thirds of the companies in the XLU ETF are in a
bullish point & figure formation, up significantly from 40% a few months
ago. We’d like to see a bit more of a broad based rally within the sector as
the equal-weight ETF is still lagging the market cap weighted ETF but we could
see that strength improve if the coming pullback proves to be shallow.
While we are happy that one of our recent allocations are
panning out, the sector outperformance tells us a bit more about overall market
conditions. For one, it portrays a reduced level of confidence in the overall
economy as utilities are generally considered to be an economically defensive
sector. Along with the utilities sector, one would expect the consumer staples
sector to confirm this, which it has. The consumer staples sector, also an
economically defensive play is one of the few sectors that is exhibiting
increasing momentum of late as the rest of the market is stalling.
In addition to a lack of economic confidence it may also
signal that the fears of tighter monetary policy are overdone. Looking at the
price action of longer term U.S. treasuries, one will also see a positive shift
in momentum. Similar to the utilities and consumer staples sectors, TLT
(iShares +20 year gov’t bond ETF) has its RSI (14) over 50 and he weekly MACD
has signaled positive momentum. As is the case with the utilities and consumer
staples sectors, we are expecting a near-term pullback of TLT but should the
pullback be minor and the positive momentum continues to pick-up, we would
expect the broader markets to weaken. The trading pattern of these three ETF’s
is not indicative of a thriving economic outlook nor a strong rally in the
broader stock market. Time will tell and we believe the coming action off of
near-term weakness will be a telling signal of things to come.
Michael A.
Gayed, CFA writing for Seeking
Alpha stated, “Meanwhile, the bond
market is sending powerful messages here. Friday's payroll report on the
surface suggests that the Federal Reserve will likely raise rates in September
as hiring continues along its mediocre pace. Stocks fell and long-duration
Treasuries (NYSEARCA:TENZ) rallied on that to cap off the week with meaningful
yield curve flattening. This is important to pay attention to. The bond market
seems to be anticipating that disinflationary and contractionary pressures are
rising. This is problematic for the Federal Reserve because if they do raise
short-term rates in September, the long-end of the curve suggests it could be a
significantly negative force, in turn increasing volatility (NYSEARCA:VXX) in
risk assets to the point that it may force monetary policy makers to rethink
the robustness of economic activity. This in turn should also make the stock
market doubt its own discounting of a future which simply never comes. As
proven in our award winning paper which can be downloaded by clicking here,
stock market volatility tends to rise after such price action in Treasuries
takes place.”
Credit Spreads
A recent article in Bloomberg
Business pointed out, “Credit traders
have an uncanny knack for sounding alarm bells well before stocks realize
there’s a problem. This time may be no different. Investors yanked $1.1 billion
from U.S. investment-grade bond funds last week, the biggest withdrawal since
2013, according to data compiled by Wells Fargo & Co. Dollar-denominated
company bonds of all ratings have lost 2.3 percent since the end of January,
even as the Standard & Poor’s 500 index gained 5.7 percent. “Credit is the
warning signal that everyone’s been looking for,” said Jim Bianco, founder of
Bianco Research LLC in Chicago. “That is something that’s been a very good
leading indicator for the past 15 years.” Bond buyers are less interested in
piling into notes that yield a historically low 3.4 percent at a time when
companies are increasingly using the proceeds for acquisitions, share buybacks
and dividend payments. Also, the Federal Reserve is moving to raise interest
rates for the first time since 2006, possibly as soon as next month, ending an
era of unprecedented easy-money policies that have suppressed borrowing costs.”
“All of this has
corporate-bond investors concerned enough that they’re demanding 1.64
percentage points above benchmark government rates to own investment-grade
notes, the highest since July 2013, Bank of America Merrill Lynch index data
show. That’s also the biggest premium relative to a measure of equity
volatility since March 6, 2008, 10 days before Bear Stearns Cos. was forced to
sell itself to JPMorgan Chase & Co., according to Bank of America Corp.
analysts led by Hans Mikkelsen in an Aug. 13 report. “Unlike the credit market,
the equity market well into 2008 was very complacent about the subprime crisis
that led to a full blown financial crisis,” the analysts wrote. “While we are
not predicting another financial crisis, we believe it is important to keep
highlighting to investors across asset classes that conditions in the high
grade credit market are currently very unusual.” So if you’re very excited
about buying stocks right now, just beware of the credit traders out there who
are sending some pretty big warning signs.”
S&P 500 - Fundamental
and Technical Problems
We have written
in the past that we believe the stock market is fundamentally overvalued currently.
While we are still unclear what will be the ultimate catalyst to “break the
bull”, we have also pointed out in previous postings here, here
and here
that market internals appear to be breaking down somewhat. We believe we are at
a critical stage in the bull market that will set the stage for a rapid
movement in the U.S. stock market.
This wait and see mode is apparent to many fellow market
watchers.
S&P 500
Decision Time? – The Short Side of Long: “Just a quick update regarding the S&P 500. For now, the US large
cap index continues to trade above the 200 day moving average. By October of
this year, it will be exactly 4 years since the index has suffered a 10% on the
closing basis. That is one of the longest stretches in years. Furthermore, if
we close above the 200 MA by this Friday, it will be 184 out of 188 weeks of
trading above this moving average. Obviously, the longer this rally goes on
for, the more risk builds into it. But for now, speculators just need to
concern themselves with the tight range in S&P 500, as seen in the chart
below. A break in either direction should be close…”
Planning for the
Worst
In our analysis last week we stated that we were initiating
portfolio protection should there be a weakening stock
market. We wrote, “Market fundamentals
are signaling over-valuation and market sentiment/momentum appears to be
weakening. This along with less accommodative monetary policy on the horizon
increases the risk of a market correction, in our view. We will maintain our
existing portfolio but will start introducing “portfolio insurance” in the
coming weeks and months as the market dictates. It is impossible to predict
market tops and bottoms but it is prudent to alter the risk profile of the
portfolio with changes in market data. We’d rather risk a portion of future
upside if we are wrong in our analysis than risk previous gains if we’re right.”
Indeed having an action plan in place is an important part
in the task of asset management. We are certainly not trying to “time the
market” or pick tops and bottoms. In our view that is a futile process and
impossible to do with any type of consistent accuracy. We have our positions in
place based on our analysis but are willing to adjust the risk parameters
within the portfolio to provide added hedging protection should we be correct
in our assumptions of a softer outlook. If we are wrong, then our expectations
are that the positions in the portfolio will continue higher and we would have
sacrificed a small portion of capital appreciation in return for portfolio
insurance and investor peace of mind. Perhaps if enough investors take this
portfolio approach, the coming correction may never materialize. A recent
posting from Ivanhoff
Capital states the possibility. “One
could argue that if enough people believe there’s a deep correction coming,
everyone will sell and actually cause this correction to happen faster and be
even bigger. The truth is that funds that actually move markets don’t go to
100% cash. They just reallocate capital between less liquid, but more lucrative
asset classes and hedge. Since everyone will start buying protection,
volatility will spike. Equity prices might not drop more than a few percent
because most funds would be already protected and they won’t sell their
positions. Put options will expire worthless. Correction predictors will be
made fun of. Everything will go back to normal. By definition, deep market
correction always comes by surprise for most. If enough people expect a
correction and act on their perceptions, it will either not happen at all or it
will be much shallower than most expect. I’d be a lot more concerned when the
market is down 5% and everyone is blindly buying the dip than when the market
is down 5% and implied volatility is through the roof because everyone is
afraid and buying protection.”
Whatever the market has planned for us, we just want to
avoid a situation where a client goes through a panic selling mode. Panic
selling without a plan in place is a sure way to destroy assets.
Panic Selling
Speaking of panic selling, I read an interesting article in Business
Insider that addresses panic selling. They write, “Investing in the stock market isn't for everyone, especially the
faint-hearted who can't handle the downs as well as the ups of the market. Even
in big bull markets, you'll see dips in stock prices. Successful investors
outperform by being patient and riding out the volatility. Losers panic and
sell at what might appear to be the beginning of downturns. Losers make the
mistake of thinking they can predict what'll happen next and unsuccessfully
time the market. Bank of America Merrill Lynch's Savita Subramanian examined
what happened to stock market investors who sold at the first signs of
volatility. "We compare a buy-and-hold strategy vs. a panic selling
strategy from 1960-present," she said in a recent note to clients.
"We assume an investor sells after a 2% down-day and buys back 20 trading
days later, provided the market is flat or up at the end of that period." Can
you guess what happened? "This strategy underperforms the market on a cumulative
basis since 1960 both overall and during every decade, given the best days
typically follow the worst days."
“The table below shows
how sitting in the S&P 500 compared to panic-selling during the past ten
decades. Even during the bad periods, panic-selling was a failing strategy.”
Joseph S. Kalinowski, CFA
Additional Reading
SPY
Trends and Influencers August 15, 2015 – Dragonfly Capital
GRANTHAM:
We could be headed for a 'very different' type of crash in 2016 – Business Insider
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