The Potential Depth of the Corrective Action

Markets’ darling leaders sell off? Check. Defensive sectors rotate up? Check. Seasonality coming into play(if you believe such stuff)? Check. S&P 500 VIX spiking? Not check. We have yet to see the S&P 500 really start to come down off its highs for the year just yet. Although, the market action has probably felt terrible for those heavily weighted to the NASDAQ, we have yet to see some heart-wrenching downside action in the S&P 500.

SentimentTrader just shared a note about the lack of volatility in the VIX and the downside potential in the S&P 500, “There have only been two other times in the past 20 years that the Nasdaq Composite had dropped more than -8% from its 52-week high, but the VIX “fear gauge” was still below 17.5, a scenario we have now. It shows relative complacency in the face of a sell-off in higher-beta stocks. Those two occurrences were March 28, 2002 and May 15, 2008. The S&P 500 sold off more than -15% over the next three months both times.

As usual, the statistics suffer from a small sample size within a relatively short period.

However, the facts are the facts.

Add in that earnings season has been off to a fairly weak start and you have that much more evidence to make you pause and consider before allocating more long capital right now. For any readers who are EPS hounds and swear that stocks always follow earnings, here’s a snapshot courtesy of Thompson Reuters’s Alpha Now that also supports a pause in the action through the spring and potentially summer.

S&P 500: EARNINGS AND REVENUE GROWTH TREND

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And to keep my confirmation bias fully intact, here’s a snippet from Louise Yamada courtesy of CNBC. I can’t believe I’m quoting material from the hack-shop CNBC, but Louise truly is a legend in the institutional research side of technical analysis. Anyways, she states, “I don’t think the pullback is already over. I think that it’s an interim pullback, and we’ve certainly seen what we’ve expected, in the Internet and biotechs coming off. And I think that although they may bounce, there’s probably still a little bit more to go on the downside…If we break that level(1,750 on the S&P 500), that will be the first lower low that we would have seen all the way back to 2011, really…Below 1,750, support lies at 1,650.

If we hit that 1,650ish area, then that’s approximately 10% to 12% off the highs for the year. But who’s to say we have to have a minimum 10% correction? I’ve been calling for that level of correction to clear things out a bit in the market. Many other commentaries have also focused on the need for at least a 10% correction in the S&P 500 to work off overbought levels.

Richard Dickson, Chief Market Analyst at Lowry Research, recently gave an interview at FinancialSense.com providing his outlook on the “need” for a correction of at least 10% in the S&P. If you’re unfamiliar with Lowry Research, they are one of the true OG’s in the game of institutional level technical analysis and the oldest firm in the US to provide such services. Dickson stated that:

We’ve already had two corrections well over 10% from 2010 to 2011 in this bull market and, historically, if you go back and look at the various bull markets and use the Dow Jones on a closing basis, we’ve never had more than one 10% correction in a bull market… Since 1940, we’ve never had more than one, so this has been a little unprecedented in the fact that we’ve already had two. So, to say “well, we need another one”…my response to that is we’ve already had two, how many do you want?… As things stand right now, any pullback, whether it’s 5% or 10%, in our opinion, would simply be a buying opportunity.

So there you have it. Buy the dip according to Dickson.

Still though, want some basic ideas on how to play some downside action? Buy VXX or leverage it up and buy some Calls on VXX. You can buy some Puts on the SPY or eliminate the risk of purchasing the optimal option and purchase the 3x leveraged SPXU from ProShares. It may be a little late, but utilities ETF’s such as XLU have been the home of the defensive minded for several weeks now. The typical disclaimer applies regarding your own trades.

I intended to share some thoughts and charts on the serious distortions to the financial landscape, as stated at the end of my last post. My apologies but you’ll just have to wait till the next post again, where I will definitely talk distortions. I promise. Bis spater.

Analogous Equities Markets – 1970’s & 20Teens

Secular bull? Or bear about to do its thing on “unsuspecting” market players? These are questions making serious rounds on the world wide interlinking-web. That’s because fear sells and nothing gets eyeballs and clicks for the user-ravenous financial sites like some market-topping bear talk.

If you were alive and investing in the 70’s, or like myself, have read up on the stock market action of the 70’s then one can see how similar the two time periods seem to be acting(at least in the S&P 500). Don’t worry, I’m not about to hit you with yet another comparison chart of some calamitous US financial event laid over current action. Instead, I’d like to share some work by Lance Roberts. For the record, I like those comparison charts but I also take them for what they are…entertainment. At best they’re another useful input and at worse they’re just noise.

If you’re unfamiliar with Mr. Roberts, he consistently writes compelling market pieces. I happen to think he’s one of the more under-appreciated financial commentators on the web right now. He’s the co-founder and general partner of STA Wealth Management. Earlier in the year, Mr. Roberts shared some graphs comparing current times to the secular bull formed in the 80’s and the fakeout in the 70’s. At STA they definitely have Austrian economic tendencies in their communications regarding the markets, and so obviously can lean toward a more bearish stance at times. Or as other Austrians call it, just being realistic in light of all the economic data readily ascertainable.

They have significant assets under management of approximately $500 million to $600 million, so these guys are the real deal. Specifically, they focus on the client who possesses low six-figures to approximately $5 million in capital, so they’re not exactly whale hunters. STA feels that market is an underserved niche of wealth management. I’m not trying to plug their services nor do I have any relationship with their firm. Like other commentators or service providers I include in my posts here at MarginRich.com, I’m fairly certain STA doesn’t even know this blog exists. I just want to share with my readers another financial blogger whose work I really enjoy. You can also find work by Lance Roberts at Advisor Perspectives, home of dshort.

Now back to the charts Roberts shared in January. The first one shows a direct comparison of the current period to the false breakout of the late 60’s into what looked like a new bull going into 1973.

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As we all know, The recession starting in 1973 was one of the worse times to be in the stock market in its history. The next chart shows the S&P’s performance and the realization of the false hopes for investors during those time periods.

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Sorta looks like the decade of the Oh-Oh’s, except the action up to 1973 produced higher highs. As opposed to what we experienced in 2000 and 2007 in the S&P 500 with virtually equal tops. The reason for that was obviously all the capital was pouring into the NASDAQ in 2000.

Moving on to the last chart. Roberts shows the total picture with the final washout in 1981 and the true beginning of the 18 year mega-secular bull market that helped to explode the growth of the mutual fund and retirement investing industries. Of course there were up’s and down’s during the real secular bull, but boomers blessed with the easiest time to make buy and hold gains during peak earning years helped to build the academic case of always investing in stocks for the long run. Not that I want to get into any philosophical debates on investment strategies or the level of difficulty of investing through the 80’s and 90’s. I use the term “easy” through the lenses of hindsight.

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The point of sharing these charts is to increase awareness that this 5 year run that America has been on off of the 2009 lows, may not be the start of a real secular run like we saw from 1982 to 2000. In 1982, the conditions were more like a final “cleansing”, so to speak. The new CEO of America was instilling a lot of genuine hope and assuaging genuine fears with genuine actions, not lies or baseless rhetoric. Valuations were exceptionally low with single digit P/E’s and very enticing dividend yields across the market. Price inflation had been beaten back by the last semi-responsible Fed head.

Simply put, these are not conditions that exist today. In fact, the exact opposite of each of those conditions exist today. I understand that the music is playing but do you want to keep dancing? Conditions are decidedly different due to deep distortions across the financial landscape. But hey, I’m only one voice of many and if you’re one of plenty of people(including professionals) who think we’re in the midst of a secular bull market, then by all means keep putting new money to work. However, even if you’re dollar cost averaging and you don’t believe in “timing” the market, now may be a time to build your cash levels.

Don’t just take my word for it. In a previous post I cited some thoughts shared by Seth Klarman and Jeremy Grantham. They each communicated their fears of the frothiness of these markets but that the markets will continue to move higher before an inevitable bust. Now the inimitable Howard Marks has essentially shared the same sentiment in his latest Memo From Our Chairman. Collectively, these 3 gentlemen help oversee more than $200 billion in assets under management. In addition to their combined multiple decades of experience, their respective savvy has made each of them billionaires. Now if scions of the investment world such as these fellas are telling you to be cautious, do you really want to be the rebel without a cause out there allocating your capital based on the premise that trees DO grow to the sky?

Look I know the path of least resistance for the markets is up and I’ve reinforced that in previous posts. It’s just that based on the distortions, it really feels like a reckoning is coming. And just some basic cycle research yields a time table of approximately 12 to 24 months from now for some potentially tough times as an investor. I’m not talking about exiting the markets entirely. I’m talking about raising cash levels to be prepared when the real values potentially present themselves and minding your stops. Next time I’ll share some hopefully enlightening charts and thoughts on those aforementioned distortions.

A Read of the Tea Leaves and an Update to the ETF Portfolios

Well how about that correction in the S&P 500? Everyone suffered the 6% downward move and now we can all resume earning wealth…or can we? Is there some negative energy left in these markets? The tea leaves tell me that the corrective move is not over. As a reminder, just reading the tea leaves is about as antiquated as can get for a method of analysis. Looking at some squiggles on a chart and then making wholesale investment decisions is dangerous, but still, I think it’s one of the practical components on the speculator’s tool belt.

Let’s start by taking a look at the S&P 500, using SPY(weekly) as our proxy, and then we’ll move into some complimentary areas that may help shape the analysis. Bear in mind with Plunge Protection out there and HFT pace-setting through momentum ignition, all analysis is completely nullified should new highs be strongly set and the uptrend is fully resumed. Now prepare to be over-charted.

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I think when this correction resumes, we’re looking at an endpoint underneath the 50-Day EMA(blue line). I think it’ll kiss that into the 165ish area before bottoming out. I just don’t believe that a 6% move down is the end of it. In 2013, all the corrective moves capitulated at the Bollinger mid-point. From the wide ranging fear that I observed, that just doesn’t feel appropriate for the correction here to start 2014.

Take a look at the VIX for moment. Yeah, yeah, I know the VIX is played out but it still provides clues as just one chart of many in attempting to get a better feel for market action.

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The markets haven’t seen fear like that since 2011. Another one of my favorite indicators, the NYMO, is indicating some further weakness. I’ve previously commented on the NYMO’s ability to help traders get positioned for market action. It’s hitting not one, but two indicators providing a signal for a resumption to the downside. Observe:

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I have no worries that the major uptrend will resume after the corrective washout. These markets have been in need of a steam release for some time, but the obvious path of least resistance is upward. Those little exhalations near the end of 2013 essentially counted as non-moves, so a little fear and loathing is healthy for the uptrend to renew with some vigor going into the 2nd quarter. There are a couple of additional asset classes that may potentially shed a little light as to further direction subsequent to the completion of the corrective move. First, there is the yield on the 10-year Treasuries:

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Okay, all kidding aside on my make-believe and totally fake “Rhombus of Hades” pattern, a downside move in yields in combination with ZIRP will continue to push market players into equities; especially if that yield pushes much lower to potentially 2.4% or even as low as 2%. I’m not saying that yields aren’t going to go higher in the long-term, just that the near-term outlook is presenting a potentially downward path in yields.

The Nikkei has maintained a fairly solid correlation with the S&P 500 and its action looks constructive as it may be basing for a resumption of its own uptrend. The two indicators below are the MACD and Full Stokes.

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One last set of charts I’d like to share is the Equity Hedging Index(“EHI”). The EHI is one of the many proprietary models that can be found at SentimentTrader.com. It’s a contrary indicator, meaning lower extremes in the chart should produce a rally in the markets and vice versa. The EHI aggregates several inputs such as cash raising, Put purchases, and various other factors in order to construct a usable indicator. For more details, visit the site and take a free trial to see if the service is right for you. As I’ve stated on numerous occasions, I do not receive any compensation from them and I’m quite confident they don’t even know the MarginRich blog exists. Fortunately for my readers, Jason Goepfert, proprietor of SentimentTrader, is cool enough to allow people to republish his work as long as it’s not excessive and the work is credited.

Here’s a current read of the EHI.

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And in case you need a visual on how well the EHI has performed in assisting traders see where some of the bigger turns have been occurring, observe the following chart from January 14th, 2014.

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It’s not perfect, but then again, no single indicator is. If using technical analysis, it’s best to observe a wide variety of charts and cumulatively interpret them, so that one may obtain a more productive assessment. But this is all rubbish really because bias inherently sways emotions and thought process, and thus the analytical outcome must be considered questionable. If this sort of analysis is all you rely on, such as what I do here for the blog, then more power to you. For the record, before committing my own capital I analyze a broad swath of data; not just squiggles. Occasionally, squiggles may be all it takes to ascertain that a function-able trade has presented itself, but I like to mix fundamental analysis in combination with micro or macro economic reads.

It is decidedly better to test quantifiable inputs to statistically determine, so to speak, probable outcomes when attempting to make valid trading decisions. Have a read of this Price Action Lab blog entry. Based on his analysis, Mr. Harris states that the market is in mean-reverting mode. Long story short, he basically states that the market is fragile and so any suitable catalyst could cause a correction.

My conclusion is that I wouldn’t pick now to be throwing all my chips into the middle of the table as if everything is all clear. There are enough signals out there stating that one should trade with caution, especially if attempting to position long. It may be best to wait in cash, but if you gots the stones and the know-how, then it appears a nice set-up is forming for shorting or Put option strategies.

Before I bid you adieu, just want to let readers know that I’ve created a new link up top called Portfolio Updates. That’s where I’ll be placing the ETF portfolio updates from the January post titled, A Few Sample ETF Portfolios to Watch. I would describe the results thus far as interesting, but not all that compelling just yet. If you haven’t read the article then click the link and have a read, then check the updates to see how they are stacking up.

Early to the Unattended Short Party Again

Just wanted to apologize for a lack of posting activity. For newer readers expecting a little more activity, it gets tough around the holidays with family demands and traveling. My goal going forward is to post at least twice a week, and at the very least, once a week. I know that’s not on par with your favorite daily reads, but I hope I can continue to potentially add value to your investment life.

The markets just keep running, even with this past week’s slight consolidation. Hell, Friday’s pop was enough to put the S&P 500 at basically even for the week, the Russell 2000 a touch off the highs for the year, the NASDAQ at post-2000 highs, and the DOW in the same position as the Russell at a touch off the highs. Some consolidation, huh? Previously, I reasoned that a correction was on the horizon and illustrated with some charts why I thought that a correction was imminent. The results…

WRONG! The markets have been looking like a small blow-off would occur since the summer. Those signals were all false though and chartists who have been attempting to short the market keep coming up just that…short. The lesson that you should not fight the Fed keeps getting firmly taught in 2013, as noted by the under-performance of hedge funds, shorts artists, and tape readers. None the less, have a look at the following set of charts from several weeks ago. In a normal world that’s not flooded with liquidity chasing up financial assets around the world, these charts would generally portend of a change in trend. However, this ain’t a normal world to be speculating in.

These charts depict several factors of risk taking and risk abating, which one would think would normally affect the greater markets. Divergences abound and yet the rising continues. Observe:

1. SentimentTrader displayed the Rydex family of funds’ 12 year low in assets allocated to their money market funds

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2. The stock to bond ratio – one of SentimentTrader’s daily charts showing periods of over/under value in equities

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3. S&P 500 to JNK (junk bond ETF) – notice the previous downturns in the S&P 500 earlier this year when JNK turned down

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4. ZeroHedge provides a Bloomberg terminal snapshot of a nosedive in IWM shares outstanding while price remains stable

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5. Here’s another junkbond relative performance chart. Apologies to the author. I forgot from which blog I nicked it.

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6. Courtesy of DecisionPoint, going back to to 1999 one can see what a divergence from the PBI for the SPX generally means for the SPX

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Alright, enough with the slide show. There are so many more squiggle pictures that chartists could call upon to attempt to prove that a downturn is imminent but why bother? Liquidity is not going to dry up. Interest rates aren’t going to spike up past 6% and send the planet into recession tomorrow. Based on the performance of equity markets and despite a ton of divergent indicators, I’m beginning to get the feeling that the markets may just consolidate in a semi-volatile sideways range. There’s a real possibility that the markets just bounce along up and down plus or minus 1% – 3% into the new year before resuming an advance.

We keep coming back to this now overly used quote from 2007 by Chuck Prince, former head of CitiBank: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” This little gem has popped up almost everywhere in the financial blogosphere recently, so I figured I’d find a gratuitous reason to post it too as it is quite apropos. Good old Chucky “Cheese” Prince made this statement at the peak of the markets back in 2007 because he knew how unstable things were and yet he continued to allow the SIFI(systemically important financial institution) he ran to trade and underwrite garbage.

And while I’m at it, in case you don’t know what the co-crown prince of golden parachutes looks like; here’s his picture. Truly a face you can trust with managing hundreds of billions.

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For those ill-informed about Mr. Prince, he walked away from Citi with a cool $100M for overseeing the destruction of the bank. The reason he’s a co-crown prince of the golden parachute set is because he shares the crown with Stanley O’Neal, but I digress. We’re talking about the potential for a sideways consolidation in the market and not rehashing sour grapes on a who’s who behind the SIFI’s that have changed our world as we know it. As for speculative advice, well I have exited my short positions. I hedged my last move against the SPY and simply broke even. I’m currently taking a step back and allowing for the picture to clear up a little for a trader such as myself.

In my next post, I intend to touch on what matters and what doesn’t matter anymore in finance, investing, and economics. And there just may be a hint of informed sarcasm. As for speculating, if you are positioned long, stay long. Enjoy your paper profit ride, but don’t forget to mind your stops and make those profits real if needed. If you’re trading and miss the lack of real volatility, then now may be a good time to catch up on some insightful reads. Seriously, look at that picture up above one more time. Tell me that’s not exactly who my last post was describing. Cheers!

Smells Like Some Correction Stew May Be Cooking

Disclosure:  I do not claim to be clairvoyant. I’m fully aware of the fact that I could just as easily be wrong about any prognostications forthwith. I also know you are tired of me disclaiming this over and over but I don’t want anybody to get the wrong idea that I think I’m some kind of market shaman. These are just my interpretations. They can be profitable or at the very least entertaining.

In particular, the charts of the stock indexes are painting a picture of that correction I mentioned in the previous note I sent about “market timing.” In that note, I had stated what I thought were two probable outcomes for the stock markets. Specifically, I said, “…for the stock markets we could see a bounce back to new highs from here and then a stronger, scarier takedown somewhere in the late-July through mid-September range. It’s more probable that we chop along moving sideways through the Summer with some up and down bouncing and then finish out the year strong as animal spirits recover and taper talk dies down with renewed vigor behind the rhetoric of quantitative easing.” It appears as if scenario 1 may be the play, but still with a strong finish to the markets for the year.

I see this potential move playing out similar to the Summer of 2011. In February of 2011, the S&P 500 had a nice little 7% correction just to whet all the speculators’ whistles and then…BAM! May came along with the fear already established from the 7% correction and the worries of the 1 year anniversary of the infamous “Flash Crash,” and so began a 3 month-long 20% correction. You can observe the action on the Weekly chart below. The Daily chart below it seems to be showing the beginning of the current potential down-move. Monday’s action is not a good sign either and is supportive of the call for a corrective move. As I mentioned in the “market timing” note, this correction(if it occurs) will not be the big one. Articles will be published on the worldwide-interconnected-net about long-term resistance at the highs of 2000, 2007, and now 2013 but this down-move shouldn’t be of the same magnitude as the previous 2 biggies. The true big one, which feels like 2 or 3 years away, will probably be a combination of a bank’s default due to excessive leverage in their derivatives position and a country’s outright default on its debts. Beware of Italy. These actions will initiate a waterfall of negative effects amongst the large financial entities as nobody knows who owes who and who has what collateral for all the intermixing of credit transactions. I spent enough time on that in the previous note on derivatives. This correction will present an opportunity to profit on the way down for the alert trader or at the very least provide some quality entry points at the bottom for the more conservative, before a potential year-end rally.

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I would look for a move between 10% and 15% off of the high of 1,700ish. A 10% move down would take the S&P to the bottom of the Bollinger and the 50-day EMA on the Weekly chart. It would take a 20% correction to get the index down to the 200-day EMA. A move of that magnitude just doesn’t feel right, especially if the bulk of this move occurs in August and finishes out in the beginning of September. There are multiple ways to play a correction. For the non-tape-reading speculators or un-fool-hardy timers, I won’t bore you with details. Some easy suggestions though would be:  Calls on the VIX equivalent ETF, Puts on the S&P 500 equivalent ETF, Puts on TM as the Nikkei should move down in conjunction, or short the sector leaders(with Puts) but specifically Consumer Discretionary as I think it’s time has come for a real breather. Bear in mind that trying to front run a leader sector is not the brightest move. These are just un-vetted potential plays being thrown out.

Interestingly, I have some additional charts from SentimenTrader to support a corrective move but the strength of the correlation of these charts to the S&P 500 is admittedly dubious. This first sentiment chart only goes back 7 years, which to a statistician makes the sample size virtually unusable. Fortunately, I am not a statistician. I’m a speculator and the chart is a sentiment reading of the members of the NAAIM, which is the National Association of Active Investment Managers. These members include billion dollar mutual fund companies and large-scale financial advisors. The chart is intriguing because over the last 7 years, each time there has been a correction in the S&P 500 with at least a 45 point move down in sentiment followed by a V-shaped correction in the sentiment then there has always been an even larger correction in the S&P 500 shortly thereafter. This is denoted by the red lines. The second quirky chart is of the Rydex Inverse funds and asset inflows. It’s a contrarian chart, so over the last 11 years every time the 3-month change in asset inflows to the inverse funds moved by 75%; a rally took place. This is because usually the retail speculator or unskilled advisor will use these funds thinking they’re smart and standing apart from the herd. They are almost always wrong, as denoted by the green arrows. What is peculiar though is that this almost always happens after a substantial decline, per SentimentTrader, and the most recent read that hit the 75% change mark was after that little 7.5% move back in May and June. I think that may be due to higher-skilled traders positioning this time ahead of the potential corrective move in the S&P 500. The indicator is usually a contrarian sure thing but it doesn’t smell right this time. And if you like to trade in any capacity, I would strongly recommend a subscription to SentimenTrader. It provides access to a wealth of indicators that have proven valuable to me time and again. I’m not plugging because they kick me back anything. I’m positive they don’t even know this blog exists. I’m just a satisfied subscriber.

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And of course this hasn’t exactly been the most awe-inspiring earnings season either. It hasn’t been bad, but there are all sorts of interpretation on releases and the facts are the facts. Top lines are lagging badly and the new trend appears to be “beat and revise downward.” That doesn’t feel like strength to me. Additionally, thanks to those damn reserve releases by the our friendly Wall St. banks, the Financials have been destroying all sectors when it comes to earnings surprises and thus carrying the S&P 500 on its fraudulent back through Q2. Observe the following charts, courtesy of ZeroHedge:

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Obviously, you know there is no love lost between me and the “elite” banks. The problem is that when Financials are carrying the day for earnings, trouble has a habit of following. For true strength, we need the sectors underlying actual economic growth to be leading; not the damn derivative rolling, reserve releasing banks. I find this information to be supportive of the evidence relayed above.

As usual, I’d like to leave you with one last chart to provide some final support behind the thesis. This chart illustrates margin debt(aka investor credit) levels on the NYSE and the correlation to S&P 500 performance. This chart is courtesy of Doug Short. What you’re looking for here is that once margin debt levels peak very close to or past the purple dotted line, then the margin levels begin to taper leading to a correction. This chart creates the perception that a big correction, similar to 2000 or 2007, is on the way and maybe even imminent. Again, I firmly do not believe that is the case. I will reiterate that I think we’re looking at a 10% to 15% correction with the potential to go as high as the low 20%’s for the total corrective move.

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This correction has the potential to fall right in line with a rise in gasoline prices if the last note I sent regarding oil prices accurately described a petrol spike. It appears that oil is leveling before a reversion to normalized price levels, but we’ll have to wait and see. If this note proves to be correct I hope that you’re able to take advantage of the data in your own specific way, whether that’s speculating, bottom buying an equity, or raising cash on a name you were ready to liquidate but were unsure of the timing.

Read, Read, and Read some more. Good luck out there.