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3 Things Worth Thinking About

Submitted by Lance Roberts of STA Wealth Management,

Correction Awakens Sleeping Bears

Since the end of 2012, the S&P 500 has been on an inexhaustible rise despite rising geopolitical tensions, extremely cold weather and weak economic data. The driver, of course, has been the massive liquidity inflows from the Federal Reserve that have catapulted the markets from their previous upward bullish trend into an accelerated push.  This is shown in the chart below.

However, the recent market correction has taken on a different flavor with a deterioration in market internals and a narrowing of leadership.

Walter Murphy noted on Wednesday that:

"NYSE declining stocks exceeded winners by 5:1 while the up/down volume ratio was bearish by a more robust 11:2 margin.

 

In recent comments, we thought that last week’s breach of the 1978 double-bottom was a warning for lower lows. The importance of that breakdown was brought home today for at least four reasons. First, the S&P closed below what has been the dominant intermediate uptrend line from the November 2012 low. Second, the percentage of NYSE stocks below their 200-dma is below 45% for the 1st time since November 2012. Third, the decline has an impulsive look to it. Finally, intermediate to longer term Coppock oscillators are deteriorating for a majority of indexes and stocks."

With both the number of S&P 500 stocks above their 200 day moving average and on "bullish buy signals" deteriorating since mid-2013, the increasing divergence of prices from the underlying performance is cause for concern.

I have also noted that the market has broken below the accelerated bullish uptrend, and a normal 38.2% correction would pull the index towards 1750 currently. While such a decline currently seems beyond the grasp of reality, it would actually be a healthy 13% retracement from the peak. However, since such a correction has not been witnessed since 2012, it will feel far worse for most individuals who have become overly complacent during the market's accelerated advance.

Portfolio Action: What is missed by the "buy and hold" crowd is that "portfolio management" is NOT about selling everything and hiding in cash. As investors, our job is "buy low and sell high." With the markets showing signs of deterioration on multiple levels, this is probably a good indication that it is time to prepare to rebalance portfolios, "trim" winners and "sell losers."

However, with the markets oversold on a very short-term basis it is advisable not to "panic sell," but use "bounces" to rebalance portfolios. Yes, this will mean an increased cash weighting in your portfolio that is earning NOTHING, however, having cash is what gives you the ability to "buy low" when the current correction process is complete. 

 

Plunging Oil Prices Hit Energy Stocks

The recent spike in the US Dollar has impacted many areas of the commodity complex but has been particularly nasty to oil prices. There are many issues weighing on oil prices currently from reduced demand due to globally weak economies, a reduction in driving miles, continued improvements in fuel efficiency and a rising supply/demand imbalance due to the explosion of domestic "fracking."

Recent estimates from of demand growth from OPEC, the U.S. Energy Information Administration (EIA) and the International Energy Agency (IEA) place demand growth at 900,000 to 1.05 million barrels a day in 2014, and rising to around 1.2 million to 1.3 million barrels a day in 2015. The problem is that supply growth is projected to surpass that demand by rising to 1.6 million barrels a day in 2014 and 1.3 million barrels a day in 2015. Most all of that supply growth will come from fracking in North Dakota’s Bakken, and the Permian Basin and Eagle Ford plays in Texas.The Dollar Spike And Market Corrections

While fracking has been a boon to U.S. energy stocks the costs of drilling wells has been climbing, and the decline rate of production from fracking is extremely steep. This year independent oil producers will spend roughly $1.50 for every $1.00 of revenue they get back. Furthermore, it will take roughly 2,500 new wells a year just to sustain the output of 1 million barrels a day in the Bakken shale alone. (As a comparison Iraq can do the same with 60 wells)

If the confluence of the rising dollar and supply/demand imbalances push oil prices below $85/bbl the profitability of drilling new wells becomes much less attractive and existing revenue streams for producers will deplete fairly rapidly. The poses a significant risk to energy related investments due the recent deviation in price performance from the underlying commodity. 

As shown, the performance of energy stocks has historically been closely correlated with the performance of oil prices with the exception of the liquidity driven asset inflations in 2007 and 2012-13.

Portfolio Action: Energy related investments are under pressure by falling energy prices and the rising dollar. As discussed above with reference to "portfolio management," energy is an area that is ripe for "pruning and weeding" on any bounce. There is much "hope" built into energy stocks currently but there is mounting evidence that fracking may not be the "nirvana" most are expecting.

 

U.S. Dollar Spikes And Historical Market Impacts

As I discussed yesterday, the implications to investors of a strongly rising U.S. dollar is important as it has a negative effect on stock market prices. One of the last remaining last remaining footholds of the "bulls" has been the strength in corporate profits.

"With valuations now expensive, interest rates set to rise and yield spreads narrowing as the Fed removes monetary liquidity, the risks to markets have risen substantially since the beginning of the year. This increase in risk, as the Federal Reserve extracts support from the markets and economy, is being reflected by the surge in the dollar as 'safety' is sought. This has occurred each time QE has been extracted, and the surge in the dollar has been historically associated with market corrections."

As Sigmund Holmes recently penned similar thoughts:

"The dollar also rallied in the [2011] although it didn’t really get started until later in the correction in September and October. This time the dollar has had a major rally even before the official end of QE. The end of QE 2 also ushered in the Euro crisis and once again, albeit to a lesser degree, we are seeing problems in Europe. One final similarity is that the economic data going into the correction was fairly good as it is now. It was only after the correction and the onset of the European problems that US economic data started to deteriorate. One can’t help but think of George Soros’ theory of reflexivity whereby it is markets that move the economy rather than the other way around.

 

We’ll see if this continues to develop in a similar fashion to 2011. I have a sneaky suspicion that it may actually turn into a bigger correction. There are a lot of people in this market who really don’t want to own it and any hint of losses may be enough to send the hedge fund and mutual fund traders to the door in an effort to protect the old year end bonus."

Portfolio Action: The spike in the U.S. dollar is a drag on U.S. exports that comprise roughly 40% of domestic profits. Again, there is much "hope" built on sustained growth in U.S. profits as shown in the chart below. (Read: Analyzing Earnings Q2 2014)  

The reality is that the trend is historically unsustainable and eventually will lead to a mean-reverting event in asset prices as fantasy collides with reality. The loss of capital, when it occurs, will be much greater than most are currently capable of comprehending. Again, this why a disciplined process of "portfolio management" is necessary to protect capital against such catastrophic losses.

Final Note:  I heard an advisor say recently that major stock market declines only happens during recessions. While he is correct, here is something worth pondering:  "Did a recession cause the correction, or did the correction cause the recession?"