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Bullish Hopes, Bearish Signals

Submitted by Lance Roberts via STA Wealth Management,

Over the last couple of weeks, I have discussed the entrance of the markets into the seasonally strong period of the year and the potential to increase equity exposure in portfolios on a "short-term" basis. To wit:

"With the markets EXTREMELY overbought short-term, the setup for putting money into the market currently is not ideal.

 

However, as shown in the chart below, the markets have registered a short-term BUY signal that suggests that we remain alert for a pullback that generates a short-term oversold condition without violating any important supports."

The chart below updates that analysis through Monday's close.

"As shown, the recent surge in the markets has driven asset prices back resistance near the old highs. Simultaneously, the markets are pushing into very overbought conditions with a rather extreme deviation from the longer-term moving average. Such deviations tend not to last for an extended period.

 

In plain English it essentially means the markets have likely completed its current advance and need a short-term correction to provide a better 'risk/reward' entry for investors to increase equity exposure." 

As shown in the chart above, the expected correction began in earnest this week. Currently, a correction back to previous support levels (2040-2060) will likely find "buyers" betting on the traditional year-end rally. 

Long-Term Concerns Remain

However, it is the longer-term picture that I remain worried about. As noted by my friend Joe Calhoun at Alhambra Partners:

"Stocks also belie this belief that the Fed finally has it right, that growth is finally accelerating and the real recovery is finally underway. Yes, stocks have rallied nicely the last few weeks and have nearly recovered from their August swoon. But all that has done so far is to bring stocks back to where they were in mid-August just before the sell off. While it is certainly possible that we will yet make new highs, I think it is important that momentum is not confirming the move higher except, again, in the very short term. Long term momentum indicators still show a market in the process of topping."

He is correct. As shown in the MONTHLY chart below, a variety of measures still remain very concerning on a long-term basis registering signals only witnessed at peaks of past bull markets.

There is little evidence currently that the rally over the last couple of months has done much to reverse the more "bearish" market signals that currently exist. Furthermore, as noted by Jochen Schmidt, the current market action may be more indicative of market topping process.

As shown in the next chart, Jochen's point can be seen more clearly by looking at a longer-term chart of previous bull market topping processes.

The combined "sell signals," as measured by moving average crossovers, momentum and MACD, have only coincided near major bull-market peaks and bear-market bottoms.

Importantly, those coinciding signals can occur several months before the actual change to the overall "trend" of the market occurs.

Currently, with two of three longer-term "sell signals" registered, with only the final moving average crossover remaining on a "buy" signal, investors should remain more cognisant about relative risk levels in portfolios currently. 

Not unlike previous market topping action, the markets could indeed even register "new highs," as witnessed in both 2000 and 2007 before the major market correction begins. This is typically how "bull markets" end by providing false signals and sucking in the last of those willing to "buy the top." The devastation comes soon after.

Warning Signs Everywhere

Many have pointed to the recent correction as a repeat of the 2011 “debt ceiling default” crisis. Of course, the real issue in 2011 was the economic impact of the Japanese tsunami/earthquake/meltdown trifecta, combined with the absence of liquidity support following the end of QE-2, which led to a sharp drop in economic activity. While many might suggest that the current environment is similar, there is a marked difference.

The fall/winter of 2011 was fueled by comments, and actions, of accommodative policies by the Federal Reserve as they instituted “operation twist” and a continuation of the “zero interest rate policy” (ZIRP). Furthermore, the economy was boosted in the third and fourth quarters of 2011 as oil prices fell, Japan manufacturing came back on-line to fill the void of pent-up demand for inventory restocking and the warmest winter in 65-years which gave a boost to consumers wallets and allowed for higher rates of production.

2015 is a much different picture. 

First, while the Federal Reserve is still reinvesting proceeds from the bloated $4 Trillion balance sheet, which provides for intermittent pops of liquidity into the financial market, they are now seriously discussing “tightening” monetary policy by the end of the year.

Secondly, despite hopes of a stronger rates of economic growth, it appears that the domestic economy is weakening considerably as the effects of a global deflationary slowdown wash back onto the U.S. economy.

Third, while “services” seems to be holding up despite a slowdown in “manufacturing,” the service sector is being obfuscated by sharp increases in “healthcare” spending due to sharply rising costs of healthcare premiums. While the diversion of spending is inflating the services related part of the economy, it is not a representation of a stronger “real” economy that creates jobs and increase wages. (via Zerohedge)

Fourth, the strong US dollar, as compared to other currencies racing for the bottom, is having a negative effect on companies with international exposure. Exports, which make up more than 40% of corporate profits, are sharply impacting results in more than just “energy-related” areas. As I discussed recently, this is not just a “profits recession,” it is a “revenue recession” which are two different things.

The chart below shows the S&P 500 as compared to the US Dollar. Since the turn of the century, declines in this ratio below the 18-month moving average, have been coincident with more severe market reversions and economic recessions.

Lastly, it is important to remember that US markets are not an “island.” What happens in global financial markets will ultimately impact the U.S. The chart below shows the S&P 500 as compared on a performance basis to the MSCI Emerging Markets and Developed International indices. I have highlighted previous peaks and subsequent bear markets. Currently, the weakness in the international markets is being dismissed by investors, but it most likely should not be.

 

Looking For "Santa Claus"

As I suggested above the "seasonally strong" period of the year may present an opportunity for more seasoned and tactical traders willing to take on additioinal risk.  However, for longer-term investors the risk/reward ratio is not favorably tilted currently.

As we progress though the last two months of the year, historical tendencies suggest a bias to the upside. This is particuarly the case given the weakness this past summer which has left many mutual and hedge funds trailing their benchmarks. The need to play "catch-up" will likely create a push into larger capitalization stocks as portfolios are "window dressed" for year end reporting.

This traditional "Santa Claus" rally, however, does not guarantee the resumption of the ongoing "bull market" into 2016. 

For that corporate earnings will need to recover, and soon. However, as Joe notes in his missive, this is unlikely to occur:

"That shouldn't really be that surprising considering what is going on with earnings. With so much hoopla surrounding the Fed it has almost been lost in the shuffle but earnings this quarter have not been very good overall. If you look at "operating earnings" – earnings before all the bad stuff that is allegedly one time but rarely is – over 70% of companies are beating estimates although the beat rate for revenue is quite a bit lower. However, reported earnings paint a different picture with less than half the companies beating estimates. This kind of divergence happens every cycle as we get near the end of the expansion. It speaks to the quality of the earnings and the creativity of CFOs at the end of an expansion.

 

Companies this cycle have loaded up on debt to buy back stock and keep earnings per share rising. That and other means of cost cutting were necessary because revenue growth has been hard to come by. Particularly hard hit recently have been the US multinational companies, hit by the double whammy of a rapidly rising dollar."

There is a vast difference between having a strong dollar in a strongly growing economy, and a strong dollar in a weak one. The later weighs on further growth as the deterioration of exports is not offset by the rising consumption of imports. As I discussed last week, a combination of plunging imports and exports is something that should not be ignored.

"The sharp rise in the dollar, which has been cited by many companies as the reason for weak earnings results due to the negative impact to exports, should be a boon for consumers as the stronger dollar makes imports cheaper. However, that has clearly not been the case and suggests the domestic consumer is substantially weaker than other headline data suggests."

 

The import/export data is suggesting that the global weakness arising from China and the Eurozone have now impacted the domestic economy. While the Fed continues to suggest that economic strength is improving, the underlying data continues to suggest it isn't."

As I have continued to suggest, there is a probability that the markets could rally through the end of the year. However, without a strengthening of the earnings and economic backdrop, such a rally will likely be a continuation of the current market topping process over the intermediate term.

While none of this means that a major market reversion is imminent, it does suggest taking on an accelerated risk profile in the current environment will likely not be greatly rewarding.