Stocks: Risk Management Back In Vogue

July 31, 2014

Fed: Sooner Than Expected?

We noted on July 26 and again on July 29 that recent data may force the Fed to raise rates sooner than the market expects. Note the first item in the The Wall Street Journal’s list of what may have sparked Thursday’s selloff:

Investors said an upbeat reading from the labor market sowed concerns about the Federal Reserve possibly raising rates quicker than many investors anticipate. Some pointed to disappointing earnings reports from U.S. companies Thursday, which disrupted what has been a strong season for corporate profits. Others pointed to Argentina’s default on some bonds and fresh worries that the euro zone’s central bank will need to provide more stimulus.

Evidence Showed Mounting Concerns

Regular readers know we use hard data and evidence in hand to assist with risk management. Three examples were helpful in recent days; last Friday’s video outlined evidence of waning bullish conviction, a July 26 article showed a lower high that was forming on the weekly NYSE Composite chart, and a July 30 piece showed evidence of concern on the ratio of stocks (SPY) relative to bonds (AGG).

Evidence Continues To Say Be Careful

Is there anything else that can help illustrate the observable shift in investor confidence that has been taking place? Yes, we could cite numerous examples, including the charts below showing the performance of the S&P 500 relative to the VIX Fear Index. The first chart shows a bullish breakout that occurred in early May (see green arrow). Notice how the risk-on vs. risk-off ratio stayed above previous resistance (red arrows) for several weeks and carried into July 4th weekend. The second chart shows the same ratio as of July 31. The breakout has been “given back”, which indicates investor concerns have increased sharply.

Inflation Creeping Into Wages?

Wednesday’s FOMC statement noted the Fed “will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments”. A big part of what spooked the markets Thursday was new data showing inflation potentially creeping into wages. From Reuters:

U.S. labor costs recorded their biggest gain in more than 5-1/2 years in the second quarter and a gauge of trends in the jobs market fell to an eight-year low last week, bolstering the economy’s outlook. Though economists cautioned against reading too much into the rise in the employment cost index, they said a tightening jobs market suggested wage growth would soon accelerate significantly.

Investment Implications – The Weight Of The Evidence

Our market model uses a wide array of inputs to monitor the stock market’s risk-reward profile. Enough deterioration was present on July 25 to trigger two rules-based defensive chess moves, cutting equity exposure (VTI) and adding some bond exposure (TLT), along with some cash.

Thursday’s broad selloff called for another reduction to the equity side of the equation. We will enter Friday’s session with more cash and an open and flexible mind. The market now needs to “prove it to us” before we will consider redeploying assets into growth-oriented assets. The key is not to anticipate or forecast – we need to see it.

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July 31, 2014

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Bullish Case: Improving or Deteriorating?

July 30, 2014

Fed Stays Easy

The Federal Reserve provided a mixed message Wednesday, but the tone remained equity friendly. From Reuters:

The Federal Reserve on Wednesday reaffirmed it was in no rush to raise interest rates, even as it upgraded its assessment of the U.S. economy and expressed some comfort that inflation was moving up toward its target. “Labor market conditions improved, with the unemployment rate declining further,” the Fed said in a statement. “However, a range of labor market indicators suggests that there remains significant underutilization of labor resources.”

Stock Market Risk

When intraday volatility picks up, it is often difficult to see small changes that are taking place. For example, it may surprise some that the S&P 500 is down for the week through Wednesday; it has given back 8 points since last Friday’s close. The weekly chart on the left below shows the broader NYSE Composite Index as of July 4. The chart on the right is as of Wednesday’s close. What can we learn from them? While the big picture still favors bullish outcomes, the odds of the stock market morphing into a correction are higher today than they were on Independence Day.

Stocks Or Bonds?

Conventional wisdom is that stocks are a better place to be when the economy is expanding and interest rates are rising. The charts below show stocks (SPY) relative to bonds (AGG). The conviction to own stocks over bonds was stronger on July 4 than it is today. In fact, the basket of bonds is beating the S&P 500 this week.

Since weekly charts only plot one point per week (Friday’s close), the look of the charts above after the bell Friday is more important than intraweek.

GDP And The Fed

Wednesday started with a better than expected reading on the U.S. economy, which increased jitters heading into the 2:00 p.m. EDT Federal Reserve statement. From Bloomberg:

Today’s Commerce Department report showed gross domestic product expanded at a 4 percent annual pace in the second quarter, confirming the Fed’s view that a first-quarter contraction was transitory. Consumers, whose spending accounts for 70 percent of the economy, have grown more confident as the labor market improves and rising share prices boost wealth. “The GDP print this morning had given the market some pause as to how hawkish the Fed might be,” Stacey Nutt, chief investment officer at ClariVest Asset Management LLC in San Diego, California, said in an interview. “Now it seems like they were not as hawkish as feared.”

Investment Implications – The Weight Of The Evidence

Our approach is fairly simple, since the risk of bad things happening is marginally higher today, we prefer to take less risk than what we were willing to accept on July 4. Less risk does not mean “bearish”, “no risk”, “short”, or “100% bonds”. It simply means a lower allocation to stocks (VTI) and a slightly higher allocation to cash and bonds (TLT). If stocks are backed by improving conviction in the coming weeks, we are happy to increase the equity side of our portfolios. Conversely, if the charts continue to roll over in a bearish manner, we have already taken the first risk-reducing step. Currently, the weight of the evidence says, “stay long for the most part, but it is prudent to pay closer attention until things improve.” We will enter Thursday’s session with a flexible and open mind.

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July 29, 2014

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Fed Delivers Warning To Investors

July 29, 2014

The Federal Reserve is an interesting study in public relations. The Fed has twelve districts that release statements and publish studies. The Federal Reserve Board is comprised of seven members who often make public statements about monetary policy. The chair of the Federal Reserve Board also testifies and conducts Q&A sessions with the media. Often, statements coming from the various sources within the Fed seem to be highly contradictory and confusing, something that serves a purpose in the realm of monetary policy.

Fed Cares About Inflation Expectations

Experienced investors know central bankers care about their legacy, as most professionals do. While casual investors may believe all the Fed cares about is higher stock prices, the Fed is genuinely concerned about allowing inflation to get ahead of them. If inflation expectations begin to pick up, it can change habits, which ultimately can lead to real world inflation.

Fisher’s Shot Across The Bow

On Sunday night, The Wall Street Journal published an opinion piece by Richard Fisher, president of the Federal Reserve Bank of Dallas. The text serves as a warning to complacent investors that the Fed cannot keep interest rates near zero indefinitely. The op-ed opens with a single sentence paragraph:

“I have grown increasingly concerned about the risks posed by current monetary policy.”

That is a pretty strong opening statement meant to get the attention of investors and businesses impacted by interest rates.

Making The Same Mistakes?

If you were investing during the dot-com bubble, you remember the Fed failed to tighten margin requirements, which allowed speculation to run rampant. The Fed is often criticized for “keeping rates too low for too long” between 2003 and 2005. For example, the Federal Funds Rate was at 2.25% in January 2005. In the July 27, 2014 Wall Street Journal (WSJ) opinion piece, Fisher states:

“I believe we are at risk of doing what the Fed has too often done: overstaying our welcome by staying too loose, too long.”

Incentives To Take On Risk

Fisher noted that Janet Yellen was also aware of the potential risks of maintaining the Fed’s current stance. From Fisher’s WSJ piece:

“In her recent lecture at the International Monetary Fund, Fed Chair Janet Yellen said, ‘I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns.’ She added that ‘[a]ccordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability.’ I believe that time is fast approaching.”

Investment Implications – Good To Be Aware Of

Should we sprint for the equity exits after reading Fisher’s comments? No. However, it is good to be aware of the Fed’s willingness to raise rates sooner than many market participants believe. The risk is not related exclusively to a rate increase. It is the timing of the rate increase that could catch some investors off guard.

How do we use all this? Fed policy is one of many inputs impacting the battle between bullish economic conviction and bearish economic conviction. As noted on July 28, the market will guide us if we are willing to listen. Not much has changed this week. Therefore, the 80% confident 20% concerned analysis in this week’s video still applies. Therefore, we continue to hold a mix of stocks (SPY), leading sectors (XLK), and a relatively small stake in bonds (TLT).

The possible market-spooking outcome this week or in the weeks ahead is if the Fed signals an interest rate hike may be coming sooner rather than later. Again, it is not the act of raising rates that matters, but the timing.

The Market Will Guide Us If We Are Willing To Listen

July 28, 2014

Lessons From 1994

If you were investing in 1994, you probably recall it was a difficult year. Notice the similarities to 2014 in the text from The Economist below:

CAST your minds back to 1994. The Federal Reserve had kept rates at (what seemed then) the low level of 3% for three years in an effort to allow the financial sector industry to recover from the savings & loan crisis, a problem that was the result of reckless expansion and lending (thank goodness they learned the lessons of that disaster). The Fed then started very modestly to tighten monetary policy with a quarter point rate increase. But the bond market had its worst year since the late 1920s.

As interest rates began to rise in 1994, stock investors began to become concerned about the possible negative impact on the economy and earnings.

What Could Kick Off A Correction?

It could be any number of things, including a shift in Fed policy, rising inflation, or weak economic data. It is more likely that a stock market correction will be ushered in based on numerous factors. This week brings a few potential catalysts: GDP and a Fed statement Wednesday, and a monthly labor report Friday.

What Does A Healthy Market Look Like?

If we understand what extreme cases look like, it is much easier to discern between normal volatility and something that may morph into a more serious and prolonged correction. Not too many bad things can happen as long as the S&P 500 remains above the moving averages shown in the chart below.

What Does A Correction Look Like?

If we compare and contrast the chart above and the chart below, we can see they are quite a bit different. Warning signs were visible in early May 2010. Stocks did not bottom until early July 2010. If you are skeptical, this video walks through the 2010 chart step by step, showing observable shifts that occurred early in the corrective process.

Housing Data Met With Early Selling

Monday morning was dominated by sellers after a worse than expected report on housing. From Bloomberg:

Stocks slumped earlier in the day as fewer Americans than forecast signed contracts to buy previously owned homes in June, a sign residential real estate is struggling to strengthen. An S&P index of homebuilder shares dropped 1.6 percent to the lowest level since May.

Investment Implications

It is not possible for the S&P 500 to enter a multi-week or multi-month correction without closing below 1955. On Monday afternoon, the index was trading at 1980, or well above 1955.

Since the S&P 500 was basically flat at press time on Monday, the statements below from July 26 still apply:

It is fair to say we remain about 80% confident and 20% concerned about equities. While the 80% figure is still encouraging, it is not as high as it was even a week ago. Therefore, we continue to hold U.S. stocks (SPY), and leading sectors, such as transportation (IYT). However, we reduced our stock exposure Friday and took a relatively small stake in bonds (TLT). Since rising rates are a concern, we kept some powder dry in the form of cash.

Part of the 80% confident is based on the fact that the S&P 500 is still trading above all the moving averages shown in the 2010 charts above. At some point, the evidence will begin to shift. It is not necessary to try to guess or anticipate when a correction will begin. When the evidence changes, we will make the necessary adjustments.

Fed May Help Open Crack In Correction Door

July 26, 2014

Debate About First Rate Hike Looms

Even if you follow the markets from a distance, you know the Fed’s near-zero interest rate policies have played a big role in the stock market’s recent gains. Markets get jittery when the expression “first rate hike” starts to make the rounds. The Fed is due to release a policy statement on Wednesday, July 30. From The Wall Street Journal:

While Fed policy makers are unanimous on the bond-buying program, they are increasingly divided on when they expect to start raising short-term interest rates from near zero, where they have been since late 2008. “I am finding myself increasingly at odds with some of my respected colleagues at the policy table,” Richard Fisher, president of the Federal Reserve Bank of Dallas, said in a speech earlier this month. He predicted the Fed could start raising rates by early 2015 “or potentially sooner.”

Investors Having Second Thoughts?

Regular readers know we make decisions based on observable evidence, rather than predictions. The weekly charts of the broad NYSE Composite Index below provide an example of an observable shift in investor conviction.

Can The Fed Keep Stepping Back?

When the Fed considers raising interest rates, or is in the midst of tapering, the question becomes can the economy stand on its own? A mixed report on the U.S. economy Friday did not clarify things for the economic bulls. From Reuters:

Shipments of these so-called core capital goods fell 1.0 percent. Core capital goods shipments are used to calculate equipment spending in the government’s gross domestic product measurement. It was the third month of decline in shipments, prompting some economists to temper their second-quarter growth estimates. “The weak performance in core capital goods shipments during the quarter suggests that this segment of the economy is unlikely to contribute much to economic activity,” said Millan Mulraine, deputy chief economist at TD Securities in New York.

What Is The Market Telling Us Now?

While it is far from time to panic, the market is not as confident as it was 20 calendar days ago. The bulls are still in control, but the odds of a stock market correction have increased a bit. This week’s video compares confidence vs. concern as of Friday’s close.

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While markets tend to get jittery during periods of Fed policy reversals, volatility has been tame in recent weeks. It is important to keep an eye on both the stock and bond markets in the coming weeks. A spike in interest rates could usher in a rough period for stocks and bonds similar to 1994.

Monthly Labor Report Coming Friday

The Fed will not be the only big event for investors in the coming week. The always-obsessed-about monthly labor report is due to be released before the opening bell Friday. From Bloomberg:

Employers probably added more than 200,000 jobs for a sixth consecutive month in July, according to the median estimate of 35 economists surveyed before nonfarm payrolls data due Aug. 1. “The payroll number is going to be strong,” said Phyllis Papadavid, a senior global-currency strategist at BNP Paribas SA’s corporate and investment-banking unit in London, on July 23. “That will underpin shifting expectations around the dollar for the second half of the year.”

Investment Implications - Risk Management

Based on the evidence we have in hand, it is fair to say we remain about 80% confident and 20% concerned about equities. While the 80% figure is still encouraging, it is not as high as it was even a week ago. Therefore, we continue to hold U.S. stocks (SPY), and leading sectors, such as transportation (IYT). However, we reduced our stock exposure Friday and took a relatively small stake in bonds (TLT). Since rising rates are a concern, we kept some powder dry in the form of cash. We will enter next week with a flexible and open mind given the busy calendar of events. If we are willing to listen to the market’s pricing mechanism, and allocate accordingly, managing risk and reward will be much easier in the weeks ahead.

Stocks: Confidence vs. Concern

July 25, 2014

Still Relevant Big Picture Risk Management Articles - Weekend Reading.
More links and charts on Twitter.

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July 25, 2014

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Why Higher Stock Market Highs Matter

July 25, 2014

Post with charts is available on See It Market.