You Can Draw Your Own Conclusions About Risk vs. Reward
You Can Draw Your Own Conclusions About Risk vs. Reward
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Charts Provide An Unbiased Reference Point
One of the great things about stock charts is they allow us to track the markets using reference points from the past. For example, we may have drawn a trendline three weeks ago, then three weeks later the market rallies back to the trendline and reverses. Therefore, in today’s post we are going to republish a previous post, but with updated charts as of February 3, 2016. The updated charts alllow us to ask:
Have the charts improved in terms of looking more like the bullish turn in 1994?
The original post, “Do The Bulls Have Any Reason For Hope?”, was dated Jan 12, 2016. The same post appears below with updated charts.
Flexibility: An Ally In Markets
We recently outlined numerous concerns about the sustainability of the current bull market in stocks. Experience tells us that thinking we know what the future looks like is a big mistake. If you are skeptical about the previous statement, look at the track record for economic and market forecasts; it is not good. Therefore, under our approach we allocate our portfolios based on facts.
Since market profiles can improve when new facts come to light (see March 2009), it is important for us to keep an open mind about all future outcomes (bullish and bearish).
Markets Are Always Dealing With Good And Bad News
Markets and charts always reflect the net balance between good news and bad news. Bear markets start when the net balance shifts to the bad side of the ledger. The previous statements can be applied to any year with any mix of good and bad news.
Historical “Open Mind” Case
Given the 2016 market profile is concerning, it is logical to ask:
Have stocks ever rallied from a similar good news vs. bad news profile?
The answer is yes, in 1994-1995. Before you say, but today is different, keep in mind the market was dealing with good and bad news in 1994, just as it is today. The charts in 1994 reflected the net interpretation of all the good news and all the bad news.
Trends Reflect The Net Aggregate Opinion
One way to keep an eye on the market’s net interpretation is to look at market trends. When trends are bullish, it tells us the net interpretation is positive relative to future expectations. When trends are bearish, it tells us the net interpretation is indicative of concerns about future outcomes. The two weekly charts below show trends (the net interpretation of all fundamental data) in late 1994 are similar to trends in early 2016. There is nothing magical about the 25, 50, or 100-week moving average; we could have used the 50-day and 200-day or any number of technical methods.
From A Similar Profile, Some Improvement Took Place
In 1995, when good things started to happen, the improvement started to show up on the chart (see below). Notice how the slopes of the 25-week (blue) and 50-week (red) flipped from negative to positive. In 2016, the slopes of the 25-week and 50-week remain negative. If the S&P 500 rallies in 2016 and the slopes of the 25-week and 50-week turn back up, it will improve the odds of good things happening.
What Happened Next In 1995?
Stocks did very well tacking on an additional 41% of gains between early 1995 and mid-1996.
Important Point: No Improvement Yet In 2016
For the 1994 analogy to remain alive, the 2016 S&P 500 chart needs to show improvement; something that has not happened yet. The present day profile continues to reflect a net concern about future outcomes, similar to periods in 2007-2008 and 2000-2001.
The Historical Cases Can Help Either Way
Can the 1994 case help us with bearish odds? Yes. If the 2016 chart starts to deviate from the 1994 analogy, it speaks to increasing bearish odds. For example, the 2011 analogy worked very well in 2015, as clearly demonstrated here. However, the 2011 analogy appears to be breaking down in 2016 (as outlined here), which speaks to increasing odds of bad things happening. The keys in 2016:
Our purpose here is not to say the market’s profile will or will not improve in 2016, but rather to point out that history says things can improve from a similar net aggregate interpretation of all the good news and all the bad news. The bulls are on the ropes, but the ten count has not been given yet.
Is The Third Market Myth About To Be Exposed?
This week’s stock market video looks at three investing myths. Two of the myths have been taken off the table; the third remains. What could happen when the third market myth falls?
Fed Speaker Monday
After last week’s Fed statement, the market will be looking for some additional insight when Fed Vice Chairman Stanley Fischer speaks Monday. From MarketWatch:
It is likely to be standing room only at the Council on Foreign Relations on Monday as the market strains to hear Fed Vice Chairman Stanley Fischer’s latest views on the economy and interest-rate policy. “Obviously Fischer is going to get a fair bit of attention, coming so soon after the January statement and with a fair bit of question of what they meant,” said Michael Hanson, economist at Bank of America Merrill Lynch.
The Most Important Story Of Our Investment Lifetimes
This week’s video features the “three legs of the stool” story. The story focuses on three market myths and the impact on the psychology of global financial markets.
Investment Implications - The Weight Of The Evidence
Given the damage done to the market’s risk-reward profile in January, it is too early to determine the significance of Friday’s big rally in stocks.
The charts below show similar points during the dot-com bear market and financial crisis bear market. Takeaway number one is each bear market (or correction) is unique. Takeaway number two is not too many good things happen when the 50-day (blue) is below the 200-day (red) and the S&P 500 is below both moving averages. In the 2000-2001 example, stocks did not find a bottom for another 18 months. In the 2007-2008 case, stocks remained in a downtrend for an additional 9 months.
As noted in this week’s video, ugly looking market profiles can begin to improve at any time, which means it pays to remain highly flexible and open to all market outcomes (bullish and bearish). Given what we know today, cash, some currencies, and bonds (IEF) continue to offer a better longer-term risk-reward profile relative to stocks (SPY).
The Most Important Story Of Our Investment Lifetimes
An Apple A Day
Apple (AAPL) is due to report earnings after the bell Tuesday. Wall Street is known for lowering expectations prior to earnings in order to paint a more favorable picture of the actual results. Investors will have the hard numbers in hand in a few hours. From MarketWatch:
Analysts surveyed by FactSet expect Apple to just barely set a new iPhone sales record of 75 million, though that would mark a year-over-year improvement of just one million, versus much higher growth rates in the past. Morgan Stanley told investors in a note on Tuesday that they should brace for the first year-over-year sales decline for the iPhone since its 2007 launch.
Trends Speak To Economic Conviction
When the net aggregate opinion of all market participants is favorable, markets tend to push higher. Conversely, when the net aggregate opinion becomes pessimistic, markets tend to drop. Moving averages help us monitor the market’s pulse. During a correction, the S&P 500 (shown in black below) tends to drop below the colored moving averages. Also note the slopes of the colored moving averages (MAs) tend to roll over during sharper pullbacks in equity prices. The bullish period on the right side of the chart looks quite a bit different (price above MAs, slopes of MAs are positive).
How Does The Same Chart Look Today?
Even with the S&P 500 up 23 points during Tuesday’s session, the slopes of the moving averages are all negative, which is indicative of a bearish trend. Our interest in stocks would increase if the chart below can morph into something similar to the right side of the 1990-1991 chart above.
Investment Implications - The Weight of The Evidence
As noted in this week’s video, the concerning evidence is starting to spill over into longer timeframes. The hard data in hand continues to lean toward bonds (IEF) and cash, relative to equities. With a Federal Reserve statement coming Wednesday at 2:00 pm, it is prudent to keep an open mind about all outcomes, while respecting the market’s current waning risk-reward profile.
Fed Statement Wednesday
Heading into this week’s FOMC meeting, the Fed has been unable to convince skeptical markets about the prospect of multiple rate hikes in 2016. From The Wall Street Journal:
Officials at the U.S. Federal Reserve have penciled in four rate increases this year, but investors have long doubted the U.S. central bank will follow through and market turbulence could give officials pause. They must weigh low inflation and worrying signs from tumbling stock markets against a job market that is fast improving and potentially taking up economic slack.
S&P 500 Trying To Hold Key Level
From a short-term perspective, the stock market bulls prefer to see the S&P 500 Index remain above last Thursday’s high of 1,889. A daily close below that level could increase selling pressure.
Longer-Term Signals Hard To Ignore
Regardless whether or not stocks can mount a countertrend rally, the outlook for the remainder of 2016 will remain questionable. This week’s video covers some ominous longer-term signals similar to those that occurred in November 2000 and January 2008.
Market Looking For A Change In Fed’s Tone
If the Fed sticks to the “four rate hikes in 2016” script this week, the odds of further declines in equity prices will increase. The bulls are hoping for a more dovish tone given recent weakness in global markets. From The Wall Street Journal:
Fed officials are preparing for a policy meeting next week, at which they are widely expected to keep short-term rates on hold after lifting them in December. Traders in futures markets see a 70% probability the Fed will keep rates on hold again at a March policy meeting and less than a 50% chance it will move rates up again by midyear.
Will Friday’s gains be fully retraced?
100% Normal And To Be Expected
In this week’s video we noted that markets would be easy if they went up every day during a bull market and down every day during a bear market (see clip). As humans, when we see bearish charts, we tend to expect the market to drop every day. Since we know markets do not work that way, it is prudent to remind ourselves that any sharp drop (correction/bear market) is typically accompanied by sharp countertrend moves.
Mental Preparation Important
If we know a countertrend move falls into “normal” territory, it is easier to filter out the noise when the next one begins. Right now, the stock market is in a downtrend. We assume it will remain in a downtrend until proven otherwise. Therefore, any initial rally in 2016 will be treated as a countertrend rally (aka noise) until the data proves otherwise.
If Stocks Bounce
The table below shows some reasonable levels that the NYSE Composite Stock Index could rally back to, along with the percentage gain from the close on January 20, 2016. The purpose here is not to predict, but rather to become mentally prepared for an inevitable countertrend rally that will occur at some point in the coming days/weeks/months.
Four Levels That Have Been Relevant In The Past
The chart below shows what may be a neckline on a weekly head-and-shoulders pattern. The pattern is described here relative to a similar pattern in 2008. It should be noted that as long as the market stays below the neckline, stocks remain vulnerable to dropping further before any countertrend move. As of January 20, the market remains below the neckline.
Weekly lows in August 2015 and January 2016 both occurred near 9,513 on the NYSE Composite Stock Index.
9,732 was relevant in early 2014 and again in late 2015; it may be relevant again, but this time “what once was support may now act as resistance”.
9,886 found buying support after a sharp drop in October 2014; it may be relevant again, but this time “what once was support may now act as resistance”.
Stocks Continue To Drop Scenario
If the breach of the neckline, shown in the first chart above, holds, stocks could continue to fall further as they did in 2008. Since studies have shown predictions about where stocks will be in several weeks or several months tend to be no better than a coin flip, we will continue to monitor and adjust rather than anticipate and hope.