CCM Clients: We raised some additional cash in the vast majority of client accounts today. We will continue to monitor the markets and economic reports closely in the coming days and weeks.
Archive for August, 2010
Last week, we mentioned in the post Stocks Take on Increasingly Bearish Tone that the market’s outlook remained very fragile. Our decisions to raise some cash on Wednesday, Thursday, and Friday of last week were based on a deteriorating technical picture.
With weak numbers from the Philly Fed and another disappointing employment report, the market looks terrible today. Volume is up sharply vs. the same time yesterday, which indicates a heavy bearish bias. Similarly, the advance-decline ratio and up-down volume ratios are very weak, favoring the bears.
We worked last weekend to prepare for possible market weakness this week. Unless the market makes a big recovery, which seems unlikely, the odds are very good we will raise more cash to protect principal.
While the numerical values of the technicals have improved, the short-term health of the market remains mixed with a tentative bullish bias. The consumer discretionary sector’s strength relative (RS) to the S&P 500 made a new six-week high yesterday, which is a positive sign. The sector includes Home Depot, Lowe’s, Ford, Walt Disney, and Amazon. In the recent past, when consumer discretionary stocks have shown leadership relative to all stocks in the S&P 500, it has been bullish.
The CCM BMSI closed yesterday at 1,549, which is a bullish reading, but one that needs to be monitored closely given recent trends in economic data. The recent trend of disappointing jobless claims remained intact as this morning’s weekly report came in above expectations.The four-week moving average of claims increased to 482,500 last week, the highest level since the week ended Dec. 5, 2009, from 474,500.
On Saturday, we posted charts in Where could the stock market’s slide take us? For now, the markets have held at areas that made sense as of Friday’s close. Below, the charts as of Saturday’s post are shown in the “Before” portion and the charts as of Tuesday’s close are shown below the “After” portion.
While these charts show steps in the right direction, Monday’s moves do not mean much unless the markets can build on the gains.
A significant step would be for the markets to reclaim their 200-day moving averages. The 200-day on the S&P 500 stands at 1,116.
In their understandably concerned state of mind in the present day, investors may have lost sight of the longer-term drivers of asset prices. Bonds, especially U.S. Treasuries, have merit presently as high levels of debt have sparked concerns about deflation. However, in the long-run, the case for stocks, commodities, commodity-related currencies, and precious metals looks quite a bit stronger than the case for bonds.
In the current 24-hour news cycle, we have three separate stories that are significantly intertwined and related to this topic:
- According to the Washington Post, the Obama administration opened its conference on the future of housing policy yesterday with Treasury Secretary Tim Geithner promising both an overhaul of Fannie and Freddie and a continued federal role in backstopping mortgages
- James Bullard of the St Louis Fed told The Wall Street Journal the Federal Reserve might need to commence a program of moderate purchases of U.S. Treasury bonds if inflation continues to fall.
- In the Great American Bond Bubble (WSJ), Jeremy Siegel and Jeremy Schwartz, compare the current state of the U.S. Treasury market to the tech bubble of the late 1990s.
The long-term outlook for U.S. Treasury bonds is questionable at best, yet investors continue to make bigger and bigger bets on government IOUs. Earlier this year, the Congressional Budget Office (CBO) said the government faces a “daunting” fiscal future. Federal budget deficits will average $600 billion over the next decade, according to CBO’s outlook. “U.S. fiscal policy is on an unsustainable path to an extent that cannot be solved by minor tinkering,” said CBO Director Douglas Elmendorf.
Despite the “daunting” and “unsustainable” state of the government’s finances, Tim Geithner’s comments yesterday gave no indication taxpayers would be leaving the cash-draining mortgage business anytime soon. In the end, losses at Fannie and Freddie related to the financial crisis may cost taxpayers $305 billion, according to one estimate recently published by Mr. Zandi and Alan Blinder of Princeton University.
The further we go out into the future, the higher the probability the government will turn to the printing press, which is not good news for longer-term inflation rates, nor holders of U.S. Treasuries. Recent policy moves by the Fed and James Bullard’s paper making the case for further quantitative easing signal to the markets the Fed is willing to print more money if needed.
Treasury bonds may have appeal in the short-to-intermediate-term as markets wrestle with deflationary forces. However, do bond holders really believe the political will exists today, or will suddenly surface in the future, to address the “unsustainable” state of U.S. financial affairs? It is much easier to print money than to cut budgets or raise taxes. The U.S. will be forced to make some hard decisions related to spending and taxes, but you can bet money printing will be part the equation in the foreseeable future.
The harsh reality we are faced with prompted Warren Buffet to remark:
A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, at some point, it’s going to inflate its way out of the burden of that debt.
Not only are the long-term fundamentals unattractive for holders of U.S. debt, but valuations are also prompting comparisons to the tech bubble of the late 1990s. From this morning’s opinion page in the Wall Street Journal (The Great American Bond Bubble, Siegel and Schwartz, 08/18/2010):
- A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds.
- We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.
- The rush into bonds has been so strong that last week the yield on 10-year Treasury Inflation-Protected Securities (TIPS) fell below 1%, where it remains today. This means that this bond, like its tech counterparts a decade ago, is currently selling at more than 100 times its projected payout.
- Those who are now crowding into bonds and bond funds are courting disaster.
- If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear?
In Stocks Continue to Walk a Fine Bull-Bear Line, we acknowledge the short-to-intermediate term outlook for stocks, and risk in general, remains bullish, but very fragile. Longer-term, the fragility of the bullish outlook for stocks, commodities, and precious metals will probably be strengthened by macro forces that point in the direction of money printing and inflationary outcomes. Therefore, an investor should keep oil, copper, gold, silver, the Australian dollar, Canadian dollar, and commodity-related stocks on their long-term radar.
We often refer to the market’s bull-bear line of demarcation. When the market hovers in bull market territory, but just above bear market territory, the risk-reward profile of stocks can shift rather rapidly in either direction. The market remains bullish currently, but has little room for error from its current position.
In the chart below, green is best, yellow is neutral to a little concerning, orange is concerning, and red represents an unfavorable risk-reward environment from a historical perspective. The table below still contains quite a bit of green. However, the one to three month outlook remains uncertain. When BMSI scores fall into negative territory, the market’s historical risk-reward profile becomes unfavorable. Just above the zero line for BMSI scores, the profile is quite favorable.
The bottom line is we need to remain patient and nimble in the current environment. The markets are leaning bullish, but the outlook remains very fragile.
As of 1:45 p.m. ET, stock market internals look decent which reduces the odds of a sharp sell off today. Internals can change rapidly and anything can happen in a fragile market, but for now they are holding up.
All analysis of the financial markets is probabilistic in nature, which acknowledges up front the possibility you could be wrong. While the markets may blow through every line in the charts below, it is important for us to understand approximate areas where buyers could become interested in stocks and other risk assets. Thinking in probabilities allows us to better balance risk and reward as we make allocation decisions in the days and weeks ahead.
While the risk-reward profile of the markets deteriorated significantly on Wednesday, Thursday, and Friday of last week, we must respect markets can find buyers when it seems extremely unlikely. There is little in the way of evidence supporting an abatement of the current decline in stocks over the next few days. The charts presented here identify some areas where the market could unexpectedly find some buying support over the next few days or weeks.
Markets tend to have symmetry in terms of tops and bottoms; notice market behavior near the parallel lines below.
This weekend, we are reviewing our asset allocation models which help us understand market leadership and potentially attractive investments for the next few weeks to a year. We are also reviewing client accounts in terms of cash levels and exposure to risk.
We will enter next week ready to approach further declines in asset prices. When the S&P 500 was trading near 1,010 in early July, we mentioned being patient may allow us to assess the risk-reward profile of our portfolios under more favorable conditions. That is exactly what we did last week; when prices were higher, we decided to reduce our exposure to cyclical assets.
As we mentioned in Stocks Take On Increasingly Bearish Tone, we must acknowledge the recent gains by the bears and be prepared for all outcomes.
The last three trading days have done significant damage to the market’s risk-reward profile. The S&P 500’s chart is taking on a more and more bearish tone; something that has us concerned. The market’s failure in the last three trading days to hold the 200-day moving average discounts some of the recent progress made by stocks and risk assets in general.
NYSE advancers vs. decliners and up/down volume ratios were again better on Friday (as they were on Thursday). The S&P 500 closed below its 50-day moving average, which is bearish short-term. Volume ran well below yesterday’s level, which is not surprising on a late summer Friday.
We raised some additional cash in numerous client accounts today. The S&P 500 remains above the bull/bear demarcation line according the CCM BMSI, but the outlook remains very fragile. Our decisions to raise some cash on Wednesday, Thursday, and Friday were based on deterioration in the market’s risk-reward profile. We are open to reducing risk further should the market’s tone remain negative next week. There is no question we will enter the week with a defensive bias. A move back above the 200-day (now at 1,115) would reduce our short-to-intermediate-term concerns.
Unless economic data improves in the next five weeks, the odds of the Federal Reserve expanding their quantitative easing program at their September 21, 2010 regularly scheduled meeting are well above 50%. If you take the time to read James Bullard’s Seven Faces of “The Peril” (our guess is many commenting on it have not read it), the possibility of a “bazooka” move by the Fed, in terms of quantity and longevity, could be coming sooner than many talking heads believe. The following is taken directly from Bullard’s case for additional quantitative easing (bond buys):
In the Japanese quantitative easing program, beginning in 2001, the BOJ (Bank of Japan) was unable to gain credibility for the idea that they were prepared to leave the balance sheet expansion in place until policy objectives were met. And in the end, the BOJ in fact did withdraw the program without having successfully pushed inflation and inflation expectations higher, validating the private sector expectation. The U.S. and the U.K. have enjoyed more success, perhaps because private sector actors are more enamored with the idea that the FOMC and the U.K.’s Monetary Policy Committee will do “whatever it takes” to avoid particularly unpleasant outcomes for the economy.
A Fed announcement in the next six weeks which calls for a vast expansion of quantitative easing would go a long way in terms of reminding “private sector actors” the Fed “will do whatever it takes” in their quest to inflate asset prices (stocks, commodities, and real estate) and create positive inflation. As we have said in the past, regardless of whether or not a “bazooka” move will be effective in the long-run from an economic perspective, it can impact asset prices and the financial markets in the short-to-intermediate term.
We do not believe quantitative easing or money printing is the path to prosperity, but we do believe strongly a “bazooka” move by the Fed has the potential to push financial markets higher for a few weeks or a few months. If the markets deteriorate further between now and early September, we need to incorporate possible Fed moves into our short-to-intermediate-term allocation decisions. We are not planning on the Fed doing anything or planning on any specific market outcome, but we are assigning probabilities to possible Fed moves and possible impacts on asset prices. Prudent money management should be based on probable outcomes and risk-reward profiles.
CCM Clients: We are updating all our models this morning using data from yesterday’s close. We will study the risk-reward ratios of similar market conditions using the CCM BMSI and the 80-20 Correction Index. We are taking a hard look at the relationship between daily 80-20 scores and weekly/monthly scores. Given the market’s recent rally off the July lows and the weakening state of the economy (slower growth), we may continue to tweak our allocations to move more in line with current conditions. We have seen nothing yet to change our view of the probabilistic outlook into year end, but the risk-reward profile for the next 30 to 60 days has deteriorated in the last three trading sessions. As we did yesterday, we will spend the entire day conducting research and reviewing client accounts. We remain open to further risk-reduction if the facts point us in that direction.