Archive for March, 2011

Will 1970s-Style Inflation Derail the Bull Market in Stocks?

Thursday, March 31st, 2011

Inflation can adversely affect corporate profits, household discretionary spending, and stock prices. Rising costs for raw materials have a dampening effect on profits. Increasing costs of food and energy begin to account for larger and larger portions of a household’s disposable income. From an investment perspective, when the annual inflation rate jumped significantly between 1971 and 1974, stock market (SPY) returns eventually suffered as shown below.

High Inflation and Stocks

With the Fed creating asset inflation via quantitative easing, it is important investors keep their eye on the inflation ball over the next six to eighteen months. Aaron Smith, managing director of Superfund Financial Ltd. and Superfund USA Inc., told Bloomberg:

Coffee, sugar and cocoa prices will rise five- to 10-fold by 2014 because of shortages that will mean consumers getting “swamped” by food-price inflation, according to Superfund Financial.

A lack of farmland and rising costs means growers will fail to keep up with demand.

“There’s a tremendous shortage of food, there’s a tremendous shortage of arable land. Any kind of food products are going to increase.”

The negative effects of rising food prices are amplified in many emerging countries since food makes up a larger percentage of household spending than in more developed nations, such as the United States. Inflation contributed significantly to the somewhat rare outperformance of U.S. stocks relative to the emerging markets between October 2010 and February 2011 (see below).

U.S. Stocks relative to Emerging Markets

Understanding any projection spanning roughly 40 years is subject to significant revisions over time, the figures highlighted by Bloomberg below are still unnerving:

World food production will have to increase by 70 percent by 2050 to meet increasing demand from an expanding global population, projected to rise to 9.1 billion by 2050 from 6.9 billion now, Hiroyuki Konuma, the UN Food and Agriculture Organization’s regional representative in Asia, said in an interview in Bangkok on March 9.

On March 15 we showed the impact of QE2 on asset prices. With food prices rising at rapid rates and oil sitting at almost $107 per barrel, the Fed is caught between the proverbial rock and a hard place. The hard place is the deflationary forces that still exist in the form of excess debt, excess capacity, high unemployment, and strained balance sheets. The rock is the rising threat of inflation. If the Fed bows to inflation, global stock markets will be forced to stand on their own, which did not go well after the Fed closed the books on QE1. QE2 is slated to be wrapped up in June.

The markets have rebounded impressively off extreme oversold conditions that were present on March 16. While the current advance is somewhat tentative, it remains possible the S&P 500 could march toward 1,400 or 1,440 before inflation or the absence of quantitative easing spooks investors. The CCM 80-20 Correction Index closed Thursday at 1,206, a level that historically corresponds to favorable market outcomes more often than not. The risk-reward ratios of 6.06, 7.10, and 9.08 looking out six, nine, and twelve months respectively are attractive (see table below).

market outlook - risk reward

On March 28, we outlined some issues, including the end of QE2, which we continue to believe necessitate a flexible approach to the markets. We are happy to hold our current positions and have been redeploying cash since March 17 into energy (XLE), materials (XLB), commodities (DBC), and mid-caps (IWP). Rationale for favoring these areas of the market was provided on March 21 and March 23.

Stock Market Breadth Continues to Improve

Thursday, March 31st, 2011

We often use the Summation Index as a way to illustrate changes in market breadth. Market breadth refers to the number of advancing stocks vs. the number of declining stocks. Healthy markets have broad participation, meaning more stocks are going up than are going down.

A slightly different way to look at the market’s internals is to compare the number of stocks making new highs to the number of stocks making new lows. Healthy markets have a much higher percentage of new highs relative to new lows.

While the chart below is very busy and looks complicated, the concepts are simple. The black and red line that looks like a reading from a heart monitor is NYSE New Highs – New Lows (or Net New Highs). The thin colored lines are various moving averages (MAs) for the heart-monitor-like line. The moving averages tend to cluster in the center of the graph. A weak market tends to stay below the moving average cluster and a stronger market tends to stay above the moving average cluster. The recent pattern has been when (1) New Highs – New Lows makes a significant low below the moving average cluster (see green arrows) , and then (2) moves above the moving average cluster (see blue arrows), stocks have gone on to post gains (see purple lines). Notice on the right side of the chart, we recently had a low (see (1)) followed by a move above the moving average cluster (see (2)).

Stock Market Breadth is Improving

While we know the general concepts presented have potentially bullish implications, we have not done extensive back testing of the pattern above, which means we would term it anecdotal bullish evidence. However, the Bull Market Sustainability Index (BMSI) does use NYSE New Highs – New Lows and the moving average cluster. The BMSI has been extensively back tested.

Moving back to our more familiar measure of market breadth, the Summation Index, the chart below shows, as of the close on March 30, market breadth continues to improve. When the Summation Index turns up, it increases the odds of stocks being able to sustain a rally. Note the stock market’s performance (shown at top of chart) following positive turns in the Summation Index (see green boxes). We are seeing a similar turn now.

Stock Market Outlook - Investing Blog

This analysis is based on how markets work. It has nothing to do with what anyone “thinks” is going to happen, nor is it based on someone’s interpretation of the fundamentals. This is a probabilistic analysis that respects markets can do anything at anytime, even when the odds are in our favor.

‘Whipsaw’ Strategy for Stocks

Wednesday, March 30th, 2011

According to Investopedia, a whipsaw is a condition where a security’s price heads in one direction, but then is followed quickly by a movement in the opposite direction. The origin of term is derived from the push-and-pull action used by lumberjacks to cut wood with a type of saw with the same name.

As we stated yesterday, our End-of-a-Correction Model has checked off 94% of the items on the list of things we would expect to see when the market is turning from a short-to-intermediate downtrend to a short-to-intermediate uptrend. Is it still possible that stocks make a lower low by dropping below the intraday low on March 16 of 1,249? Sure it is – anything is possible when millions of people are digesting new information and making buy and sell decisions based on their interpretation of the information.

Based on the market’s recent extreme oversold condition, we believe that if stocks make a lower low, it will be accompanied by positive divergences. A positive divergence occurs when stocks make a lower low, but an indicator or indicators make a higher low. When positive divergences are present, it is much easier to (a) hold your long positions, and (b) add to your long positions.

An example of a whipsaw followed by a positive divergence is shown below. The orange arrows highlight bullish signals in RSI and MACD. For our longer-term investment perspective, these proved to be false signals since stocks made a new low soon thereafter (see orange line). The good news is the lower low was accompanied by a positive divergence in MACD – stocks made a lower low while MACD made a higher low (see green solid line). The July 2010 low proved to be a good buying opportunity as we postulated on July 3, 2010, despite that being a time where it was easy to find bearish articles and analysis.

Whipsaw Strategy for Stocks

If stocks make a lower low that is not accompanied by positive divergences, we must respect and plan for the possibility of a longer and more painful correction in stocks and risk assets. In the present day market, the Summation Index continues to give bullish signals (see below).

Whipsaw Definition Stock Market Trading

Bulls Get Benefit of Doubt - End of QE2 Concerning

Tuesday, March 29th, 2011

James Bullard, President of the Fed’s St. Louis Bank, is speaking in Prague today. According to Bloomberg:

He said four areas in particular are raising “macroeconomic uncertainty.” These included turmoil in the Middle East and north Africa, the natural disaster in Japan, “the U.S. fiscal situation and the possibility of a government shutdown,” and Europe’s sovereign debt crisis.
Chairman Ben S. Bernanke has given no indication the central bank will deviate from its plan to buy bonds through June to spur economic growth and reduce 8.9 percent unemployment.

Since QE2 is due to end in June and given the “macroeconomic uncertainty” mentioned by Mr. Bullard, we continue to believe flexibility is required (see post) relative to the market’s current advance. The monthly employment report will be released this Friday at 8:30 a.m. EDT - another reason to remain open-mined about both bullish and bearish outcomes.

As of Monday’s close the S&P 500 Index has checked off 94% of the boxes on the what-you-would-expect-to-see-at-the-end-of-a-correction list. False turns are the exception, rather than the rule, so we will continue to give the bull market the benefit of the doubt until we see evidence to the contrary.

The CCM 80-20 Correction Index closed Monday at 1,167. As shown via the table below, this 80-20 level corresponds to favorable risk-reward outcomes from a historical perspective.

market outlook - risk reward

A risk-reward ratio of 1.00 represents a situation where the upside and downside for a given market are equal. Higher risk-reward ratios are more favorable. The table below takes a closer look at the S&P 500’s current profile. The ratios near the bottom of the table show the average and median risk-reward ratios – the current ratios are shown in the colored boxes above. If we look out six weeks to a year, the market’s current risk-reward profile from an historical perspective is very favorable.

investing blog - market outlook - risk reward

Flexibility May Be Key During Current Advance

Monday, March 28th, 2011

As we mentioned on March 22, a case can be made for the S&P 500 Index reaching 1,400 to 1,440 sometime in 2011. Currently, the economy is growing, earnings are respectable, and the Fed continues to print money. However, a few significant concerns require a flexible approach to the markets:

  • Debt problems continue to plague Europe and the United States
  • The Fed is hinting at slowing down the printing presses.
  • The market’s current advance is beginning from a somewhat extended technical state.

Monday morning brings more somewhat troubling news from Europe. Ireland said it wants the senior bondholders of banks to take a haircut in the form of loss sharing. According to Bloomberg:

Ireland’s government wants “a sustainable and comprehensive solution that involves recapitalization, but also an element of burden sharing as well as a funding package for Irish banks,” Coveneny told RTE in an interview yesterday. “A lot of delicate and difficult discussions are going to take place over next two to three weeks, if not slightly longer.”

For those with short memories, last year’s ‘flash crash’ correction occurred in part due to concerns about debt and the euro. Since January 11, 2011, risk investors have had a tailwind in the form of a weak U.S. Dollar. A debt scare in Europe could spark a rally in the U.S. Dollar, which all things being equal would be a negative for stocks and commodities.

As we outlined in detail on March 15, asset prices have been broadly impacted by the Fed’s second quantitative easing program (QE2). The Fed seems to be posturing for ending QE2 either on June 30 as scheduled or at their April 26-27 meeting. It remains to be seen if the markets can stand on their own without the aid of the Fed’s printing presses. According to a Bloomberg story, James Bullard, the St. Louis Federal Reserve Bank President, seems to be closing the door on any hope for QE3 (at least for now):

“The economy is looking pretty good,” Bullard told reporters in Marseille, France, today. “It is still reasonable to review QE2 in the coming meetings, especially this April meeting, and see if we want to decide to finish the program or to stop a little bit short.”

“We’re far away from normal policy,” Bullard said. “I think it’s important to take a few steps back to normality. Even if you make a few small moves, monetary policy will still be accommodative for some time to come.”

“If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we’re going to start withdrawing our stimulus, and I’d start by pulling up a little bit short on the QE2 program,” Bullard said. “We can’t be as accommodative as we are today for too long, we’ll create a lot of inflation if we do that.”

Our third concern relates to the extended state of the markets when viewed on weekly and monthly charts. The CCM Bull Market Sustainability Index (BMSI) currently sits at 3,900, which tells us the current advance may be shorter in duration than the move off the November 2010 lows. Our 80-20 Correction Index paints a little more encouraging picture with risk-reward ratios for stocks being favorable relative to historical averages.

market outlook - risk reward

In terms of our investment approach, the market’s recent extreme oversold condition gave us an opportunity to redeploy cash by adding to our positions in energy (XLE), materials (XLB), commodities (DBC), mid caps (IWP), values stocks (VTV), and industrials (VTI). Due to our concerns outlined above related to debt, the Fed, and an extended market, we must be willing to raise cash again in relatively short order if the current rally proves to be short-lived.

Market Outlook Continues To Improve Despite Numerous Concerns

Friday, March 25th, 2011

Bull markets are said to “climb a wall of worry”, which speaks to the contrarian role of investor sentiment relative to stock prices. The news continues to provide reasons to be concerned, and yet the market has gained 5.2% since making an intraday low of 1,249 on March 16. According to Bloomberg:

European Union leaders cut the startup capital for the future euro emergency aid mechanism after German demands to make smaller upfront payments stoked fresh concerns about Europe’s effort to quell the debt crisis (full story).

Japan’s nuclear regulator said one reactor core at the quake-damaged Fukushima Dai-Ichi power plant may be cracked and leaking radiation. “It’s very possible that there has been some kind of leak at the No. 3 reactor,” Hidehiko Nishiyama, a spokesman at the Japan Nuclear and Industrial Safety Agency said in Tokyo today. While radioactive water at the unit most likely escaped from the reactor core, it also could have originated from spent fuel pools stored atop the reactor, he said (full story).

Ireland’s government may have to inject an additional 27.5 billion euros ($39 billion) into the country’s banks after a third round of stress tests next week, according to a survey of analysts and economists. That will exhaust about 80 percent of the 35 billion-euro fund set up last year in Ireland’s international bailout to shore up the country’s lenders, according to the median estimate of 10 analysts and economists surveyed by Bloomberg News (full story).

Investors Intelligence surveys stock market newsletter advisors and produces a way to track sentiment in the form of their bull/bear ratio. From a contrarian perspective, extreme ratios on the high end tend to be bearish; extreme readings on the low end of the range tend to be bullish. If investor sentiment continued to be stubbornly bullish in the aftermath of recent events in Japan, the Middle East, and Europe, it would be a red flag for the markets. The good news is the bull/bear ratio has dropped from a recent high of 3.00 to the current reading of 2.26, which aligns well with what we would expect to see during on ongoing bull market.

What are the technicals telling us about the market’s recent rally attempt? They are telling us to respect the move and that the odds favor it continuing. Is it possible that the bullish indications outlined below are incorrect and the market “whipsaws” us in the form of a resumption of the recent declines? Yes, but possible and likely are not the same thing. The odds favor a continuation of (a) the current rally attempt, and (b) the primary trend, which is up and bullish. As outlined on March 22, we continue to believe the S&P 500 could reach 1,400 to 1,440 sometime in 2011.

From a big picture perspective, despite the recent correction in stocks, investors on the long side of the market have three major factors in their favor: (1) the economy is growing, (2) earnings are strong, and (3) monetary policy remains extremely accommodative. Consequently, we began to redeploy cash on March 17, including adding to our positions in energy (XLE, XOP, IEZ), materials (XLB), commodities (DBC), precious metals (SLV, GLD), mid caps (IWP), value stocks (VTV), and industrials (XLI). We provided some sector specific rationale to support these moves on March 20. In Oversold Market May Represent An Opportunity, we outlined a rare “extreme oversold condition” that from a historical perspective (1982-2011) offered a favorable risk/reward entry point for cash.

Simple support and resistance analysis tells us “what was once resistance now becomes support” as prices move up. The market now has several forms of possible short-term support in close proximity, which improves the risk-reward profile for taking cash off the sidelines.

Stock Market Outlook Improving

Developments in the March 24 trading session also supported investing some additional cash. Market breadth refers to the number of advancing issues and the number of declining issues in a given market. Healthy markets have positive breadth or broad participation in rallies. The Summation Index, shown below, is an intermediate-term measure of market breadth. Currently, the Summation Index is trying to make a bullish turn (see green arrow in lower-right of chart below). Notice how the S&P 500 acted (see top of chart) after the Summation Index made positive turns in the past (see green boxes). Since we always think in probabilistic terms, the move in the Summation Index increases the odds of a sustainable turn in stock prices.

Stock Market Outlook Improving

Continuing with the probabilistic theme, numerous short-term technical indicators have turned bullish on the chart of the S&P 500 Index (see Part I and II below).

Stock Market Outlook Improving

As we mentioned previously, it is possible, but not likely, that these are false signals and the market will soon turn down again. Based on studies of recent corrections and subsequent rallies, we have a “correction model” which looks at eighteen different things we would expect to see at the end of a correction and at the beginning of the subsequent rally. As of the close on March 24, eighty-three percent of the boxes have been checked in a bullish manner.

Stock Market Outlook Improving

According to a Commerce Department report released on Friday, U.S. real gross domestic product increased at a 3.1% annualized rate in the fourth quarter, revised up from the 2.8% pace reported one month ago. These numbers are nowhere near what we would expect to see near the onset of a new bear market.

Market’s Next Move May Be Telling

Thursday, March 24th, 2011

From a very short-term perspective, the market is in technical no man’s land. Numerous positive developments have occurred, such as RSI rising off low levels. However, numerous concerns, such as RSI remaining slightly below 50, have yet to be cleared.

One more day of gains, especially something of decent magnitude, would most likely clear the vast majority of our concerns. If the market cannot cross these short-term hurdles, a move on the S&P 500 back toward 1,267, or even 1,225, is possible. If the bulls can take advantage of the recent extreme oversold CCI reading of -236, a quick pop back toward 1,315ish is easily envisioned.

Due to the uncertainties listed above, along with ongoing concerns in Europe, Japan, and the Middle East, we have kept some cash on the sidelines and still hold some relatively conservative positions, such as consumer staples stocks. We stand ready with buy orders if conditions warrant adding a little more risk to our portfolios. We still favor energy, mid caps, and industrials.

If stocks move higher from here, we will be happy relative to the cash we recently redeployed and our other long positions. If the S&P 500 makes a lower low, then we are happy to invest cash at an even more attractive entry point. We made no moves yesterday.

Mid Caps Attractive as Mega Caps Get Expensive

Tuesday, March 22nd, 2011

With the bulls in control of the longer-term trends and the bears fighting to maintain control of the shorter-term trends, mid cap stocks may offer a good way to sit on the bull/bear fence. If the S&P 500 heads toward 1,225, which is not out of the question, all things being equal larger-capitalization stocks will tend to hold up better than their small-cap brethren. From a fundamental perspective, Barron’s recently noted that Morgan Stanley completed a capitalization study from several different perspectives. According to Morgan Stanley via Barron’s:

“We analyzed five different market cap cohorts (mega, large, mid, small, and micro) on five major subjects (market risk, valuation and profitability, interest rate considerations, oil price movements, and M&A activity). Despite our cautious bias toward the market, we don’t have a strong preference for mega-caps at today’s levels. If the market falls by 10% or more, then mega- and large-caps should do best, but otherwise the evidence is mixed and we continue to think mid-cap exposure is prudent.”

Morgan Stanley likes mid caps based on a fundamental study. The best investments have both positive fundamentals and positive technicals. Comparing large, mid, and small caps on a relative strength basis also gives the nod to mid caps. The graph below shows the performance the Mid Cap 400 Index (MDY) relative to the Russell 2000 (IWM), which is a widely accepted small cap benchmark. Mid caps began strengthening in late 2010 and have gone on to establish a positive trend relative to small caps.

Mid caps attractive relative to small caps

The Mid Cap 400 Index is also performing well relative to the Vanguard Large Cap ETF (VV).

Mid caps stocks attractive relative to large caps

As we outlined on March 22, with the bull market in stocks intact and with strong global growth projected for the balance of 2011, having the S&P 500 reach 1,400 or 1,440 is within the realm of possibility. Under those circumstances, mid caps may offer a way to boost your returns.

Our asset allocation models have several mid-cap ETFs ranking above the S&P 500 Index in terms of attractiveness, including the top-ranking mid caps slanted toward growth, IJK and IWP. Deciding between the two was primarily a liquidity decision for us. We choose IWP which trades 566,000 shares per day vs. IJK’s 264,000.

Any positive news from Japan is good for the markets, and more importantly for the brave people affected by the quake and subsequent tsunami. Bloomberg reports:

Ocean currents and natural dilution of sea water contaminated by Tokyo Electric Power Co.’s crippled nuclear plant are likely to spare marine life and the underwater ecosystem from devastation, scientists said.

Three Forms of Support For Stocks

Tuesday, March 22nd, 2011

The S&P 500 held near three possible support lines recently. Please see earlier comments for more details on the big picture.

Stock Market Support and Resistance

Market Outlook Improves: S&P 500 Eyes 1,400 to 1,440

Tuesday, March 22nd, 2011

Bloomberg has an aggressively titled article this morning, All Clear Sounded as Markets Shrug Off Multiple Black Swans. Some key points relative to a bullish outlook:

  • Interest-rate derivatives, bond sales by the riskiest borrowers and rebounding benchmark stock indexes all show increasing confidence in the economy.
  • Goldman Sachs Group Inc. forecasts a global expansion of 4.8 percent this year, while JPMorgan calls for 4.4 percent. The average over the past two decades is 3.4 percent.
  • The Institute for Supply Management’s U.S. factory index for the U.S. rose to 61.4 in February, the highest level since May 2004.
  • China said in January that industrial production rose 13.5 percent in 2010, while growth in Europe’s service and manufacturing industries accelerated to the fastest pace in more than four years last month, led by Germany.
  • The Federal Reserve is continuing to pump cash into the U.S. financial system by purchasing $600 billion of Treasuries through June to spur jobs and avoid deflation in a strategy called quantitative easing.
  • AT&T’s agreement to buy T-Mobile USA from Deutsche Telekom AG for $39 billion in cash and stock to create America’s largest mobile-phone company is another sign of confidence in economic stability.
  • Markets have consistently rallied amid shocks, called black swan events by Nassim Nicholas Taleb, the New York University professor. Taleb wrote the 2007 bestselling book, “The Black Swan”.
  • From a fundamental perspective, experienced investors know the periods shown below were less than friendly in terms of stock market returns. Stocks stumbled in July of 1990; bear markets were wrapped around economic weakness in 2001, 2008, and 2009.

    Bear Markets and GDP

    With global growth in 2011 projected to be roughly 35% above the average for the last twenty years, and U.S. markets doing quite well relative to their foreign brethren, the threat of an imminent recession in the United States appears to be quite low. If that is the case, then history tells us the threat of a new bear market kicking off soon also appears to be relatively low.

    From a technical perspective, we are seeing changes in recent days that suggest the market is regaining some bullish traction. According to one of the best trading books ever written, Trading for a Living by Dr. Alexander Elder, RSI or the Relative Strength Index can help us spot a possible change in trend a few days in advance:

    Classical charting methods work better with the Relative Strength Index (RSI) than with other indicators. Trendlines work well with RSI. RSI often completes patterns a few days in advance of prices. For example, RSI trendlines are usually broken one or two days before price trendlines.

    As shown on the chart of the S&P 500 below, RSI broke above the downward sloping blue trendline on Monday, which increases the odds that stocks are finding their footing.

    Stock Market Support and Resistance

    The CCM Bull Market Sustainability Index (BMSI) was created to help us better discern between normal corrective activity in an ongoing bull market and the possible onset of a new bear market. Recent BMSI readings tell us the bulls remain firmly in charge from a longer-term perspective. In the table below, note the favorable risk-reward ratios looking out two-to-twelve months for the S&P 500 Index. The term ‘risk-reward’ concedes that all markets have risk, but the odds appear favorable currently on the long side of the market.

    CCM Bull Market Sustainability Index

    The BMSI (table above) was in the ‘overbought’ red zone in late February and early March making it difficult to invest new funds due to the unfavorable risk-reward profile for stocks. The recent pullback has cleared that troublesome condition allowing us to be more open to redeploying some of our cash. As we have done since last Thursday, we continued to be buyers on Monday adding to our holdings in energy (XLE, IEZ), materials (XLB), industrials (XLI), mid-caps (IWP), and value-oriented stocks (VTV, SCHV). The rationale for our interest in energy, materials, and industrials can be found in our March 20 post on strategy . One of the best times to consider investing cash is when you have an ‘oversold’ market near support. The market recently held near some logical support levels we outlined on March 16 (see pink and green summary table). We also had a rare ‘oversold’ condition that we covered on March 20.

    The CCM 80-20 Correction Index (table below) has also shown improvement over the last three trading sessions. From the 80-20’s perspective, the risk-reward profile for stocks is quite favorable looking out three-to-twelve months. A comparison of the current market profile (see figures between arrows) to average and median profiles (see bottom of table) highlights what currently appears to be a favorable market in terms of potential bang (upside) for the buck (downside risk).

    Stock Market Risk Reward

    Looking at support and resistance, it is logical to assume if the market has regained its bullish posture, the S&P 500 may go on to surpass the recent high of 1,344. Bull markets by definition make higher highs. We remain in a bull market. Looking out to the balance of 2011, it is not out of the question that the S&P 500 Index moves to possible resistance levels between 1,400 and 1,440.

    Stock Market Support and Resistance

    A move to 1,400 represents a gain of 7.85% from the close on 03/21/2011. A move to 1,440 would put smiles on the bull’s faces in the order of 10.93%. Putting a splash of cold water on that favorable outlook, we have yet to complete a turn in the present day confirming a short-term shift from a downtrend to an uptrend in stocks. As of Monday’s close, we have seen 61% of the technical developments that history suggests we should see at the end of a pullback, which is why we have kept some powder dry in the short-term. You never know when another ‘black swan’ may be around the corner.

    Stock Market Support and Resistance