Short Takes

As we mentioned on March 17, an “oversold” CCI reading of -236, which is rare, recently occurred on the daily chart of the S&P 500 Index. This weekend we went back and found all the cases, during a bull market, where CCI hit -236 between 1982 and 2011. It only occurred 40 times. From a historical risk-reward perspective, it may offer a very good entry point for cash. Risk-reward ratios historically fell between 5.39 and 30.05 in favor of bullish outcomes when you look at the market’s performance three weeks to twelve weeks after a CCI reading of -236 or lower was registered on the daily chart of the S&P 500.

Before we invest more cash, we would like the market to check off a few more of the “things we would like to see” as shown in the table from March 17 (see “Patience is a Virtue” table).

Since the markets have pulled back significantly from their recent highs, it is a good time to revisit our big picture investment strategy. Attractive sectors, based on fundamental and technical data, include energy (XLE) and industrial stocks (XLI). While a good case for stocks in the materials sector (XLB) also exists, we prefer the materials themselves (commodities) relative to stocks.

The fallout from the devastation in Japan may hamper the growth of nuclear power in the United States, which in turn could increase the demand for more traditional sources of energy including oil and coal (KOL). According to CBS News:

Right now, the South Texas Project, as this nuclear power plant southwest of Houston is called, produces nearly 8% of the electricity used in Texas. Until ten days ago, it looked as if NRG, the New Jersey company that owns it, was on track to start building two new reactors here, creating 8,000 jobs and enough power to light two million homes. “It’s not necessarily a fatal setback, but it’s a substantial setback,” said David Crane, the CEO of NRG. “If you ask me, can I give you assurance that this plant will be built, it very much depends on what’s going to happen [in Japan], what’s the reaction going to be once this event is over and people are assessing the implications.”

Energy stocks have maintained their leadership even through the market’s recent pullback, which is a good sign in terms of them remaining attractive in the coming weeks and months.

Barron’s looked at the need for Japan to increase energy imports to replace lost capacity:

S&P analysts are bullish on U.S. refiners with operations on the West Coast. Those refiners could be called on to supply refined products to Japan, whose refining capacity has diminished considerably. Among the refiners that could benefit are Tesoro (TSO), Valero (VLO) and Alon USA Energy (ALJ), says equity analyst Tanjila Shafi.

One of the top holdings in the industrials exchange-traded fund is Catepillar (CAT), which was also mentioned by Barron’s:

Of the stocks S&P equity research covers, Jaffe says Caterpillar (CAT) has the largest footprint in the Asia-Pacific region.

With the heavy damage to buildings, homes, and infrastructure in Japan, demand could increase for products, equipment, and services related to the rebuilding effort that will take years to complete. According to the Wall Street Journal:

The major rebuilding effort that will need to take place should eventually benefit companies that make building materials and construction equipment, Standard & Poor’s Equity Research Services analyst Michael Jaffe said in the strategy report. Construction giant Caterpillar Inc. (CAT, $105.09, +$1.97, +1.91%) in particular has a sizeable presence in Asia, Jaffe pointed out. Caterpillar said its facilities in Tokyo, Akashi and Sagami were not damaged by the earthquake and are on the outside of the current Japan-mandated evacuation zone. Separately, Caterpillar said in a filing with the Securities and Exchange Commission that its global dealer sales are up 59% for the three months ended February.. During the same period the company’s North American sales grew 55%.

Until the markets regain their footing, the nuclear situation in Japan becomes less dire, and the ongoing unrest in the Middle East subsides, we prefer physical commodities to the stocks of material producers. If the equity markets weaken further and/or the economic outlook deteriorates, the odds of the Fed moving toward QE3 increase. Under those circumstances, commodities become attractive as an alternative to paper currencies.

Dow Jones summed up the possible investment implications of recent events in Japan as follows:

The tragedy in Japan is still unfolding, and the extent of the devastation is uncertain, but there will come a time when the country will rebuild. When that happens, the reconstruction effort will be massive and lengthy, and will involve both Japanese and international companies. With that in mind, Standard & Poor’s highlighted some of the companies and industries that could see greater demand for their products and services as Japan recovers. The S&P selections aren’t so surprising — concentrated on building materials, engineering and construction firms that will be called to repair and rebuild Japan’s housing and infrastructure, and oil refiners that could meet the country’s energy needs now that its nuclear power industry is crippled.

We are open to adding to our positions in energy, including oil-related equipment makers (IEZ), industrials (XLI), and commodities (DBC, SLV). However, we still want to see some improvement in the markets as we outlined in Strategy and Outlook for a “Prove It to Me” Market.

Just as we backed away from risk over the last few weeks, we took a step back toward risk on Thursday. We updated our CCM Asset Allocation Model, which compares 220 asset classes/sectors/subsectors head-to-head. Understanding we may be a little early in terms of redeploying some cash, our rationale was as follows:

• We remain in a bull market until proven otherwise.
• Overbought conditions have been cleared.
• Many markets rebounded today from extreme oversold conditions allowing us a better risk-reward entry point than what has been available since the summer 2010 lows.
• About 35% of the short-term “buy signals” have already occurred, which is why we were not overly aggressive today.
• CCI for the S&P 500 is rising after hitting -200, which often offers a good early entry point after a relatively sharp pullback.

As we have stated in the past, the incremental approach takes into account that we could be wrong from two different perspectives:

• We may be too early since stocks could make lower lows before making higher highs.
• It is possible, but not likely, a new bear market has started.

The whole purpose of having cash on hand is so we can deploy it when fear levels are high and markets are oversold. If we see the remaining 65% of what we want to see, based on our market models, we will happily reinvest more cash. If the market makes a lower low that may provide an even better entry point for the balance of our cash. The S&P 500 is now back above 1,256, 1,262, and 1,270.

We will keep an open mind about both bullish and bearish outcomes, but we have to give the bulls the benefit of the doubt given the technical state of the markets, recent economic data, and still extremely “loose” monetary conditions. There is a decent chance that sometime in the next few weeks buying today may feel like a mistake based on price. However, our guess is if the markets do make lower lows positive/bullish divergences will be present signaling an even more attractive entry point.

In yesterday’s analysis, we stated, “We believe the strongest potential support exists near 1,256″. The support table from yesterday’s post is shown below:

Is It Time to Trade Stocks and Silver for Gold? also presents some evidence that supports being ready to act fast with our cash if needed.

Market professionals and experienced investors consider it to be common knowledge that silver has more real-world uses than its precious metal sister gold. Silver is used in coins, photography, batteries, bearings, electronics, and mirrors. Silver also aids in numerous medical applications and even contributes to helping capture and use solar energy. The Silver Institute describes “silver uses” as follows:

Demand for silver is built on three main pillars: industrial and decorative uses, photography, and jewelry & silverware. Together, these three categories represent more than 95 percent of annual silver consumption. In 2007, 455.5 million ounces of silver were used for industrial applications, while over 128 million ounces of silver were committed to the photographic sector, 163.4 million ounces were consumed in the jewelry market, and 58.8 million ounces were used in the silverware market.

Why is this indispensable metal in such demand? The reasons are simple. Silver has a number of unique properties including its strength, malleability and ductility, its electrical and thermal conductivity, its sensitivity to and high reflectance of light and the ability to endure extreme temperature ranges. Silver’s unique properties restrict its substitution in most applications.

While gold is used in numerous consumer products, such as in computers and electronics, according to geology.com about 78% of the gold consumed each year is used in the manufacture of jewelry. Investors also respect the use of gold as an alternative to paper currencies and as a safe haven asset.

The point is silver tends to be in greater demand relative to gold during economic expansions and bull markets. Gold tends to be in greater demand when concerns rise about economic downturns or geopolitical events. These basic investment tenants describe how stock investors can benefit from monitoring the gold/silver ratio, which is simply a study of the demand for gold relative to the demand for silver. Before looking at how the gold/silver ratio can help us better understand the threat of an ongoing correction in stocks, we will review recent historical cases that illustrate swings in relative demand for these precious metals.

According to a February 28 story in The Daily Reckoning:

The US Mint sold over 6.4 million silver Eagles in January, more than any other month since the coin’s introduction in 1986. China’s net imports of silver quadrupled in 2010, to 122.6 million ounces, roughly 13.7% of global production. Meanwhile, mine production can’t meet worldwide demand; the only way demand gets fulfilled is from scrap supply.

On March 10 we showed how defensive assets, such as the VIX and utilities, were gaining strength relative to the stock market. Just as the changes in relative strength can help us better understand a possible shift in market sentiment, the gold/silver ratio could be termed the “defensive/expansion ratio”. When investors are playing defense, the ratio rises since gold is in favor relative to silver. When investors are less concerned with Armageddon-like events and more focused on better economic times, the ratio falls since silver is in favor relative to gold.

In terms of where the economy sits right now, the Fed opened its March 15 statement with an upbeat tone:

Information received since the Federal Open Market Committee met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually. Household spending and business investment in equipment and software continue to expand.

On March 15 we looked at the performance of numerous asset classes and market sectors under two scenarios – during the April-August 2010 ‘flash crash’ correction and during the subsequent QE2-induced rally off the August 2010 lows. Today we dig a little deeper into the data to help us better understand the risk of another prolonged correction occurring in the coming months. The table below shows how investments related to precious metals performed during a defensive/corrective period (left) and during a period where economic expansion/inflation-friendly assets were in favor (right). Investments related to precious metals are highlighted in green. Gold is represented by the gold ETF (GLD). Silver is represented by the silver ETF (SLV).

Just as we would have guessed, gold outperformed silver during the ‘flash crash’ correction by a margin of almost 2-to-1. Similarly, when market participants became less fearful and began to focus on economic growth and QE2, silver significantly outperformed gold in late 2010 and year-to-date.
The question of the day is:

What are silver and gold telling us now and how does it potentially impact the stock market?

The chart below shows a bullish turn in the gold/silver ratio that was “confirmed” by a higher high on April 27, 2010. Think of April 27 as a bullish turn in the defensive/expansion ratio, meaning defensive-minded investors overtook bullish investors in terms of their conviction.

As shown below, the stock market did not perform well after the bullish turn in the gold/silver ratio. Compare April 27 in the chart above to April 27 in the chart below.

The good news is the present day gold/silver ratio is not telling us to swap our silver and stocks for gold; at least not yet. The gold/silver ratio remains in a downtrend (pink line), which means the conviction of gold buyers has not yet surpassed the conviction of silver buyers. Said another way, the conviction of defensive-minded investors has not yet surpassed the conviction of economic bulls.

Three things need to happen from a technical perspective for gold to gain the upper hand on silver. The first one, breaking above the pink trendline, has not even occurred yet. It may indeed happen in short order, but for now the gold/silver ratio is terming the current state of the stock market as a “pullback”. It may indeed upgrade the classification to a “correction”, but relative to the events of 2010 we have not even met that standard yet.

In terms of our investment strategy, this analysis does not alleviate our concerns about Japan and the fast-approaching completion date for QE2. As we stated yesterday, this remains a ‘prove it to me’ market, meaning we have been and are open to raising more cash using the incremental approach. On Wednesday, we cut back further on gold stocks (GDX), Australia (EWA), Germany (EWG), and inverse-Treasury bonds (TBT). The current state of the gold/silver ratio does leave us open to better than expected outcomes over the next few weeks. Our short-term bull/bear checklist, based on the S&P 500, remains in the “be patient” range.

The CCM 80-20 Correction Index is telling us to remain defensive, but to also keep an open mind relative to where stocks may be in three-to-six months. In the tables below, high numbers indicate more favorable conditions in terms of historical risk vs. reward.

The figures in the tables are as of Wednesday’s market close. Notice the current risk reward numbers (top of table below in yellow and green) and are attractive relative to the market’s average and median profiles under various conditions.

The market’s current profile, from a positive perspective, means little unless we see evidence starting to accumulate which points to a probable change in the short-term trend. Said another way, until we see evidence to the contrary, we need to maintain a defensive bias. Once the evidence begins to shift, we have to look at the market objectively to make the best allocation decisions possible.

Today’s post can be found here.

While the natural human reaction to the market’s steep decline today is to sell based on fear, the current profile of the S&P 500 relative to history tells us some patience may be in order. Most people make emotional decisions in the stock market. Most people do not make money in stocks. We have to be willing to think independently and make decisions based on facts, instead of emotions.

The CCM 80-20 Correction Index is telling us to remain defensive, but to also keep an open mind relative to where stocks may be in three-to-six months. In the tables below, high numbers indicate more favorable conditions in terms of historical risk vs. reward.

The figures in the tables are as of Monday’s market close.

The market’s current profile, from a positive perspective, means little unless we see evidence starting to accumulate which points to a probable change in the short-term trend. Said another way, until we see evidence to the contrary, we need to maintain a defensive bias. Once the evidence begins to shift, we have to look at the market objectively to make the best allocation decisions possible.

As of 11:30 p.m. EDT, S&P 500 futures are down 1.55%. According to a Bloomberg story:

Japan’s Prime Minister said the danger of further radiation leaks from a crippled nuclear power station is rising after three explosions and a fire at the site 135 miles north of Tokyo. Naoto Kan appealed for calm in a televised address, saying his government was doing its utmost to contain the radioactive leakage at Tokyo Electric Power Co.’s Fukushima Dai-Ichi plant following last week’s earthquake and tsunami. Blasts have occurred at three of the station’s six reactors since March 12 and a fire was discovered in a fourth unit’s building today.

From the Wall Street Journal:

TOKYO—Japan’s nuclear crisis showed signs of spinning out of control Tuesday, after officials reported a third explosion and warned of possible damage to a critical part of the cooling system at the troubled Fukushima Daiichi nuclear-power complex.

During the last week, we have been doing research on the market’s downside risk. We will present the results sometime in the coming days. The S&P 500 has good support near several levels; including 1,270, 1,256, and 1,225, which means we need to keep a level head and monitor the markets and situation with an open mind. Markets often find an intermediate bottom soon after the peak level of fear. We are not discounting the risks; we are simply stating the fact that investment decisions based primarily on fear often turn out to be poor decisions. A detailed look at the possible impact of upcoming Fed statements can be found in Will the Fed Hint at QE3 and Surprise the Bears?

Given the increasing risks in Japan and the significant drop in S&P 500 futures, we will amend our market strategy to the following:

• We will continue to be patient with our cash until the news from Japan calms down a little and the technical picture in the U.S. improves.
• Since we have been raising cash for a few weeks, if Tuesday’s session gives us some hope for an approaching intermediate bottom, we will hold our longs and see how the S&P 500 acts near key levels, including 1,275, 1,270, and 1,256.
• If the S&P 500 finishes below 1,294 and/or 1,289 on Tuesday, we may consider raising some additional cash using the incremental approach. We may cut back further on energy (IEZ) should the bears continue to control the market.
• If the market can find its footing soon, or near the levels above, we are willing to consider some redeployment of cash, possibly using a broad market approach (VTI or SCHB). A reversal near 1,270 or 1,256 would allow us to redeploy more cash than a reversal near 1,290 or 1,294.
• Broad weakness may also have us consider reducing our exposure to technology (QQQQ).

Given the stark contrast between asset class performance before and after the implied announcement of QE2, the Fed’s statements related to quantitative easing in the coming weeks will have a significant impact on the outlook for stocks and the relative attractiveness of asset classes, market sectors, and subsectors.

The Fed is scheduled to issue statements on March 15 and April 27, 2011 with the following concerns as a backdrop:

• Higher food and oil prices.
• Unemployment hovering near 9%.
• Turmoil in the Middle East.
• Devastation and ongoing uncertainty in Japan.

With QE2 set to end on June 30, the natural questions for market participants are:

• Should we be concerned?
• Did QE1 and QE2 impact asset prices?
• Is QE3 a possibility?

We believe the answers to all three questions are “yes”. The chart below shows the very uncomfortable transition from QE1 to QE2.

For those market participants who doubt whether QE3 hints by the Fed will have an impact on asset prices, the chart below shows the S&P 500’s performance after Ben Bernanke’s August 27, 2010 Jackson Hole speech, which basically told the markets QE2 was on the way.

The role of asset prices, balance sheets, and ‘full employment’ in the Fed’s decision-making process are often underestimated by those who focus primarily on inflationary pressures. Consequently, many investors and economists are forecasting the U.S. Federal Reserve will raise rates sooner than history would suggest. The chart below was published by Bloomberg on February 9, 2011.

Bloomberg’s commentary related to the chart above:

After the past two U.S. recessions, the Fed didn’t start raising policy rates until joblessness had fallen about three- quarters of the way back to the full-employment level, the CHART OF THE DAY (above) shows. To satisfy that requirement, the jobless rate would need to be 6.5 percent, compared with today’s 9 percent.

Just as the chart above implies rates may stay lower longer than most believe, it is also possible the market may be underestimating the odds of the Fed bringing QE3 to life in the coming months. If any portion of the March 15 and/or April 27, 2011 Fed statements leave the door open to QE3, the impact on the markets could be significant. We recently studied the performance of ninety-two assets classes/sectors/investment options when:

• QE1 Was Not In Play: Between April 23, 2010 and August 26, 2010.
• QE2 Was In Play: Between August 27, 2010 and March 9, 2011.

The results of the study will help us focus on different areas of the market based on the Fed’s statements related to quantitative easing. The table below summarizes our findings when looking at the top eighteen performers under the two scenarios. The very limited overlap in asset class performance between the left and right sides of the table below highlights the importance of the Fed’s stance on quantitative easing relative to the outlook for both defensive and inflationary/economically-sensitive assets.

The investments that provided the detail behind the summary table above are shown in the colored tables below. Notice only two investments, silver (SLV) and agriculture (RJA), performed well in both QE environments. The investments highlighted in blue below recently showed improving relative strength which supported raising some additional cash in the last week.

If the Fed leans toward more quantitative easing, we will focus on assets on the right side of the tables above and below, including expanding our search to similar inflationary options. If the Fed leans toward wrapping up quantitative easing in June, we will consider the relative merits of the defensive assets on the left side of the tables above and below.

All bull markets have backing from market participants based on both speculation and fundamentals. Speculators are a normal part of functioning asset markets since they provide needed liquidity. A healthy and sustainable bull market has a reasonable balance between its reliance on fundamentals and speculation.

The rally off the 2010 summer lows, in our opinion, was based heavily on speculation. On August 27, 2010 with the financial markets teetering on the deflationary abyss, Ben Bernanke signaled QE2 was on the way in his Jackson Hole speech.

The speculative bent to investing since the summer 2010 lows has many market participants, including us, concerned that an end to quantitative easing could usher in a repeat of the sharp declines in asset prices seen between April 23 and August 26, 2010. If this scenario plays out, we will monitor the relative strength of the defensive assets and inflationary assets listed above in order to make more informed investment decisions.

As we await the Fed’s statements due on March 15 and April 27, we should keep in mind Federal Reserve Chairman Ben Bernanke’s response, while recently at the National Press Club, to a question about the potential for QE3:

“In the end, we’ll just ask the same questions. Where’s the economy going, and what do various inflation indicator look like? We’ll ask those questions. If unemployment is still too low, then we may continue. If we’re moving towards full employment, then we won’t need to stimulate more.”

Remarks from William Dudley, President of the Federal Reserve Bank of New York, during a recent speech at New York University may also provide some insight to the Fed’s stance:

“The economy can be allowed to grow rapidly for quite some time before there is a real risk that shrinking slack will result in a rise in underlying inflation.”

The recent drop in the unemployment rate may also factor into the Fed’s decision-making process. Caroline Baum noted in a recent opinion piece:

In the last two months, the civilian unemployment rate plummeted from 9.8 percent to 9 percent. While payroll growth, derived from a separate survey of businesses, was tepid, history suggests such steep falls aren’t a drop in the bucket. Large month-to-month declines in the unemployment rate are rare and “usually signal the start of a very strong upturn in growth,” says Joe Carson, director of economic research at AllianceBernstein in New York.

With a weak stock market, high unemployment, and recent events in Japan, comments made by Charles Evans, President of the Federal Reserve Bank of Chicago, during a recent interview with the Financial Times may foreshadow Fed statements in March and/or April geared toward accommodative policy:

“The message that comes out of what I think of as high-quality research on this subject is that policy ought to remain accommodative for really quite a while, even a while after conditions start to improve.”

A March 2 BusinessWeek/Bloomberg article covering the possible continuation of the Fed’s asset purchase program stated:

A third round of purchases “has to be a decision” of the Federal Open Market Committee, and “it depends again on our mandate” for stable prices and maximum employment, Bernanke said in response to Texas Representative Jeb Hensarling, the House panel’s vice chairman and a critic of QE2.

Responding to a question from Representative Nydia Velazquez, a New York Democrat, Bernanke said the Fed’s policy of keeping its benchmark rate near zero for an “extended period” helps provide support to the economy, “which in our judgment, it still needs. The economy’s recovery is not firmly established, and we think monetary policy needs to be supportive,” he said.

Looking at the case for ending QE2, Bloomberg noted on March 4:

Economists such as Joseph Lavorgna say the Fed should stick to its commitment to end the program in June. “What markets would like are clear rules,” said Lavorgna, chief U.S. economist at Deutsche Bank Securities Inc. in New York. “If they said they are going to end in June, they should end in June.” That’s a view shared by the Philadelphia Fed’s Plosser, who is also a voting member of the FOMC this year.

Regardless of whether it is embedded in the March 15 or April 27 Fed statement, based on the remarks from the Atlanta Fed’s Dennis Lockhart, we can expect some direction from the Fed relative to where they are headed with quantitative easing:

“It is important that we communicate so we don’t surprise markets, regardless of the chosen path of that particular policy,” he told reporters after a speech in Tallahassee, Florida.

An AP article from March 14 does a good job summing up the situation as the Fed heads into their March 15 meeting:

The Fed chief and a majority of his colleagues argue that the economy still needs support from the bond purchases, especially with unemployment still high and home prices in many areas depressed. But a vocal minority on the Fed has raised concerns that the bond purchases, combined with higher prices for food, fuel and other commodities, will spread inflation through the economy. They also say they worry that the purchases could feed speculative buying that could inflate new bubbles in the prices of stocks or other assets.

We believe the key portions of the AP statement above are the “Fed chief and a majority of his colleagues” versus “a vocal minority”. The history of the Fed in recent years is that the Chairman tends to set policy. Since Ben Bernanke remains at the helm, we will remain open to the possibility of a third quantitative easing program (QE3), which could significantly alter the market’s general outlook and relative performance of asset classes. Another scenario, a stronger than expected economy, could discount the need for QE3, but under those conditions inflationary assets will most likely outperform defensive assets.

Some anecdotal evidence that traders positioned themselves for the possibility of inflationary statements from the Fed comes via the relative strength charts below. The charts show Monday’s trading session. Notice how defensive assets weakened relative to the S&P 500 in the afternoon.

Inflationary assets drew more interest from buyers late in the day. These charts mean little except that the expectation on the street is leaning toward inflationary rather than deflationary statements from the Fed on March 15.

Monday’s market action did contribute to our decision to take no further defensive actions near the close. We will wait for the Fed’s statement and monitor the market’s reaction both on Tuesday afternoon and Wednesday morning.

UPDATE 2:00 p.m. EDT: The vast majority of our positions have some form of support relatively close to current prices. Therefore, based on our current cash and conservative asset allocations, as long as these levels hold, it makes sense to be patient. If these levels are violated, we will consider our options. These levels could be broken in the next few hours or the next few days, but as of this post they remain relevant.

While we believe the bull market remains intact and stocks will make higher highs later in 2011, we cannot assume that will be the case. It is important to remain defensive until we see evidence of a positive turn in risk assets. We are reviewing client accounts again today - we may move more money to the sidelines - please see the bottom of this nuclear post for more specifics related to possible strategy.

The chart below is an updated version of a chart presented on March 11. As of 12:20 p.m. EDT on Monday, the MACD bearish cross we have been concerned about has occurred. MACD red is above MACD black. However, this is a weekly chart – therefore the signal becomes more meaningful if the chart looks this way as of the close this Friday 03/18/2011.