Archive for the ‘Stocks - U.S.’ Category

Trading Range or Stock Correction Remain Most Plausible Scenarios

Tuesday, April 15th, 2014
  1. The mixed-bag economy and mixed-bag market continue to call for defensive contingency plans.
  2. Given what we know today, a rapid and sustainable push to new highs in stocks appears to be the least likely scenario, behind consolidation/correction.
  3. Earnings have been decent so far, but Wall Street makes sure the expectation bar is set at a comfortable level.
  4. An allocation of stocks, bonds, and cash allows for needed flexibility and migration paths until a more dominant theme can emerge.

Playing The Low Estimate Game

Isn’t amazing how the majority of companies meet or beat earnings expectations quarter after quarter? Wall Street has always done a nice job of managing investor expectations. From Bloomberg:

“It’s quite likely that U.S. earnings will beat expectations because analysts have set the bar quite low,” James Butterfill, who helps oversee about $50 billion as head of global equity strategy at Coutts & Co., said by phone from London. “There probably won’t be any particular pressure on margins this quarter, so earnings momentum will continue to rise. I do expect the harsh winter to have impacted the most energy-intensive companies.”

Inflation Aligns With Ongoing Fed Taper

The good news Tuesday came on the earnings front, with Coca-Cola (KO) and Johnson & Johnson (JNJ) eliciting a bullish response. The bad news was related to inflation. From Reuters:

U.S. consumer prices rose in March, but inflation pressures remained generally benign, which should give the Federal Reserve ample scope to keep interest rates low. The Labor Department said on Tuesday its Consumer Price Index increased 0.2 percent last month as a rise in food and shelter costs offset a decline in gasoline prices. Economists polled by Reuters had expected a 0.1 percent rise.

Central bankers tend to print money until inflation forces them to slow down the presses. Today’s inflation data aligns with an ongoing Fed taper.

Ukrainian Military Action?

The unrest continues between Russia and Ukraine. It is possible the markets will have to digest some form of military action, which checks a glass half empty box. From The Wall Street Journal:

A Ukrainian military operation to wrest control of cities in the east from pro-Russian militants has begun, Ukraine’s acting president said Tuesday, as Russia’s foreign minister warned use of force could derail international talks on the crisis. Oleksandr Turchynov said that a phased “antiterrorist” operation began in the early morning hours in the northern Donetsk region, where the majority of the cities commandeered by pro-Russian forces are located. But there were no immediate reports of specific action and it was not clear how big the effort was.

Investment Implications: Mixed Bag = Mixed Allocation

From a fundamental perspective, there are many positives (earnings Tuesday) and many negatives (Fed taper). From a technical perspective, the longer-term trends remain bullish, but the intermediate-term trends shifted to a “risk-off” stance last week. Our nearly equal weights to cash, stocks (SPY), and bonds (TLT) remain appropriate for the current mixed investment climate.

Resistance Test Would Come At 1,850

Another example of a mixed picture is the chart of the S&P 500 below. The good news is the index has gained back 25 of the 49 points lost last week (early in Tuesday’s session). The bad news is various forms of prior support (green arrows below) and prior resistance (red arrows) seem to be congregating near 1,850ish. A reversal below 1,850 could bring a return to last week’s risk-off environment. A decisive break above 1,850 could open the door to a retest of the recent highs (near 1,900).

We have shown frustrating and indecisive charts in recent articles. We could produce additional examples from numerous corners of the market, including the chart of the small cap ETF (IWM) below. If investors had strong convictions about a brighter economic future, we would expect small caps to be performing well, rather than treading water for six months.

Indecisive markets are frustrating animals. If we remain patient and disciplined, the market will tip its hand. For now, a mix of stocks, bonds, and cash offers an appropriate balance between risk and reward. We questioned the sustainability of the bullish advance in stocks on April 4 with the S&P trading at 1,865. We remain concerned with the S&P trading at 1,827.

Stock Bounce Does Little To Alleviate Concerns

Monday, April 14th, 2014
  1. The stock bulls got a nice fundamental trifecta Monday with good news on the economic, central bank, and geopolitical fronts.
  2. However, the rally attempt thus far has done little to alter the market’s intermediate-term risk-reward profile.

Retail Sales: Better Than Expected

After the stock market sells off significantly, any form of good fundamental news can create a fairly significant “oversold” bounce. The stock market bulls got what they wanted Monday in the form of retail sales. From Reuters:

U.S. retail sales recorded their largest gain in 1-1/2 years in March in a decisive sign the economy is bouncing back from its weather-induced slumber. Monday’s upbeat report was the latest to indicate growth was set to accelerate in the second quarter after an unusually cold and snowy winter hobbled activity early in the year.

The good news did little to alter the “economic concerns are increasing” look of the weekly chart below. Consumer discretionary stocks (XLY) still looked ugly on a relative basis as of 2:00 p.m. EDT Monday.

ECB: Good News and Bad News

Risk takers prefer easy money policies from central banks since the added liquidity has to land somewhere. The good news from the European Central Bank (ECB) Monday was they signaled a willingness to expand their stimulative measures. From Reuters:

The dollar rose against the euro on Monday after European Central Bank President Mario Draghi signaled the bank would ease monetary policy further, while strong U.S. retail sales data also boosted the dollar against the yen. Draghi said in Washington on Saturday that “a further strengthening of the exchange rate would require further stimulus”. Bank of France chief Christian Noyer hammered home the message saying: “The stronger the euro is, the more accommodative policy is needed.” “The ECB is taking the value of the euro more seriously in their approach to monetary policy,” said Thierry Albert Wizman, global interest rates and currencies strategist at Macquarie Ltd in New York. The statements marked the ECB’s strongest signal yet that it would act to head off further gains in the euro.

Given the Fed’s easy money policies have been a big driver of stocks in recent years, it is fair to say that all things being equal stock market bulls feel more secure when the U.S. greenback is weakening. The bad news Monday was comments about ECB policy helped push up the U.S. dollar.

The Big Picture

Since investors have much longer time frames than traders, looking at risk from a weekly perspective makes more sense. This week’s stock market outlook video provides numerous forms of observable evidence that point to a deteriorating outlook for equity investors.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

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Ukraine: A More Peaceful Path?

There is no question the Russia-Ukraine standoff has weighed on the minds of investors in recent weeks. The bulls can make an argument that tensions eased a bit Monday. From The Wall Street Journal:

A day after threatening a full-scale military operation to drive pro-Russian militants out of a string of eastern Ukrainian cities, the country’s acting president offered an apparent olive branch Monday, saying he wasn’t opposed to a countrywide referendum on possibly granting regions greater autonomy. The move appears to signal increasing desperation from Kiev, highlighting it has few options for a real response as opponents take over further territory.

Investment Implications – Show Me

Is it possible stocks have found a bottom? Yes, but one day does not make a new trend. Last week we noted the concerning lack of progress in stocks, which is a symptom of increasing economic concerns. The “vulnerability box” was not altered in a meaningful way during Monday’s rally in equities.

We entered the week with an allocation of cash, stocks (SPY), and bonds (TLT); a mix that aligns well with an indecisive and hesitant market. As noted on March 21, discipline is the key to ending up in the right place once a period of consolidation is complete. Last week, the scales tipped toward risk-off. Depending on how the market reacts to the incoming data, including Tuesday’s report on consumer prices, we will ratchet up or ratchet down our risk exposure over the coming weeks.

Stock Market Correction Odds Increasing

Friday, April 11th, 2014

This Week: (1) CCM Market Model, (2) DeMark counts on the S&P 500. DeMark charts and indicators are proprietary tools from Market Studies, LLC.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

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Video Is Being Processed

Friday, April 11th, 2014

Should be available here sometime around 7:30 p.m. EDT on Friday.

The End Of The Correction-Less Fantasy Land

Friday, April 11th, 2014

  1. If you are relatively new to the investing world, you may not have a realistic reference point to understand how painful stock market corrections can be.
  2. A trip down the memory lane of market corrections (1982-2014) reminds us of what a typical year in the stock market can look like.
  3. On the surface, the 2014 stock market is holding up relatively well, but the picture behind the risk-reward curtain is concerning at best.
  4. Even if a corrective episode is averted in the short run, it is only a matter of time before the correction-less investment fantasy land comes to a painful end.

The Vulnerability Box

The S&P 500 closed at 1,833 on December 24, 2013. It closed at the same 1,833 on April 10, 2014, or over three months later. Common economic sense and the law of supply and demand tell us that when stocks stop making bullish progress, bullish economic conviction is losing ground to bearish economic concerns. The previous sentence also tells us the market’s risk-reward profile has been deteriorating since late December 2013.

Bank Earnings Not Helping

What can push a vulnerable market over the edge? Answer: when the net interpretation of all the new information is bearish. One piece of new data that is adding weight to the bearish side of the scale is earnings from JP Morgan Chase (JPM). From The New York Times:

JPMorgan Chase reported an 18.5 percent slump in first-quarter earnings on Friday, as the nation’s largest bank grappled with dual challenges: sluggish revenue from trading and lackluster mortgage lending. Both issues, broadly buffeting the banking industry, damped profits at JPMorgan.

A Trip Down Correction Memory Lane

Since weekends offer an opportunity to study markets and improve our approach to investing, it may be helpful to take a quick refresher course on stock market corrections. We will focus on two questions:

  1. How far can stocks drop?
  2. How long can corrections last?

Sample of Corrections 1982-2014

In 1984, stocks dropped 14.63%. Unlike the multiple-day pullbacks in 2013, this correction lasted two hundred and eighty-eight calendar days (288).

The 1987 stock market crash occurred within the context of a bull market, and the bull market resumed relatively quickly. Therefore, it is relevant to our correction study and 2014.

In 1990, stocks corrected sharply, dropping 20% over eighty-seven calendar days.

We have covered the importance of the investment landscape in 1994 numerous times, including this March 21 article.

In 1998, the correction may have felt like a bear market based on the sharp declines witnessed on brokerage and 401k statements. The 1998 correction was outlined in more detail on April 2.

The 2010 Flash Crash was quite a bit more than a one-day media event. Stocks dropped 16.71% over sixty-seven calendar days.

A political stalemate in Washington and escalating fears of the end of the euro, helped push stocks down over 21% in 2011.

Russia Still A Concern

If you know your market history, you probably remember the fundamental drivers behind the corrections in 1984, 1987, 1990, 1998, 2010, and 2011. The drivers in 2014 could be economic concerns and Russia. From Bloomberg:

Having annexed Crimea and deployed thousands of troops along the border, Russian President Vladimir Putin has been ratcheting up pressure on Ukraine, threatening yesterday to halt gas shipments. Ukraine is dominating discussions at the spring meetings of the International Monetary Fund and World Bank, which start today. U.S. Treasury Secretary Jacob J. Lew “emphasized that Russia’s ongoing occupation and purported annexation of Crimea is illegal and illegitimate,” the Treasury said in a statement after talks in Washington yesterday with his Russian counterpart, Anton Siluanov. “The United States is prepared to impose additional significant sanctions on Russia if it continues to escalate the situation in Ukraine.”

Corrections Can Be Harmful To Your Portfolio’s Health

What are the answers to our questions of how far can stocks drop and how long can corrections last? Based on the examples presented above, the average loss was 19.50% and the average duration was 114 calendar days. Can corrections be less painful? Sure, there are countless examples of more shallow pullbacks. However, understanding what is possible helps with investment contingency planning.

Investment Implications – No Problem, If You Have Contingency Plans

Why do we always reference contingency plans? It is not prudent to assume anything about what will happen next in the financial markets. Therefore, if you use an IF-THEN approach, and the bearish IF never happens, it prevents you from overreacting to vulnerable set-ups that may or may not morph into a correction. Let’s look at a simple contingency plan example for illustrative purposes only. Over the past week, we have outlined reasons to be concerned about increasing odds of a market correction in the articles below:

  1. The Case For Slower Growth, Low Rates And Income Investments
  2. Stocks: 4 Reasons To Have Defensive Contingency Plans
  3. Dow Theory Signal Questions Bullish Economic And Market Trends

If the first contingency in your simple risk-management plan was if the S&P 500 closes below 1,815, I will reduce my stock exposure by 10%. The S&P 500 closed Thursday at 1,833. Hypothetically, if the S&P 500 fails to correct and never closes below 1,815, then no action would be taken. The concept of using IF-THEN contingency plans was outlined in detail on October 18.

Our contingency plans are governed by our market model. The model entered Friday’s session with a very large allocation to cash to offset the market’s increasingly vulnerable risk-reward profile. Based on how things look at Friday’s close, our rules-based system may call for two chess moves: (a) reduce stock exposure (again), and (b) add some conservative investments to the mix. Conservative investment moves typically involve bonds (TLT) and/or currencies (FXA). As outlined in detail on March 27, contingency planning is a quadrant two activity – important, but not urgent. Weekends are a good time for getting into quadrant two.

The Case For Slower Growth, Low Rates, & Income Investments

Thursday, April 10th, 2014

  1. Relative weakness in consumer discretionary and retail stocks is indicative of increasing concerns about future economic outcomes.
  2. Relative strength in longer-dated Treasuries, income-oriented REITS, and dividend stocks reflect decreasing concerns about a spike in interest rates.
  3. Increasing investor demand for commodities and emerging markets shows increasing confidence the Fed will honor their low rate pledge.

Vulnerable Economy?

The consumer discretionary ETF (XLY) holds many common brands, such as Disney (DIS), Starbucks (SBUX), and Ford (F). If you are concerned about your personal finances, you might logically decide to postpone that trip to Disney, cut back on the mocha lattes, and put off test driving a new Ford Focus. It seems as if some consumers have decided to stop off at McDonald’s (MCD) for their morning coffee in recent weeks (see chart below).

A telltale sign of a relatively fragile economy is weak pricing power. When companies are unsure about consumer demand, they are hesitant to increase prices. From The Street:

Prices for Arabica coffee increased over concerns about dry weather in Brazil which could cut production numbers. Starbucks may not pass that price increase to customers this year. In recent interviews CEO Howard Shultz said the company would hold off on any price increases. Some Starbucks locations reportedly lowered prices last week to combat McDonald’s (MCD_) free coffee promotion.

Expectations Toned Down On Rising Rates

Investors almost invariably are early when it comes to expectations for Fed rate hikes. Bonds are not the place to be if you believe interest rates are on the verge of rising rapidly (bonds fall in value in a rising rate environment). Therefore, if investors were becoming more confident the Fed was on the verge of an aggressive campaign to raise interest rates, the last thing they would want to do is flock to interest rate sensitive long-dated Treasury bonds (TLT). The blue arrow below shows a short-term bias toward economic fear, rather than economic confidence.

We are also seeing increasing interest in dividend-oriented investments, such as REITS (IYR), and the iShares Select Divided ETF (DVY). Dividend-paying instruments, like bonds, tend to experience a drag from rising interest rates. Therefore, the interest in IYR and DVY aligns with the low-rate/weak economy theory.

Emerging Markets Point To Friendly Fed

When the Fed prints money to suppress interest rates, it tends to be a negative for the U.S. dollar. The dollar (UUP) has been weak of late, which supports expectations for relatively tame interest rates.

All things being equal, emerging markets (EEM) economies prefer to see low rates in the United States and a weak greenback. EEM has responded.

The IMF recently voiced concerns about emerging markets debt, especially in a rising interest rate environment. If rates remain tamer than expected, some of those fears would be alleviated in the intermediate-term. From The New York Times:

As fears mount about emerging markets, American mutual fund investors with significant exposure to bonds issued by indebted companies in fast-growing economies may be at risk, the International Monetary Fund warned in a report published on Wednesday. In the Global Financial and Stability Report, I.M.F. economists highlighted the trouble spots on the financial horizon, noting the potential for growth to slow and interest rates to rise. As that happens, they estimated that problematic corporate loans could increase by as much as $750 billion and many companies may be pushed into default. That situation would hurt global investors, particularly mutual funds in the United States.

Investment Implications – Patience Is A Virtue

Our concern about adding emerging markets to our portfolios is the recent big picture trend toward increasing risk aversion. We are happy to look at all attractive opportunities, but we prefer to see more bullish stars line up before adding what can be a volatile EEM to our portfolio mix. We have been harping on clear evidence in recent weeks that pointed to a highly-indecisive market. The last 24 hours align with that theory. Wednesday, the S&P 500 was up 20 points; as of 12:30 p.m. EDT Thursday, it is down 22 points. Even though Wednesday’s rally was impressive at face value, we warned yesterday that not much had changed:

Wednesday’s sharp reaction to the Fed minutes and statements from Charles Evans did little to change the market’s risk-reward profile. Therefore, we made no changes to our current mix of stocks (SPY) and cash.

Economic doubts have impacted the emerging markets space this week. Reports from China dashed hopes for an imminent announcement of a major new form of stimulus. From Reuters:

Chinese Premier Li Keqiang ruled out major stimulus to fight short-term dips in growth, even as big falls in imports and exports data reinforced forecasts that the world’s second-largest economy has slowed notably at the start of 2014. Li stressed on Thursday that job creation was the government’ policy priority, telling an investment forum on the southern island of Hainan that it did not matter if growth came in a little below the official target of 7.5 percent. “We will not take, in response to momentary fluctuations in economic growth, short-term and forceful stimulus measures,” Li said in a speech.

The fear trade has gained some significant ground on emerging markets in recent sessions, which is indicative of increasing concerns about the strength of the never-ending global “recovery” (see chart below).

The most recent statements from China contrasted the “hopes for stimulus” story we referenced on April 3 from The New York Times:

China’s leaders are issuing increasingly clear signals that they plan another round of economic stimulus programs, as evidence accumulates that the economy is slowing more than expected this year.

The weight of the evidence is saying stocks (SPY) have greater downside risk today than they did in late 2013. Our market model has offset that risk by maintaining a very significant exposure to cash. If the indecisiveness breaks in the direction of “risk-off”, we will consider redeploying some cash into more conservative investments, such as bonds (AGG). We prefer to see how the remainder of Thursday and Friday play out before considering any chess moves. Wednesday’s bullish jawboning by the Fed is an example of how quickly an indecisive market can be influenced or flipped.

Fed Jawboning, Minutes Give Stocks A Lift

Wednesday, April 9th, 2014

Evans Picks Up Megaphone

On April 8, we outlined reasons to be concerned about stocks. The Fed pays close attention to the market’s risk profile; maybe they didn’t like what they saw. In addition to the Fed minutes that were released Wednesday, Charles Evans seemed to be carrying the “talk stocks back up” torch for the U.S. central bank. From Marketwatch:

Many people who argue that inflation is just around the corner have been repeating the same warning for the past five years, said Charles Evans, the president of the Chicago Federal Reserve Bank, on Wednesday. “I confess that I am somewhat exasperated by these repeated warnings given our current environment of very low inflation,” Evan said in a speech at an economic policy conference in Washington D.C. Evans said he still sees the economic environment pointing to below-target inflation “for several years.” Evans debunked current arguments that inflation is just over the horizon. He said that there is “substantial room” for stronger wage growth without inflation pressures building and added the Fed’s large balance sheet is not a “classic warning sign” of inflation. Commodity prices also seem to be an unlikely propellent of inflation at the moment, he said.

Evans began making dovish comments Tuesday in an effort to calm tapering fears. From Reuters:

There is a real risk that the Federal Reserve could close the tap for monetary stimulus too quickly, a top official at the U.S. central bank said on Tuesday.”One of the big risks is that we withdraw our accommodative policies prematurely,” Charles Evans, president of the Federal Reserve Bank of Chicago, told a panel at the International Monetary Fund.

The minutes from the March Federal Reserve meeting were released Wednesday, providing another source of good news for those concerned about interest rates. From The Wall Street Journal:

The dollar weakened against other currencies Wednesday after details from the Federal Reserve’s most recent meeting showed no signs of higher interest rates ahead. The minutes from the Federal Open Market Committee’s March meeting discussed keeping interest rates low as long as inflation remained below 2% and made no mention of an accelerated time frame for raising them, said Alan Ruskin, global head of G10 FX strategy at Deutsche Bank. DBK.XE +0.26% Lower interest rates have weighed on the dollar.

Investment Implications – Flexibility Takes Fed Into Account

Federal Reserve jawboning is one of many reasons to maintain maximum flexibility in the financial markets. Did Wednesday’s pop in stocks materially change the indecisive climate on Wall Street? According to the chart below, not yet.

How about that Dow Theory non-confirmation we have been concerned about; was it cleared up? The Dow has not posted a new closing high, which means the answer is “no”.

Wednesday’s sharp reaction to the Fed minutes and statements from Charles Evans did little to change the market’s risk-reward profile. Therefore, we made no changes to our current mix of stocks (SPY) and cash. The chart below, presented earlier this week, reminds us that periods of uncertainty can be resolved to the upside. Our cash will be redeployed when the market shows some conviction in some corner of the asset class world. We are just not there yet.

Stocks: Four Reasons To Have Defensive Contingency Plans

Tuesday, April 8th, 2014

  1. The global economy is on track for subpar growth.
  2. Consolidation is a symptom of investor indecisiveness.
  3. Small caps are expensive and investor demand has been falling.
  4. Recent strength in consumer staples indicates a preference for stable earnings and dividends.

Years of Subpar Growth?

You do not need a Ph.D. in economics to understand that stocks could possibly run into some problems with the Fed trying to step back while the global growth story is still a little shaky. From Voice of America:

The International Monetary Fund says the global economy is improving following the world’s 2008 downturn, but that it is “much too weak for comfort.” She said the world’s economic fortunes will only advance modestly if key global leaders fail to embrace policies to further job growth and better living standards across the globe. “We could very well be facing years of slow and subpar growth. Some have called it the new normal.”

Indecisiveness Means Higher Risk

As we have noted many times in the past, when the aggregate opinion about future economic outcomes is positive, stocks tends to perform better than bonds. Conversely, when the aggregate opinion shifts into the “we are concerned” camp, bonds tend to outperform stocks. When investors lack conviction, there tends to be no clear winner between fixed-income and equities. The chart below shows the battle between bonds (TLT) and stocks (SPY) has produced no clear winner over the past five months. Before we move to some historical examples of indecisiveness or periods of consolidation, notice the horizontal or sideways look of the chart below.

Typically, the longer the period of economic indecisiveness the bigger the move in equities once the logjam is broken. For example, as investors began to realize the expression stocks always go up was a fallacy, the S&P 500 reflected waning bullish momentum by moving sideways for twelve months. Once the period of consolidation resolved itself to the downside, stocks dropped 41% over the next two years.

As shown in the chart below, the present day S&P 500 has made little-to-no progress over the past few months. Waning bullish conviction can be attributed to many factors, including a reduction in QE, relatively tepid job growth, tension between Russia and Ukraine, slowing growth in China, and persistent low inflation in Europe.

Can periods of investor indecisiveness be resolved in a bullish manner? Sure, one example is the 18% gain in stocks that followed a nineteen month sideways market in 1986.

The Key To Catching The Market’s Next Big Move

The takeaway from the historical consolidation examples shown above is investors and traders that remained disciplined during periods of consolidation and frustration were rewarded with an opportunity to profit. The key to success in low conviction environments, as outlined in this week’s stock market video below, is discipline.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

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Small Caps Valuations Stretched

All things being equal when investors are confident about future earnings, they tend to prefer smaller companies that may be able to deliver superior growth relative to more established blue chips. Another factor is valuations, which may be causing investors to pause before adding funds to the small cap arena. From The Wall Street Journal:

There are lots of ways to determine if a stock is overpriced. For small caps, Doug Ramsey, chief investment officer at investment-research and asset-management firm Leuthold Group, likes to look at the stock price divided by an average of five years of earnings, which he says historically has been the most useful in picking times to buy and sell. By that method, the median small-company stock has a price/earnings ratio of 28.4, well above the historic median of 21.4, according to Leuthold.

The recent relative performance of small caps aligns with the theory that economic fear is gaining some traction relative to economic confidence.

Defensive Staples Trying To Make Turn

The consumer staples ETF (XLP) is at the other end of the investment spectrum relative to small caps. Top holdings in XLP include Proctor and Gamble (PG), Coca-Cola (KO), and Wal-Mart (WMT). From The Motley Fool:

By definition, staples are items that we tend to buy no matter what the economy is doing. That makes companies making or selling staples attractive, as they add a defensive element to a portfolio, bolstering it in downturns. Consumer staples companies also often offer dividends, in part due to their relatively predictable income streams.

In contrast to the emerging weakness in small caps, defensive-oriented consumer staples have been attracting more interest, which indicates increasing concerns about the health of the economy.

Investment Implications – The Song Remains The Same

The big picture is still constructive for equities from an economic perspective. A recession does not appear to be imminent. However, market corrections can occur during periods of economic expansion. Our market model has called for a reduction in equity exposure, which by default means we have more cash on hand. The four reasons presented above could be edited to five since a Dow Theory non-confirmation remains in force. If the economic bears continue to make progress, the model may call for a migration to a mix of stocks (RSP), cash, and bonds (AGG). Since flexibility is a tenet of investment success, it is important that we keep an open mind about bullish resolutions. If progress is made with Russia or if economic data comes in better than expected, buyers could return to the equity markets. Should the bulls regain traction, our short list of potential cash-redeployment candidates would include emerging markets (EEM).

The Key To Catching The Next Big Move In Stocks

Friday, April 4th, 2014

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Dow Theory Signal Questions Bullish Economic And Market Trends

Friday, April 4th, 2014

Charts Monitor, Rather Than Dismiss Fundamental Data

Critics of technical analysis often mistakenly believe that using charts discounts the importance of fundamental data, such as earnings, employment, and economic growth. Charts allow investors to monitor the aggregate investor interpretation of all the fundamental data. Said another way, charts are efficient tools used to monitor vast amounts of fundamental data, which is important since fundamentals ultimately determine which assets classes will perform best. When the economy is healthy, stocks tend to beat bonds. When economic fear dominates, bonds tend to beat stocks. In this article, we will cover the latest signal from the markets that aligns with maintaining a higher than normal allocation to cash to offset investor indecisiveness related to growth-oriented assets, such as stocks (VTI).

Dow Theory Is Based On Economic Common Sense

Dow Theory is based on a series of Wall Street Journal articles written by Charles Dow. We are not experts on Dow Theory, but the basic tenets are easy to understand. Charles Dow believed that:

  1. In order for industrial companies to increase their earnings, they had to produce and sell more goods.
  2. If industrial companies are selling more goods, then transportation companies must be delivering more goods to retailers and wholesalers.
  3. Therefore, in a healthy economy, both industrial companies and transportation companies should be experiencing revenue growth.
  4. If industrial and transportation companies are growing their revenues, then the industrial and transportation stocks should be attractive to investors.
  5. If industrial and transportation companies are doing well and are attractive to investors, both the Dow Jones Industrial Average and the Dow Jones Transportation Average should be making new highs in unison, serving to confirm a healthy economy.

A Concerning Non-Confirmation For Stocks

If investors believe industrial and transportation stocks are healthy and thus, attractive investments, that speaks to demand. When demand is strong, stock prices rise. Friday, the Dow Jones Industrial Average (DJIA) once again was unable to post a new closing high, leaving an economic divergence in place relative to the high made in the Dow Jones Transportation Average (DJTA) on April 1, 2014. The 50-day moving average, shown in blue below, helps us monitor the intermediate-term trend in the Dow Jones Industrial Average. The flat look of the Dow’s 50-day is indicative of economic indecisiveness on the part of investors. The inability of the Dow to post a new closing high is an economic yellow flag according to Dow Theory (see point 5 in the list above).

The Dow Jones Industrial Average, thus far, has been unable to push to a new closing high as the Dow Jones Transportation Average did on April 1, 2014.

The Fed Still Big Part Of Fundamental Equation

Anyone that has followed the markets closely, especially over the last four years, knows that all things being equal the stock market is not fond of any Fed move that slows the printing presses. Friday’s not too hot, nor too cold employment data most likely keeps the Fed’s tapering schedule intact. From The Wall Street Journal:

Friday’s employment report isn’t likely to shake the Federal Reserve from its strategy of slowly winding down its bond-buying program while keeping short-term interest rates pinned near zero well into 2015. Key data points were largely consistent with the Fed’s view of how the economy is evolving. A healthy payroll employment gain of 192,000 in March, taken together with upward revisions to hiring estimates for the two previous months, suggest the labor market is strong enough to tolerate the Fed’s slow retrenchment of its bond program.

Behind The Averages

After reviewing the companies in the industrial and transportation averages, it is easy to see why they represent logical vehicles to monitor the pulse of the U.S. economy. In 2014, our economy is driven by more than just industrial or manufacturing companies. The present day Dow Jones Industrial Average contains traditional producers, such as IBM (IBM), 3M (MMM), Boeing (BA), Chevron (CVX), and Johnson & Johnson (JNJ). However, the Dow (DIA) also contains Visa (V), Goldman Sachs (GS), and American Express (AXP), since the present day economy relies heavily on the financial sector. The Dow Jones Transportation Average (IYT) still has railroads, such as Union Pacific (UNP) and Norfolk Southern (NSC), but it also contains more modern logistics companies, such as United Parcel Service (UPS), Fed-Ex (FDX), and J.B. Hunt (JBHT).

How Can This Help Us Manage Risk?

If Dow Theory offers a way to monitor the aggregate interpretation of the economy, earnings, and central bank policy, then we would expect charts of the DJIA and DJTA to be helpful in terms of managing investment risk. Since a picture is worth a thousand words, when the Dow’s 50-day rolled over in 2011 (see orange arrows below), the index dropped an additional 16%. Notice how the Dow failed to make a new closing high before the big reversal in 2011.

Economic Pessimism And Investor Fear

Similar economic warnings came in 2007 and 2008 (see orange arrows in chart below). Notice during the 39% drop in the Dow in 2008 the 50-day never gave a “things are improving” signal, meaning it was helpful from a cash-redeployment perspective. The Dow was not making new highs; instead it was making a series of lower lows, which reflected a period of economic pessimism and investor fear.

Investment Implications – Time To Pay Closer Attention

Does the Dow’s inability to “confirm” the recent high in transportation stocks mean it will be all gloom and doom for the economy and stock market? No, it simply tells us to keep an open mind about some corrective activity in the stock market. While the non-confirmation does not predict future events, it does tell us the odds of a period of economic weakness are higher than they would be if the Dow was able to post a new closing high. As the godfather of technical analysis noted on Twitter, if the Dow can post a new closing high next week, it would increase the odds that the indecisive period in the markets is drawing to a close.

Our market model looks at numerous risk-on vs. risk-off ratios to monitor the market’s risk-reward profile. The chart of the S&P 500 relative to bonds (TLT) also aligns with the recent hesitant behavior by the Dow Jones Industrial Average.

The weight of the evidence agrees with the Dow and the stock/bond ratio above; stocks remain prudent, but the ongoing vulnerable state calls for a fairly significant cash buffer to offset higher odds of an equity correction. We entered the week with a significant money market stake and we left the week with an even bigger stake. Our core stock positions continue to be the S&P 500 (SPY) and an equally-weighted S&P 500 ETF (RSP). Next week’s highlights include Fed minutes Wednesday and PPI Friday.

Weekend Study

Since the Dow closed Friday with a “be careful with stocks” warning, it may be prudent to brush up on risk-management strategies this weekend:

  1. How To Monitor The Risk Of A Midterm-Election-Year Stock Correction
  2. 5 Reasons Your Simple Bear Market Plans Could Backfire
  3. The 2 Most Important Questions For Investors