Behavioral Finance, Good Harbor and Staying with the Herd:

walkersFor all of those fans of The Walking Dead out there, you know what it means when I say, “there can be safety in the herd.” One thing that’s always annoyed me about that show was they explored using the herds for cover in Season 1 and then didn’t do it again until Season 5. The zombie apocalypse has come to Georgia and why expose yourself to unnecessary risk and drawing down your ammunition when you can simply smear yourself with walker blood and blend into the herd? Yeah, you may have to hold your nose so the smell doesn’t offend you, but why pick a fight you know you can’t win? A week like this one reminds you why that most basic of zombie survival principles can be equally applied to the world of investing (and who says you can’t learn anything by watching television all day?)

For those people who decided not to waste their lives in front of the TV, the more scientific description of investor herding has to do with behavioral finance. Rather than my explaining it, let’s have Jeremy Grantham (via Pragmatic Capitalism) explain it for us:

“The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market.”

You can see this going with the flow trend simply by observing price behavior, which was supposedly random, can have some informative value (or else technical analysis really is worthless.) Investors tend to stampede out of one asset when prices begin to weaken, moving entirely to another (often buying high and then selling low) all the while keeping an eye on their competitors to see what the next shift will be. After hitting an extreme level, the move will begin reversing itself with a few intrepid traders leading the way while the rest of the herd waits for confirmation.

Let’s use the classic example of the S&P 500 ETF (SPY) and iShares 20+ Treasury ETF (TLT). The somewhat routine sell-off that began on September 8th was exacerbated by the volatility in the energy sector and leading to a major cascading sell-off as hedge funds were forced to liquidate. At the same time, TLT shot up higher as buyers moved to “traditional” safe-havens investments for protection (even though you can suffer a capital loss.) The trend reversed at mid-month following massive sell-volume on SPY and corresponding buy-volume for TLT. With SPY, you saw it on the 15th when the close was above the open and dramatically higher than the low of the day on heavy volume while the situation was nearly reversed for TLT. At that point, both were reaching extreme levels relative to their price history leading a few investors to decide it was a washout and there was now low risk in buying equities or selling Treasuries. Sometimes it pays to go with the herd while other times it’s better to fight the trend.

To demonstrate on going with the herd, last Sunday, I wrote that the most likely course for the S&P 500 this week was a drift higher to perhaps 1980 or 1990 where we could see momentum stall out as we approached the old highs. We’re going to give ourselves partial credit; we told you not to fight the trend and to keep an eye on your profits, but boy did we miss out on how much life was left in equities. But hey, who could’ve predicted the Japanese would go full monetization on us with the expansion of their QE program being enough to take down the entire anticipated Treasury issuance! Hopefully Abe won’t let this opportunity go to waste and can expand the budget deficit to go full Keynesian on deflation’s a$#. With both monetary and fiscal policy working towards the same goal, Japan might finally begin limping its way out of the lost decade.

Here at home, the Japanese QE announcement was just the icing on the proverbial cake as better-than-expected economic announcements regarding 3Q GDP, Chicago PMI, and sentiment cushioned the blow from a slightly hawkish tilting FOMC press release as well as weaker durable goods orders, personal income and income growth. But as you can see from the charts below, the bulls have been in charge.

Equity Technical Review:
First let’s look at SPY where Wednesday has been the only day where the selling pressure was strong enough to have a close below the open and while the volume has been decidedly lighter it has been nearly one way:

spy

In fact, look at the monthly chart; you can see that after hitting the 20 month moving average, we’ve recovered all of the drawdown and hit a new high while taking the pressure off and reversing the prospect of a 2/10 crossover signal indicating it was time to go short.  We haven’t seen a spread between the monthly high and low this wide in a LONG time:

%SPX Monthly

Moving over to IWM, we’ve just about recovered 100% of the drawdown from the September-October pullback, pushed out of its downtrend line and back into the consolidation zone it has been stuck in for nearly all of 2014. There’s a strong possibility of a close below the open today signaling selling pressure, but we can evaluate that more on Sunday.

IWM1

IWM2

In fact, it’s been such a risk-on, one-way trade that even the energy sector where the earnings expectations have been slashed and a rising dollar is guaranteeing more pain is having a decent day. Yinzer Analyst momentum scores have been incredibly strong; in fact the S&P 500 and IWM short-term scores are at the 1st percentile while longer-term momentum scores are still somewhat depressed. If it wasn’t for the Japanese announcement, the most likely direction for domestic equities today would have been a slight drift upwards as buyers who sold out near the bottom continue to rebuild positions, which brings me to one of my favorite market timing tools and a good example of when to fight the trend, Good Harbor.

Good Harbor Tactical Core:
You may remember that in August we discussed using the Good Harbor Tactical Core Fund (GHUAX) as a timing tool because to quote an adviser I know, “they’ve been perfect in 2014…they managed to buy at every top and sell at every bottom.” Good Harbor’s strategy is built around momentum, buying with the herd and leveraging their positions to enhance returns…which works well during periods like 2013 but the volatility and back-and-forth nature of 2014 has made them dead-last among tactical equity funds for the year. With the option to trade either at the start of the month or mid-month, Good Harbor has managed to pick entry/exit points that have neatly coincided with turning points in the market cycle.  Sometimes, it doesn’t pay to stick with the pack.

In August we showed you this chart of UWM, one of GHUAX’s preferred vehicles for adding mid-cap exposure and typically pared up with IWM:

GH1

And here’s the follow-up:

IWM

You can see that GHUAX added exposure again at the start of September, took it off at the end of the month and then choose to sit out for their mid-month rebalancing, leaving their positions mostly in intermediate bond ETF’s and possibly one smaller position in IVV (volume spikes around mid-October make it difficult to trace.) In terms of performance, they managed to capture nearly all of September’s downside while missing all of the upside with the fund down 9.44% since September 1st through yesterday while the S&P 500 is now off .44%.

GH PERF
Why do I bring this up now…because it’s the end of the month and time for Good Harbor to reallocate their portfolio’s and for some of us, time to figure out which way the wind is blowing? GHUAX is a good example of when it might be more advisable to go against the trend. What do you think Good Harbor’s volatility and return this year would have been if they had simply stuck to a 60/40 blend using SPY and AGG? About 7.8% before fees, and while it would have trailed the S&P 500, GHUAX would probably have a much lower volatility and giving a higher Sharpe ratio making it an easy sell.

At the end of the day, whether you’re going to go with the herd or fight it is entirely up to you…success depends on timing and perspective. Fighting the herd and going short (which we advised you not to do until we had the 2/10 crossover) would have just led to more losses, but going with the herd can also bring more pain in the short-term. The key is to remember your goal and your time frame and then to turn off the news and focus on what’s really important; like dressing up your dogs for Halloween.

What Really Grinds my Gears

tumblr_liuf36gXdF1qc2vw9o1_500You know what really grinds my gears? Investors who complain (or use any more graphic metaphor you want) when the companies they choose to invest in decide to recommit capital to building their businesses rather than paying out everything as dividends or share buy backs. My blood started boiling late last week after the Amazon earnings release (full disclosure: I don’t own any position in Amazon) when I’m sure to the shock of no one it turned out that the Amazon Fire phone was a complete dud and there was going to be a significant charge for the unsold inventory. Amazon’s come under a tremendous amount of pressure from sell-side analysts and commentators who demand that Amazon stop it’s R&D campaign to develop new product lines, focus on improving earnings with the goal of boosting shareholder returns from eventual dividends.

First of all, if you really want stocks that pay dividends go buy stocks that historically have paid dividends but more importantly and Amazon has been signaling for years that its focus is on growing their business, not financial re-engineering. It’s time to drop this myopic focus on maximizing shareholder return. James Montier gave an address recently (more here) where he called out shareholder maximization’s advocates and pointed out the flaws with that strategy. But maybe it’s easier to do this the business school way with a case study.

So far in 2014 Amazon is down 28.02% while the Consumer Discretionary Select Sector SPDR (XLY) is down .25%…what’s more interesting is who’s having a GREAT year. First is one firm that Amazon has firmly displaced, Sears Holding, down a mere 1.93% now after the mother of all short squeezes as well as Amazon’s most direct competitor, Barnes and Noble up almost 38% in 2014. Yes, both Barnes and Noble and Sears can attribute some of their performance in 2014 to short squeezes not to mention several years of bad performance but the real secret to their success? They’ve given up.

Wall Street likes predictable; they like dividends, stock options and share buybacks. Not only because they’ll boost “returns” but because when you engage in those behaviors are you signaling a policy that means predictability. Reinvestment in the business is out; your goal is simply to boast the stock price to help yourself (assuming you’re in management) to get out with the most you can as quickly as you can. As Montier pointed out; the average lifespan of an S&P 500 member has shorted drastically while CEO tenure has nearly been halved…probably coincides with average life of stock options.

Let’s start with Barnes and Noble (B&N), who’s market cap has become all of 1/132 of Amazon’s while the company has become a punchline in jokes about the future dead retailers of America. After half-a$%ing their own internet presence and doubling down on physical stores, they have spent years trying to develop their own e-reader, the Nook. Now they’ve largely abandoned the struggle and now seem committed to trying to maintain their position as the largest physical book-seller in America. Go ahead and ask me when the last time I bought a book at B&N was…I can’t remember either. In fact, besides coffee I haven’t bought anything at one of their stores in years and their revenue growth reflects that. One reason I couldn’t understand the need for Amazon phone was because there’s already an app to scan barcodes and buy it on-line. Now B&N’s goal is simply to enhance their cash cycle, cut out excess inventory and keep capital expenditures to a minimum. Not a bad strategy, but it just delays the inevitable which might be exactly what their management wants.

After holding steady from 2012 to 2013, executive compensation at B&N has risen over 77% in 2014 as management has been rewarded for destroying value and then abandoning their strategy for the Nook with new stock options. I know the textbook answer…stock options help to align yadda yadda yadda for the long-term, but that’s rubbish. What investors love is that they think management will do everything in its power to maximize the stock price and they can come along for the ride. Of course B&N will be dead in five years baring a sale of the company, but who cares right? You won’t own it. Neither will the founder, Len Riggio, who after initially pursing an attempt to buy the company ex. Nook to take private decided against it…and has been selling off his large holdings in the company ever since. Amazon meanwhile has actually cut executive compensation as their strategy has faltered.

And what about Amazon’s growth prospects? As a former employee of B&N, I’m not ashamed to admit that I buy nearly everything including appliances, video downloads, even gym equipment from Amazon and I didn’t blink an eye when they raised the cost of a Prime subscription. “Free” shipping has gotten me to spend more on Amazon that any one time sale could have done. So could Amazon be smarter about their business development strategies? Of course they could but what’s more important is how they use their resources to grow the business. From January 1, 2009 to December 31, 2013 B&N has enjoyed a return of all 11.08% versus 223.61% for XLY, 104% for the S&P 500 and 677% for Amazon.

Sunday Recap – Staying Alive

Last week was a heck of a wild ride for the Yinzer Analyst. My baby brother got married, I had the opportunity sit down with a local growth manager (there’s more to upstate NY than skiing and maple syrup) and to catch up on plenty of research I’ve been avoiding. The cherry on the top of my sundae was that drive from one end of NYS to the other end of NYS which more than few wholesalers have told me they call thruway hell. It does give you a lot of time to think and after much reflection on the markets and investing in general and came away with a couple of key conclusions:

  1. Growth investing is hard – ask anyone who’s decided to do a pair-trade going long Amazon and short Barnes and Noble – but more on that later. There’s a reason Benjamin Graham is so popular.
  2. Market memories are short-term at best. The fact that two weeks into a mini-recovery, the AAII Investors Intelligence survey already shows bullish sentiment back above the historic averages, the NAAIM survey showing increased bullish positioning and well you get the idea.

Now for the weekly recap:

Domestic Equities:

Following the hammer pattern established during the prior week, the S&P 500 confirmed a short-term bullish trend and exploded higher, advancing over 4.1% and reclaiming more than half of the ground given up since mid-September. Just a few points shy of the 50 day moving average, we have several hurdles in front of us. First is the 50 day followed by the legs of the downtrend line at 1980 and then prior resistance at 1985-1990. Getting over that last level and holding it is key; otherwise a head and shoulders pattern could be forming.

spx2

spx1

The real question is do we have the drive to get us there? You could see by looking at the daily chart that volume was tapering off heading into the weekend indicated a serious lack of selling pressure. But the bounce was overdue; on a weekly basis the S&P 500 had hit it’s 50 week moving average and bounced clear off of that and managed to close just above it on strong buying pressure so these week’s rally wasn’t entirely unexpected. Looking at our short-term momentum scores, we’re nearly at the highest levels of the year (we use a trailing 52 weeks) while longer-term momentum scores remain pitifully low. But with sentiment already improving, % of stocks above their 50 and 200 day moving averages outside the danger zone and inflows resuming into broad based equities, has the easy money already been made?

Take a look at IWM if you want to see a real move that could be in danger.  IWM is still trapped in a downtrend pattern that needs to resolve with a break to through the upper-trend line to confirm not just it’s own positive trend but the broader market’s as well.  If IWM weakens and breaks down, it’s hard to see large-cap stocks plowing on to the old highs and staying there.

IWM1

The Week that Was:

Looking at the rest of our tables, you can see that it was clearly a rally for some of the more recent prodigal sons here in America as tech stocks finally began to catch up after a difficult month while early-year leaders like utilities and reit’s took a breather. The rally was also a U.S. phenomenon as Eurozone stocks lagged and EM equities were dragged lower by Brazil as concerns that incumbent Rousseff would win the run-off (she did) and drag Brazilian equities lower (she did.) Eurozone bank stress tests showed that not surprisingly, more than few banks will need additional capital although the amount they need to raise does seem slightly “massaged.”

The Week that Will Be:

This week is an easy one compared to last week. Last week you needed to watch your positions like a hawk to make sure you didn’t watch small gains become small losses in the event the confirmation didn’t happen. With the solid breakout, the near-term momentum should continue to be towards drifting higher even though the easy profits have been made. Now we’re watching to see if there’s a stab back to the old highs. Best strategy to play now is the trailing stop.

What could upset the apple cart of higher profits? Earnings could always do it but this rally has been entirely inspired by the thought that tapering could be tapered or even that asset purchases could be “increased” and interest rates may have to stay lower for an “extended” period. Never has a market rally depended on so little as it does now to keep powering higher. So keep your eyes on the press release on Wednesday.

For those who desire something more tangible, you have durable goods on Tuesday, the advance reading on GDP on Thursday followed by personal income/outlays, Chicago PMI and Univ of Michigan Consumer Confidence on Friday so no taking an early weekend. Remember, if this rally has breathed some life into your performance, the goal is to stay alive.

Sunday Recap

The Yinzer Analyst is off celebrating his brother’s nuptials this weekend, so the post is going to be short and sweet tonight. Like everyone I was impressed by the recovery that market managed to stage late last week, especially in the small and mid cap segments. Am I completely sold that it’s time to buy and position yourself for another move back above 2,000? Ehhhhhhhh, nope.

First there’s what I can see:

  1. The S&P 500 had gotten very oversold in the short and intermediate term periods – with momentum scores back to levels not seen since the fall of 2011. It wouldn’t take more than a few off hand comments from a FED governor to spark a small rally.
  2. We’re back at levels where there’s prior support for the S&P.  Here’s a chart we’ve used before showing the S&P 500 finding support at a prior resistance level.

spx

Beyond what we can see is what we can infer, and for what it’s worth, I have a hard time believing the FED will be so quick to abandon their tapering plans for QE3.  Despite what Bullard threw out of the cuff, there’s been strong pressure from within and without for the FED to end QE3 and begin returning the markets to a more “normal” footing which includes scrapping forward guidance but doesn’t necessarily include raising rates or unwinding the FED balance sheet.  Both Bernanke and Yellen have talked at length about how QE programs have skewed the market’s perceptions and pricing of risk; giving in to another “taper” tantrum will just add more fuel to that fire.

And going back to the charts; we’ve had decent bounce of support – but the S&P 500 still has to challenge it’s 200 day moving average and needs to do it on better volume than we saw Friday.  Until then, the downtrend pattern remains in place for the near-term so keep your eyes on your longs and don’t let them run too far one way or the other.

bond dom int sect

Gold and Deflation– Can you love me again?

If this was the start of the great rally than everyone has been hoping for; it might be time to light some candles, say a few prayers or sacrifice a goat because today’s action was decidedly disappointing for large cap domestic stocks. After three days of strong selling pressure, the S&P 500 got off the mat early in day only to fall back on the ropes heading into the close. Take a quick look at the chart below; the S&P 500 closed below the open of the day and only slightly off the low as sellers took charge around midday. It looks like we’re going to retest the consolidation channel that held the market in irons from March to May.

SPX Daily

But that’s not what I want to talk to you about tonight. Instead we’re going to spend some time with an old love, gold, which has had a surprisingly strong October, with GLD up over 2%, GDX at breakeven and the S&P 500 down 4.8%. I’m sure the regular readers out there know that I have a complicated relationship with precious metals. I’ll admit to being a sucker for shiny things and a certain amount of drama in my relationships, but I’ve been burned by gold and silver on more than a few occasions and I’m not ready to fall in love again. However, with the recent performance I’m willing to forgive and at least have coffee.

gdx

So what the heck has been going on with the metals lately? First thought looking at this chart of GDX is that we’re just bouncing off the lows set in late 2013, shorts are being closed out, or that the miners are going back to their old role as the equity alternative for when equities start having trouble. Trust me, I’ve done the research; the only way to make money in the gold miners between 1982-2001 was to buy them when the broader market was breaking down and to sell them the second the bulls took charge.

This time, I think it might actually be different and it has nothing to do with inflation. In fact, gold is a terrible inflation hedge unless you plan to hold it for 30 years. No, what could be giving a lift to the oldest inflation hedge in the world is its opposite, deflation.

I’m not doing the math here, but when rates are hugging the zero bound and there’s at least some inflation, what happens to the real cost of money which you can define as the borrowing costs minus inflation? It goes negative. If you can borrow $100 for ten years at 2.21% and the 10 year expected inflation rate is say 2.5%, the cost to borrow is a negative .29%. Why wouldn’t you take all you could, invest in practically anything and expect everyone else would do the same? Well with commodities in 2010 and 2011, that was pretty much the case and a lot of dollars went around the globe and got into all sorts of trouble with commodities, emerging markets, and of course, gold. Of course that’s what the FED wanted, Ben Bernanke made no bones about it.

Check out the chart below I whipped together using data from FRED. It’s the anticipated cost of money over the next five years and you can see that up until QE3 and it’s supposed commitment to creating inflation, it went only one way. But with the recent optimism here in America, investors began anticipating inflation and sending the price of all commodities lower. It’s been a tough few years for the miners but guess what, things have changed in 2014. I mentioned that recent survey of the Primary Dealers where they think within 2 years of the first rate increase, the FED will be right back in the same situation at the zero bound. Yup, the people who make a market for the Treasury have no confidence that the FED will be able to raise rates while keeping the economy churning and actually creating inflation.

Real Rates

They are, to use a very crass expression…pushing rope and a few souls are stepping back into the metals market in case the FED does fail. GDX tried playing catch up to GLD, but why buy a leveraged play for such a small speculative position? Better to go with the lower volatility of the metal itself. The Yinzer Analyst isn’t buying (and certainly isn’t telling you too either just FYI), but he has to ask, can you do this again?

Sunday Recap: “It’s a New Day People”

Yes, the Yinzer Analyst has been watching “Edge of Tomorrow” and isn’t afraid to admit that he likes Tom Cruise as an actor and after the week we’ve just had in the markets, I think the movie has a few takeaways for all of us. First Bill Paxton’s character keeps repeating the phrase “It’s a new day people”, and in that he’s right. When the action begins at 9:30 tomorrow, despite what you read on Business Insider (which we love) there’s no way of knowing whether the market will be heading up or down. And if you’re Tom Cruise in that movie, you know it doesn’t really matter. You’re playing a different game altogether because (to steal a line from Battlestar Galactica), “all of this has happened before and all of it will happen again.” If you’re studying market history and enjoy pattern recognition, you’ll know that even if the market changes direction on Monday, the prior uptrend dating back to 2012 has been broken. It’s time to start planning for the market you have and what could be coming next, not the market cycle we just finished.

First, let’s review the daily S&P 500 chart I showed you last week after the strong Wednesday action that broke the downtrend pattern begun on September 19th. The breakout proved to be a false one on Thursday as the S&P gave up all of Wednesday’s gains and then some while plowing into the lower boundary of the downtrend line on heavy volume. Friday’s one day loss on a percentage basis was lower than Thursdays, but only because we fell right to the 200 day MA on even heavier volume and closed at the low of the day. All in all, very weak action as we’re right back to the lows of August 7th and hoping for bounce off the 200 day to keep us from the next support level.

spxo

Where is that support? Let’s turn to a daily chart of the S&P 500 showing the uptrend line back to 2012. Using the legs of the uptrend as support lines, we the first line in the sand is at 1800, the second at 1740 and then nothing but air until almost 1350. Could it really get that bad…yes but remember market tops take time to firm so don’t get too itchy to pull the trigger on a major short just yet.

SPXD

Playing for Position:
How do you set reference points for the S&P to get ready for a pullback? Personally, I’m a huge fan of rules-of-thumb even though I’m aware they’re not totally infallible. Let’s start with the daily chart again to understand why I think we might bounce off the 200 day MA.

  1. The daily RSI (14) score is very close to the overbought level at 30
  2. AAII Sentiment still hasn’t turned completely negative. While it is most useful as a contrarian indicator –on a short term basis it can be used for trend confirmation and as of 10.8.14, it’s holding at its historic averages. I’m sure the next weekly reading will show a 4 to 5 point swing from bullish and neutral to bearish.
  3. We haven’t encountered the 200 day MA yet – the close came on heavy volume but without touching the 200 day MA. Assuming that everyone hasn’t been redoing their algo’s this week, hitting the 200 day could spark a buying frenzy.

So what happens if we do bounce off the 200 day and move higher? What will I be watching then?

First are longer-term chart patterns; even though there’s enough literature about the failings of the 2/10 monthly crossover rule, I find it’s been useful as a reality check if nothing else. If October was to close today, we would be as close to a crossover than any time since 2012 as you’ll see on the first chart below. What happens when the crossover happens? Look at the second monthly chart from 2006-2009 – you can see the crossover in late 2007 and never looked back. Still too short-term for you? Then use the 10 month crossing over the 20 month which happened in early 2008. If nothing else, remember that this is a common tool and even if you don’t use it, lots of other people will. If they start unloading SPY when the 2 crosses over the 10, what do you think will happen next?

2009-2014 M

2006-2009M

If you plan on protecting your portfolio by loading up on inverse SPY or other relevant hedge (I’d stay away from levered inverse unless you plan to watch it daily), I’d look for another more intermediate indicator to use as a signal. I’m currently exploring using the 20 week/50 week crossover a signal for putting on short positions to cover the downside. For the Yinzer Analyst, it’s more about trying to get the overall portfolio performance to zero (market neutral), not trying to generate 4000 bps of spread when/if the market pulls back.

2007-2008W

Finally, where would I set a bottom for the market? If we do break the first two levels of support around 1800 then at 1740, there’s nothing but air between 1450 and 1350, which is REASONABLE given how far we’ve come. If any of you followed my recommendation to read Peter Oppenheimer’s piece of P/E cycles, you’d have discovered that when the market enters the “despair phase”, the P/E multiple shrinks typically around 32%. Even after this weeks’ action, the trailing P/E is 18.47 and very much above historical averages. If earnings somehow stayed where they are now, and the P/E fell 32% to 12.54, the S%P 500 fair value would drop to around 1294 representing a 47% drop from Friday’s close.

With that, it’s time to let you get your day underway but come back later this week for our next posts:
Nowhere to Run Baby-Nowhere to Hide?”
“Nothing to Fear But Deflation Itself”

Interpreting the Fed Minutes: Nothing but Pillow Talk?

Today’s release of the FED meeting minutes from the September meeting of the minds proved to be one of the more exciting…but does it signal a major trend change or is this just what they used to call “pillow talk?”
There was no mistaking the market’s reading as a whole heap of buyers stepped up to push broader equities higher at 2 p.m. when the minutes were released:

spy

Meanwhile, the FED’s concerns over a rising dollar (which they acknowledge has more to do with global weakness) hit UUP while it was already on the ropes after two weak days:

uupintra

The real standout for the day was equity precious metals where after a rough third quarter (down 5.08% versus the S&P 500 up 2.53% for a 761 bps spread) it finally found it’s mojo and was up 7.44% although some profit taking (or loss covering) late in the day trimmed the gains.

gdxintra

So what does this mean for your trades? Short term a lot, longer term….probably not much.

Let’s start with the short-term view. Today’s action definitely will help break the trend of on-going weakness as traders get their first positive news from the FED in over two weeks. As you can see from this 3 month chart of the S&P 500, the index has finally broken out of its downtrend pattern on heavier volume signaling a move back to 1980 or at least a consolidation is in the cards with the 50 day MA hanging above us. With the pullback in the dollar and rally in gold, the easy answer seems to be that the party is back on.

spxd

But take a look at that chart again and you’ll see that MACD rolling over and the market trying to fight its way to a bottom near the 1940 mark while we have strong support back at 1904.  The Yinzer Analyst’s momentum scores bottomed out recently for the S&P 500 indicating that a bounce of some kind was overdue. And look again at UUP; it’s been heading lower for several days after becoming heavily overbought (rough being a hedge fund hotel) and was due for a pullback anyway. So far, the FED minutes are just an accelerant on an existing market trend.

uup2
And what about our friend equity precious metals? Having invested in both the miners and metal (both financially and mentally) I can tell you that the golden goddess is not for the faint of heart because she is fickle with her love. From the recent peak on August 12th to the end of yesterday, GDX was down 24.29% versus the S&P 500 being off .09%. Let that sink in for a moment and then remember that for the month ending 9.30.14, the GDX 3 year annualized return was a -25.78% versus the S&P 500 up 22.05%. Now having said on more than one occasion, “the miners really can’t get much cheaper” (they did), I’m going to say again, they really couldn’t get much cheaper in 2014 as they retraced their entire 2014 advance and were back to the lows of the year where they have strong support.

gdxd

In other words, don’t wet yourself over the miners just yet. Enjoy a rally that may last a few days and take your profits (or reduced losses) when you can.

Longer-Term View:
So what can we take away from the FED minutes that doesn’t actually involve having to read said minutes? The general viewpoint everyone will be reading tomorrow is that the FED is again leaning dovish, is concerned about the rising dollar and its impact on inflation in the U.S. and weak global growth. What they’ll ignore or at the least gloss over is that the FED is still on-track for raising rates in 2015 and if you look at the colorful charts in the back, several participants now expect rates to be slightly higher in 2015 and 2016 than they did in June.

And yes, the Federal Reserve minutes do show some anxiety about the impact of a rising dollar on inflation but two key points to remember are this:

  1. Ben Bernanke famously acknowledged that QE had a negative impact on the dollar and led to large capital flows to emerging markets, causing unstable conditions and rapid EM currency appreciation. Not only did this not upset him, at the time I felt it was an intended outcome of his QE programs as it slowly helped to restore trade imbalances. I’m sure his successors must have known that ending QE would have the opposite effect, especially with a weaker Europe and China.
  2. The FED’s goal has been to keep inflation above 2% by raising velocity, not be trying to weaken the dollar to create commodity inflation. If you can raise velocity, you’ll raise consumption creating new jobs, raising wages, etc. Call it a virtuous cycle. If you simply devalue the dollar to create inflation (which is way harder than it sounds post gold standard), you’re simply reducing the purchasing power of American citizens as their wages will most likely remain moribund has they have over the last several years.

So is the FED carefully watching developments in the economy, yes. Are they going to backtrack on ending QE, no. So according to the Yinzer Analyst, these minutes are just pillow talk. They’re trying to make the pullback easier to bear without actually obligating them to change policy or really do anything. In fact, according to a survey of primary dealers, most feel that within two years of the first rate increase, we’ll be retesting the zero bound.

To Recap: Is the FED going to push off raising interest rates; not indicated at this time. The Yinzer’s viewpoint: equity markets still need time to consolidate, so enjoy the rally which we’re probably sure to get, take some profits but don’t put everything on red.

Weekend Recap

Even while driving around America’s heartland trying to get a decent cell signal, you could tell that international stocks continued to take in on the chin this week as the Euro sell-off shows no signs of slowing anytime soon. The best performing foreign ETF we regularly track, Vanguard Total World Stock underperformed the S&P 500 by nearly 100 bps for the week and that was only because of the fact 55% of its portfolio is in the U.S. Even though the various Markit PMI reports for Europe continue to show mild expansion, when can we expect the market to reverse its nasty trend?

First, consider the weakness of the Euro by looking at the U.S. dollar index:

UUP

Yes, according to Captain Obvious this chart of UUP (so you can see volume) looks very overbought on a short or even intermediate term basis, and is looking stretched even on a monthly report. And guess what? No one cares, not even a little. According to the Reuters and our friends at the CFTC (here), the net long position in the U.S. dollar has reached over $37 billion and has been above $30 billion for over eight weeks as everyone with a pulse and benchmark decides to plow into the long dollar/long bond trade, levels not seen since June of 2013. Who can blame them? Uncle buck is up 8.12% this year as of Friday while TLT is up over 18%.

Meanwhile the short dollar sister trades in commodities, precious metals, materials and energy names continue to get curb stomped with precious metals feeling the most love. According to my friends over at ETFG, GDX has lost something like 15% of its assets in the list month alone while losing over 19% in the third quarter and falling into the red for the year! XLE has also continued its breakdown as it searches for a bottom.

gdx

So when will this end? The 4th quarter usually isn’t the time for trend changes as everyone tries to ride a winner to take them to December 31st although the year-end reallocation trade has largely moved to the first two weeks of December. At this point, the dollar will keep going until someone big decides to sell and that’ll have to happen soon. Literally the buck can’t have ALL the money invested in it and the trade is pretty much one way at this point. The annual re-balancing should push some capital into European stocks, but it’ll largely just stop some of the bleeding, not cause a trend change. Until Europe manages a more decisive push into QE (and drags the German courts kicking and screaming), and the U.S. economy noticeably weakens, the long dollar trade will be here to stay.

And as for bonds, what else is there to say that a monthly chart of the ten year yield can’t cover?

sc

Domestic Equities:
Which brings me to domestic equities and their lackluster performance over the last two months. The S&P 500 and DJ Industrial Averages managed to pull themselves out of a tailspin last week but only just. The S&P 500 ran smack into its 50 day simple moving average and died there after falling out of its long-term daily trend pattern. To instill some confidence, it needs to break back into the pattern, push back to 2000 and then keep the lower bound of the trend channel all while doing so on convincing volume. Not asking for a whole lot am I?

indu

spc1

The Russell 2000 managed to have the smallest loss for the week, but for technicians out there, the pattern is disheartening. While IWM had the narrowest loss for the week, we can really attribute that performance to three factors:

  1. Good Harbor Reallocated some portion of their small/mid cap names to bonds on October 1st and as well all know, Good Harbor trades are pretty much the perfect turning point signal.
  2. IWM cracked the lower bound of its continuation pattern.
  3. IWM was really, really oversold. For a domestic equity index anyway

iwmd

gh

 Look at the charts for the DJ Industrials, S&P 500 and IWM again and tell me if you notice something? Volume was lighter on Thursday and Friday following the Wednesday sell-off, which is not too surprising but you’ll see that as you slide down the market cap scale, the pattern’s become less convincing. All three bounced off prior support levels, all three managed to break out of their short term “sell-off” patterns but as the market capitalization drops, so does the follow-through. The DJ Industrials had the strongest finish on Friday, remarkably close to their highs while the S&P 500 closed near the midpoint and IWM did noticeably worse.

What this feels like to me is a “hey, let’s get some equities on the cheap but not the “really” cheap stuff.” Like the difference between the Capital Diner, Cracker Barrel and Pittsburgh’s own Kings. Tying this in with their Yinzer Analyst momentum scores that put them close to the bottom of the their 2014 range, this has a bit of the feel of a dead cat bounce. Keep your eye on this one and if you have to play, consider these levels for sell targets:

  • DJ Industrials: We ran right into prior support around 17000. Next resistance will be around 17200 and then it’s back to the top.
  • S&P 500: First we need to clear the 50 day simple moving average at 1974, then it’s 1990 and 2000. Nice big round numbers to remember on the what could be a slow march back to the old highs.
  • Russell 2000 (IWM): We need to clear the falling 50 and 200 day moving averages around $113.50 before making a stab at each of the legs on the downtrend line. Get ready for a slog.

bond dom int sec

Strangers with Candy

The Yinzer Analyst is back in the Burgh and just in the nick of time. After spending five days in beautiful Iowa, I got to play with a combine and eat too many pork tenderloin sandwiches but most importantly managed to gain a new perspective on life.  We’ll save the re-piloting for later but getting some distance between yourself and the market is always a great way to regain a sense of balance and understand what’s truly important, even if it’s standing in a horizon-less soy bean field and working on the farmer tan.

So for all the drama on CNBC and in the financial press that I managed to pick up in greasy spoons in the heartland, since the Yinzer Analyst went to Iowa last Saturday the S&P 500 is down about 1.85% while the Russell 2000 is off 2.01%. While that 1.85% was a significant chunk of the 2014 advance, how much damage has been done to the market and what can we expect going forward.

Shorter-Term

First let’s take a look at the short term technical picture for the S&P 500 before considering what could come next. Everyone has been passing around this chart showing the S&P 500 cracking the uptrend line dating back to the start of the 2012 rally. As you can see, we’re not too far away from the last leg of the uptrend back at 1904 while there’s more support at 1900 from both prior overhead resistance and the 200 day moving average. Momentum scores are in fact are at the same low levels of August 7th before the market ripped an over 4% advance over the next month. Not saying history is going to repeat itself, but given that breaking of an uptrend line, prior support and recent weakness; we could see a small bounce over the next few days as the S&P continues to right itself.  We’ve already had two promising signs as breadth has improved the Russell 2000 bounced today after hitting key long-term support but the prior support at 1950 might turn into resistance now so be prepared for a slog back to 2000.

spc2

spc1

iwm
Longer-Term:
Pulling back to the weekly viewpoint, the S&P 500 has been showed signs of weakness several times this year as the long-rally off QE3 looks to be spent. Take a look at the chart below; it’s one that I put together in March when the S&P 500 first closed below the uptrend line that had been supporting it since 2012. You can see that there was a reaction bounce back above the trend line but the move has become exhausted as investors pull back on valuations. So what were your expectations for 2014?

spc3
The chances you’ll be able to forecast something like the annual return of the S&P 500 and be anywhere within say 300 bps of the actual return is about nil, so why do thousands of paid professionals try to do just that every year? Because it pays really well and investors want to have some number they can anchor themselves too no matter how ludicrous it is. Some of those forecasters will use “sophisticated” financial models, others will assume return to the mean historical performance, and a few will simply take last year’s performance and assume it will continue indefinitely.  But if you’re taking a wall street “pro’s” word on where they think the market will be next you, remember that it’s like taking candy from a stranger.  You have no idea what he’s giving you or why, so why would you expect he’s doing it out of the goodness of his heart?

The Yinzer Analyst grew up in a horse racing town and when it comes to setting return expectations, it helps to think of it as handicapping. You’ll never know the actual outcome ahead of the event, but you can use your observations to try to get a sense of where the market could be heading based off a few principles including mean reversion and the knowledge that the P/E ratio tends to move in cycles. Peter Oppenheimer at Goldman Sachs did some tremendous work on P/E cycles and one of the key observations is to understand that the ratio expands based on investor confidence; in the late 90’s it was confidence in the new tech boom, in the mid-2000’s it was confidence in lower interest rates and leverage. In the strong rally we’ve been in that dated back to October of 2011, the confidence in the Federal Reserve has been the key catalyst but that role is changing. Going into the end of 2013, what could anyone discern from studying the last few years of equity returns?

  1. Since the end October of 2011, the S&P 500 returned 47.48% with earnings growing about 8.5%. The bulk of investor returns came from the trailing P/E multiple rising from 14.4 to about 19.58 or nearly 36%. Remember the average trailing P/E is around 15.52.
  2. Corporate profit margins as a % of GDP was close to an all-time high but showing signs of waning.
  3. QE3 was going to end; the FED had announced the first in a series of graduated drawdowns of their bond buying activity. While there was a lot of discussion around “data dependent” most FED watchers acknowledged that the drawdown was likely on a preset course.

If you had just those three bullet points to work with (and you could totally cut out #2), what direction would you have taken your equity allocation? Would you have had 100% in equities? What about a trailing stop loss?

Now consider this:

  1. In 2014, the S&P 500 has returned 5.29% through today with earnings up around 9.3% while the trailing P/E multiple has fallen -3.73%. Even with that pullback, the trailing P/E ratio is at 18.85 and in the 88th percentile of monthly values since May of 2010.
  2. The forward P/E is still well above 15 (a level many analysts consider to be the upper end of reasonable) and if it were to fall to 14.1, the S&P 500 would be valued around 1826.94 using the S&P’s tracking consensus for 2015 earnings. Since earnings estimates tend to be overdone by around 5%, if we discounted those earnings to 123.09 we’d have a fair value of 1735.
  3. QE3 is dead and there’s no plan to resuscitate it anytime soon. In fact, the debate has shifted to how quickly we can expect rates to rise and how far that move will go.

So is the S&P 500 a good bargain at these prices, my answer is still no although you should have some exposure to domestic equity in case a stranger on the internet happens to not be telling you the truth. If the market is topping out, it pays to remember that the process tends to be long and drawn out, not something completed in a quarter.

If you’re planning on adding large new positions, remember that valuations are still high, earnings will have to carry the load going forward and if the FED does raise rates in could have a negative short-term impact on earnings growth. Like Warren Buffet once said, price is what you pay but value is what you get.