Sunday Night Recap: Can the Last be First?

Amidst the joy that comes from celebrating a winning season with a completely meaningless win for the Buffalo Bills, the Yinzer Analyst turns his thoughts to the opening tomorrow and those last few precious trade days before the start of a new year. There have been a spate of articles lately about how one man’s, or one year’s, treasure can become next year’s trash and to be honest, there’s a great deal of truth to that. Take a look at a Callan table and you’ll see there’s some logic to buying whatever’s been left behind but it’s not consistent. Buying the dogs of the DOW isn’t always a sure thing; check in on Sun America Focused Dividend to see where that got you in 2014. But that has us thinking that it’s time to check in some of 2014’s biggest losers to see how they’re setting up for a brand new year.

Can the Last be First?

First up, the biggest shocker for the broader equity market came from energy stocks; from Jan 1 to June 30th, the Energy Sector Select SPDR (XLE) was up 14.18% versus 6.95% for SPY. Since then, XLE has come crashing down 19.06% as West Texas Intermediate Crude broke down nearly 47% while SPY has chalked up a further 7.59% gain. XLE has firmed up since hitting the 200 day moving average although it has yet to break through the downtrend lines that have held the weekly chart pattern in a downtrend channel since this summer. Currently sporting some of the lowest price-to-earnings multiples to be found in domestic stocks, how long will it be before the can breakout?

XLE

As long as we’re on the subject of hard assets, how about equity precious metals, down 13.11% YTD as concerns over rising inflation become a thing of the past. The Market Vector Gold Miners ETF (GDX) showed signs of life last Friday as the potential for more stimulus in China helped spark a rally for the miners although the technical outlook has been improving for the sector over the course of the month. The miners have broken above the summer’s downtrend line and have spent most of December consolidating but have yet to break through the 50 day moving average or move beyond the longer-term downtrend line you can see in the weekly chart. Speaking from personal experience, until it can close above the 2012 downtrend line, any rally for GDX should be treated warily.

GDX

GDXW

And you can’t talk about gold and oil without talking about Russia, so let’s check in on the Market Vectors Russia ETF (RSX):

Ever since bouncing off $12 close to the 2009 lows, it’s been nothing but up for RSX but remember how quickly this can all turn around. Since 12/17 RSX has moved up 15.98% on….well I’m not really sure. Could it be the promises of China to help bail out Russia if it needs it? The lack of further sanctions? Simply closing out of short positions to reinvest closer to home? RSX may have cleared the steep downtrend line dating back to late November but still has to face to the 50 day moving average and the gentler downtrend line from last summer. Until it can get above that, I’d be very cautious about adding Russian longs.

RSX

And as long as we’re overseas, let’s wrap up this discussion by focusing on the China A-shares market where it’s been nothing but profit since coming close to a double bounce of multi-year lows this spring. It’s been a strange pattern since then;

ASHR

the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR) has a nearly parabolic advance then cools off to consolidate and digest the recent gains. Then it’s rinse, wash and repeat. It looked like ASHR was going to do more than consolidate this winter but the recent rise in speculation that the PBoC will cut reserve requirements breathed new life in Chinese equities. For now ASHR is stuck in a trading range and consolidating recent gains and while the daily chart may not show overbought status, the weekly chart sure as heck does.

Europe:

So what about the Yinzer Analyst’s favorite investment, Europe, in 2014? While I still think the U.S. will stay the core of my own portfolio until proven otherwise, I think investors need to put more focus on diversifying their portfolios next year, especially with SPY up 15.45% annualized over the last five years versus 2.81% for the iShares MSCI EMU ETF (EZU) and 5.5% for the iShares MSCI EAFE ETF (EFA.) With such strong performance, why would anyone want to see “performance drag” from investing in anything other than U.S. equities? Performance catastrophes usually start off with logic like that.

So is the Yinzer Analyst still optimistic heading into year end? First on a weekly basis EZU has managed to get back above its summer downtrend line on better volume although it still has to challenge overhead resistance around $39.

EZU

What about compared to the S&P 500? On a daily basis, the relative momentum has been bottoming out for nearly two months now although EZU began weakening as it pushed towards the relationships’ 50 day moving average. On a weekly basis you can see that while the relative momentum hasn’t gotten any worse, it sure hasn’t gotten any better. Until it can break out of the downtrend line, domestic equities are still the “safer” bet in 2015.

EZU3

EZU2

Domestic Equities:

But what about domestic equities? Are they still the sure fire wager in 2015 that they have been five years into a bull market? Continuing to focus purely on technical, you can see that the S&P 500 has finally pushed above its consolidation range but did so on very weak holiday volume and giving us essentially a neutral CMF (20) score and a notable divergence from the price trend. Given the number of managers underperforming in 2014, I wouldn’t be surprised if the action stays quiet over the next few days with the market only showing a major trend change on Jan 2nd.

$SPX

But speaking of trend changes, the sector to watch continues to remain the healthcare sector. Despite the relatively weak price action in the second half of the week, XLV remains firmly entrenched in a relative momentum uptrend channel that formed in early 2012. The question remains whether the recent weakness in Gilead will be enough to derail the entire sector and send it lower in 2015.

xlv2

xlvrelmom

Setting up for another Defensive Rally in 2015

While everyone else may be off enjoying some holiday cheer, the Yinzer Analyst is still hard at work trying to help give you the edge in 2015…mostly because it’s a great way to avoid watching 3 hours of NCIS with the family. But while investors may be patting themselves on the back for sticking around to enjoy the low volume Santa Claus rally and all new daily highs of .3% moves, I’m starting to wonder if a deeper shift in sector leadership is forming that could portend great changes in 2015. While the FOMC induced rally was a nice Christmas surprise for many managers who expected only coal in their stockings, some of the early December sector trends are beginning to reassert themselves and could be signaling a shift back to the lower volatility sectors.

First, in the interest of full disclosure, I do write for another site, ETFG.com, and the topic I’m going to discuss is one I’ve written about there previously. ETFG does offer free trial subscriptions although you should be able to access the blog without one and I’d encourage all of you to check it out although I will be discussing new material I haven’t shared there. With that out of the way, let’s start by looking at some of the more obvious developments over the last few days:

First, China A-shares are finally seeing some profit taking on investigations by Chinese authorities into market manipulation. There’s a joke in there somewhere, it’s just too obvious to make:

SSEC

Energy stocks continue to show some signs of life, but have a ways to go before breaking the downtrend XLE has been stuck in for months:

xle

Probably the most significant development this week is that profit taking has finally come to the healthcare sector as XLV has given up nearly all of the post-FOMC gains as a slate of negative announcements about products in the FDA pipeline meets year-end profit taking. Healthcare stocks had a rough first half of 2014 before coming back to life as investors sought out higher volatility wagers, but today’s 2.3% drop broke the six month uptrend pattern and could signify more selling pressure to come although some way-too-early bottom feeding might keep them in the green tomorrow. What’s going to be more interesting in 2015 is that healthcare stocks are the third largest % of the S&P 500 and have nearly twice the weighting of energy stocks. Will healthcare weakness weigh that heavily on the market?

xlv1

So where are the profits taken from healthcare names being invested? There’s been a great deal of strong performance from the lower volatility sectors that help make up some of the more common low volatility “smart beta” ETF’s such as the iShares USA MSCI Minimum Volatility ETF (USMV). The phenomenon of low volume outperformance is nothing new and is one of the most demonstrated violations of the efficient market hypothesis so of course, someone slapped together an ETF to take advantage of this and all for a measly 15 bps a year. USMV has pulled in some SERIOUS cash this year and no surprise why, it’s up over 17.7% YTD compared to 14.9% for the S&P 500 Total Return and 11.7% for the average large blend mutual fund. But this success comes at a price; USMV and other low-beta ETF’s have been trading at record price multiples which have got the greats at the WSJ and FT wondering if you’re leaving yourself open to a low vol sell-off. Take a look at the chart below and you can see a major volume spike as investors took advantage of the FOMC rally to pick up USMV at a “slightly” lower price.

usmv

How did they generate such fantastic performance in 2014? Well yes, utilities were a part of that success but only a small part. For USMV, utilities make up about 8.5% of the allocation compared to the largest sector weighting with healthcare stocks at nearly 18% of the portfolio! Consumer Staples are #2 at 14% while 2014’s masters of “suckitude” energy stocks make up all of 5.7% of the allocation. So why do I go into this now? Well with healthcare stocks are trading at record levels and investors rightly concerned about profit taking, they’ve been casting their eyes at the other large components of USMV that haven’t participated nearly as much in 2014 and cutting out the middle man by investing in them directly to avoid the possibility to big losses after the multi-year run-up in healthcare stocks.

For USMV, the third largest sector holding is tech, with the largest weighting (6.6%) in companies on the services side such as Paychex, ADP and Visa as opposed to the largest positions in the Technology Select Sector SPDR Fund (XLK) like Apple or Google. I use the Vanguard IT VIPER as a better representation of low vol tech and you can see that as fears about the reality of rate hikes in 2014 set in this fall, VGT began making headway against the S&P 500 (using SPY) only to lose steam in mid-December when the “everyone in the pool” rally started on 12/16 and both VGT/XLK underperformed last week. Today it managed to get back above the uptrend line as reason returns after the initial joy starts to wear off (sort of like what happens after buying your wife a new car for Christmas.)

VGT

After tech stocks, the next largest USMV position is in the financial sector where high performing REIT’s are only around 3.4% of the allocation with insurance making up over 7.7% with the largest single holding being Chubb (CB) at over 1.3%. As you can see in the charts below; Financials (using XLF) and REIT’s (IYR) both lost steam versus the S&P 500 (REIT’s most noticeable in the late summer) as the sector leadership with the S&P began to change. Only with the breakdown of the energy sector in the fall do you see them begin to make ground with IYR breaking out of its momentum trade range while XLF begins to challenge it later in the year as the prospect for rate hikes becomes more realistic. In fact, financials underperformed last week not just on a pullback on low vol wagers but because the prospect for strong net interest margin growth seems more remote. One of the largest insurance sector ETF’s, the SPDR KBW Insurance Index (KIE), almost broke out of its momentum trading range versus SPY before the FOMC rally left low vol in the dust.

XLF

 REIT

KIE

In fact, if you look at this chart of utilities compared to the S&P 500 (xlu:spy) or USMV to SPY, you can see that a good portion of the mid-October rally was the contribution from low vol stocks pulling the S&P 500 higher almost against its own will given the weakness in energy stocks and the short-lived weakness against the high vol sectors last week is easing before year end.

usmv2

Again we have to wonder, will 2015 see another record year on a defensive rally?

Saturday Night Recap Fever: With Many Thanks to Janet Yellen

(This was accidentally posted last night to the wrong spot, my apologies on the delay.)

First my apologies for taking so long to get this posted but after the excitement of the last few days, I thought it best to wait till after Friday’s close before taking stock of the post-FOMC fallout. If the only thing worse than a sore loser is sore winner, everyone should just avoid the Yinzer Analyst for the next few days as Janet Yellen came through for Team Pittsburgh in a big way and confirmed that the only thing the market need fear is change itself. Despite dissension in the ranks with a slightly more hawkish leaning at 2-1, the change in language from “considerable time” to “patient” was enough to send everyone who’s lagging a benchmark and had scurried out of U.S. stocks flooding right back into them before they missed a chance to show their investors how proactive they were.

Why the rush back into U.S. equities on what was essentially a hawkish statement? From my own and non-politically sensitive point of view, the market played chicken with the Federal Reserve and won yet again. I’ll give the market the benefit of the doubt that some of the move was due to the downshift in expectations for inflation and the 2016 Fed Funds rate, pushing a potential rate hike further out into the future. Given the strong economic data over the last few months, it was reasonable to drop the considerable time language and begin bracing the market for a return to the brave new world of financial risk but the recent spike in volatility and weakness in the credit markets made the Fed feel the situation was too vulnerable to risk a major sell-off at year end. If the Yellen Fed was unable to muster their courage to raise rates after the recent employment data, just what crazy gangbusters growth needs to happen before they raise it? Or, could they potentially be waiting for the global slowdown to land on our shores so they can avoid having to raise them at all?

So if you were reducing your domestic equity allocations on expectations of a tighter Fed, what’s the most reasonable thing to do when you find out the Fed isn’t tightening at all? That’s right; you buy right back in, especially after SPY made a bounce higher after pulling back and retesting the pre-announcement price after 3 P.M. Given the weak sentiment across global equities, a global rally higher was a reasonable expectation, giving Thursday a nice gap-open higher before running into the uber-excitement that is Quad-Witching Friday. Let’s review a few charts to see how much damage was wrought and how it might shift our asset allocation expectations for 2015.

The Yinzer Analyst has been all for thinking about shifting a portion of the equity pie to Europe lately, and one of the first victims of the Fed’s announcement was the Guggenheim Currency Shares Euro Trust (FXE) which after finally breaking through its downtrend line in the first half of the week immediately feel below it following the announcement as the hog piling resumed. The iShares MSCI EMU Index ETF (EZU) had also enjoyed a stronger first half of the week against SPY before giving up all that momentum following the Fed announcement. While it enjoyed a decent return, the weak volume on the daily chart leads the CMF (20) to not support the recent move despite EZU holding the 50 day moving average.

FXE

EZU EZU

The only clear equity winner for the week besides the Chinese A-share market was the energy sector where the SPDR Select Energy Sector ETF (XLE) had a serious decoupling from either West Texas Intermediate Crude or Brent Crude and found a much strong correlation partner in broader equities. We’ve talked about how the energy sector was beginning to see its relative momentum versus the S&P 500 begin to bottom out and with it up over 9.5% for the week, XLE was one of only two domestic sector to continue pushing higher on Friday while the other select sector ETF’s lagged with the broader market. But now it’s time to put up or shut for XLE. On a daily basis, XLE is no longer oversold and about to run smack into a major gap as well as it’s fifty day moving average while looking at the weekly chart, XLE is still firmly bound within a downtrend channel although there’s perhaps another $4 or approximately 5% worth of room to run in.

ASHR2

XLE

For the bond markets, the reaction was much more mixed. With the possibility of a rate hike on hold for an additional quarter or two (depending on who you read) the immediate rally in “non-investment grade” credit was hardly surprising. Both the SPDR Barclays High Yield Bond ETF (JNK) and Shares iBoxx $ High Yield Corporate Bond ETF (HYG) were trading into deeply oversold territory and due for a bounce. Sporting yield spreads in excess of 571 bps on Wednesday and back to levels not seen since late 2012 with default rates still at low levels, they offered a reasonable risk/reward tradeoff for some enterprising investors. But with this recent rally, JNK has only managed to push its way into the prior downtrend channel. Retesting the lower boundary is probably a necessary step to confirm future strength.

jnk

The impact on the Treasury markets was also predictable but again very short-lived. Both the ten and thirty yield Treasury yields rose but remain well-within their downtrend channels. Uncle Buck resumed gathering strength and pushing back above the recent high as the evidence of docility from the Fed was enough to keep investors focused on the easy money that could be made here versus the higher risk wagers overseas.

$tnx

TYX

UUP

Time to Go All In?

So does that mean the equity rally is due to resume on Monday as investors go all-in before the Christmas holiday. The S&P 500 could push higher yes, but the odds are in favor of us having already seen the best of the move.

First, consider the market breadth. As you can see in the charts below, the percentage of S&P 500 stocks trading above their 50 and 200 day moving averages had dropped recently, but was nowhere near the lows of mid-October before the Bullard rally began and was still above the prior periods of weakness in August and February. But unlike those rallies, this move went much further and faster than anything else in 2014. If you had decided to take a flyer and bought at the close on Tuesday, by Friday you were up 4.96%. If you had bought the market after Bullard made his speech on October 16th, you were up 4.22% 3 days later. In fact, this was one of the best three day rallies this year. Buying at the momentum lows in early August at the close of the 7th gave you a three day return of 1.27%. Buying a similar low in early April gave you a return of 2.5% from the close of the 11th to the 16th.

DPX Breadth

Why is this significant? Because besides a certain amount of desperation being in play as a record number of managers looks to underperform their benchmark in 2014, it also means that a lot of the weak momentum has already been reversed. Looking at short-term readings over the last year, our momentum model went from the lowest decile to the top decile while longer term scores went from the lowest decile to the upper quartile. It means this move was a major one and while a slow drift higher this week on holiday volume can’t be discounted, I wouldn’t get overly concerned about chasing it in here as the “easy” money has been made.

From a technical point-of-view, the S&P 500 is knocking right back on the door of the old highs but could be closing in on oversold territory while CMF 20 score fails to confirm the advance after the heavy distribution of early December. The weekly charts are more interesting; you can see the CMF 20 score improved slightly (we switched to S&P 500 from SPY due to the quad witching issues) while the rally really started after the S&P 500 hit it’s 20 week moving average. The market pushed its way back into the 2012 uptrend channel, but whether it has the energy to linger there has yet to be proven.

SPX

weeklyspx

What about those with a longer-term view? Yes, with a rate hike off the table until the next FOMC meeting in January, you could approach this as investors have been given a sort of reprieve but has anything really changed? The S&P 500 is still trading at a high valuation, the earnings outlook remain somewhat downcast for the coming year and rising rates could become a reality the next time core inflation gets above 1.5% on a y-o-y basis. While most investors will keep domestic stocks as the core of their portfolio, nothing here has made the case for going all-in on U.S. equities.

Sunday Night Recap: Don’t Become a Victim of Regime Change

The first step in avoiding a trap is knowing of its existence –
  Thufir Hawat, Dune

While the above quote from Frank Herbert’s “Dune” may be one of the most used by investors and bloggers everywhere, actually following the advice is much more difficult. After all, what can you do to avoid the most common pitfalls the befoul investors when they’re in your own mind. In “Dune” Thufir Hawat is a mentat, a man whose nervous system has been adapted to processing and analyzing vast amounts of data. Relying on statistics and logic, he’s ultimately defeated by an inability to understand human sentiment and the depths an enemy will go to defeat you. Like the good mentat of the novel, you need to study your data carefully but remember that the human mind can struggle with data and often arrive at false conclusions.

One of the most power facets of human behavior in general is the need to “know” what the answer to any or every question is. Lazy journalists and their social media successors have relied on this for sales and ad revenue for years. The S&P 500 was down 3.5% last week and investors big and small are trying to determine why. Some will say a lack of confidence in Europe, others will say spillover from the energy sector is leading to profit taking elsewhere. It could be year-end asset reallocation or political concerns in Russia, or anything you want it to be. But the human mind is programmed for pattern recognitions; it was one of the great survival tools of our species, the ability to look at an event (say a lot of picked-over bones outside a dark tree line), find clues (large animal tracks), and draw a conclusion (something big is in there, stay away!) Today it persists in the need to look at an outcome such as a strong market drop and determine why or how long it can persist for.

As the computing power of our machines has begun to outstrip that we were born with, our ability to process data has increased exponentially, but if your data or process is flawed, so are your conclusions. As an example, I was updating my momentum tables this weekend and trying to come up with what I call “left field” trade ideas when I noticed that Energy Sector Select SPDR (XLE) was trading a level that I never thought possible. Using a short-term range of 5 to 30 days, XLE’s momentum is so low that round it up to the .01% is actually overstating its case. Compared to its prior history, it’s not just cheap it’s CHEAP. On a long term basis (1 to 5 years) I went out ten decimal points and still could find a number above zero. Saying XLE is hated would be understating the case.

Looking at the chart for XLE, the selling pressure hasn’t reached the level of last October but getting very close to it. Having taken out prior support at $75, you can see additional support at $72.50 and then $67.50 that might prove to be the final stopping out point. The question is who is brave enough to try buying there. Given the flood of negative sentiment, most people won’t even consider it. But remember how negative the sentiment was on the real estate sector in 2009? Everyone though they would collapse completely and instead over the next five years ending 12/12/14 they’ve outperformed with the Vanguard REIT ETF up an annualized 17.53% compared to 14.88% for SPY. Or how about Treasuries in late 2013? The iShares Barclays 20+ Year Treasury Bond (TLT) ETF is not up over 27% YTD, nearly 3x the gain of the S&P 500 TR.

What happened?  In a nutshell, there was regime change. At the heart of quantitative finance is a paradox; practitioners rely heavily on statistical theory and the assumption that data is stationary or that the relationship between two variables remains stable and unchanged over time. If variable X changes by so much, it will cause a certain change in variable y and do so consistently over the time frame in question. However, financial data is widely known and understood to be non-stationary; relationships between variables are in a constant state of flux and achieve stability for only limited periods. Despite the tools and techniques to model this instability, at its root, the market is a pool of humans (and increasingly machines) constantly updating their outlook based not only on new data but a change in sentiment which is something machine learning has yet to master. Why do I go into this now? Because I’m curious whether a regime change is about to happen to the S&P 500.

Regime change has already been taking its toll on the performance of active managers in 2014, just look at Good Harbor. The Good Harbor Tactical Core (GHUAX) Fund relies on the asset switching model they developed to rotate between equities and bonds and within equities between large and small cap ETF’s and uses leverage to enhance returns both by leveraging up longs or through inverse positions. During years like 2013 where equities consistently outperformed bonds, firms like Good Harbor can do very well for themselves and pull in a lot of assets, but 2014 has been hard on them. The constant rotation in leadership between equities and bonds in the first half of 2014 along with the consistent underperformance of small caps versus large has left GHUAX down 23% this year and GHUAX, while only a small part of GH’s overall business strategy, has seen assets drop nearly 40%.

GHUAX

The basic logic behind my own momentum model (or anyone’s really) is to identify levels where a security or index can be expected to out or underperform and to develop a trade strategy around it. Basically if short term momentum scores reach a certain low point, a positive return can be expected over a certain time frame. Looking at the S&P 500, momentum scores are close to the lows they set in early October and before St. Louis Fed President Bullard made his comments about changing the timing for ending QE3 that sparked a new rally. My first reaction was to say that equities should be due for a bounce soon that could push us back to the old highs but after creating a few charts my view has begun to evolve.

When I looked at my charts, I noticed that the short term scores haven’t been this low since early October of 2014 and before that February of 2014 but the more interesting discovery was that they really haven’t been this low, this often, since August of 2011 to May of 2012. It’s a document fact that momentum, like volatility, has a tendency to persist for long periods or put more simply, winners will keeping winning for much longer than you can expect. During the period of 8/11 to 5/12, the 30 days return after a hitting a deeply negative score just as often saw negative or at best breakeven performance compared to strongly positive performance in the period both before and after that. Likewise, very strong scores often saw positive performance rather than negative as short rallies cooled off. In other words, there was no consistent relationship between the momentum score and the subsequent return. A similar relationship existed for several months in May to August of 2010 and before that in the 1st quarter of 2009. After May of 2012 the situation changes; deeply negative short term scores saw very strong performance and typically only when scores were at their peak was there a minor pullback of less than 5%. Putting it simply, if you bought when momentum was strongest you might have suffered a small 1% to 3% loss over the next thirty days, but if you simply bought the dip, you made it all back and then some.

What was the likely culprit behind these regime changes? Well consider the only major outside variable, the main driver of equity market returns, over the last five years; the major sentiment boost provided by the Federal Reserve. Take a look at the charts below. QE1 was announced in late 2008 and ran from 12/08 to 03/10 and was followed by a period of weakness when rumors about QE2 began. QE2 ended with a serious market pullback and after a summer of rumors about QE3, the FED unveiled operation Twist II choosing to hold off on unlimited QE until the summer of 2012. After that the rest was history. Why didn’t the market break down further in 2013 when the FED got serious about ending QE3 in 2014? Because it was year-end and no one wanted to sell their positions after such a strong year. Now with heavy volatility and weak performance, investors can’t wait to sell their positions to lock in what gains they may have which could explain the weak performance across nearly all sectors and broad domestic equity markets last week.

QE1QE2

So why is it different now? Because the Fed has been signaling from the summer of 2013 that is very concerned about the effects of low interest rates on risk taking behavior and wants to return to traditional practices as quickly as possible and with the recent performance of the dollar and its impact on commodity price inflation, the Fed now has the cover it needs to wrap up their asset purchases without ever having hit the 2% inflation target. And now, Vice-Chair Stanley Fischer has confirmed that discussions are on-going about dropping the language committing to keep rates low for an extended period as soon as this week’s Fed meeting. Remember, the FOMC may believe raising rates will help increase velocity of money and raise spending because once rates begin to rise, investors will feel more confident that rates won’t rise more. Think about it this way; the pool of investors (individuals or institutions) who sit on cash because they won’t suffer a capital loss from duration if rates rise will feel more confident after the Fed Funds rate goes to .5% or 1% because they think a future rate increase is less likely. The Fed is hoping that the established positive correlation between interest rates and velocity holds true in the future.

Maybe the markets are right to be anxious about the coming end of QE3 after all. In the meantime, maybe it’s time to stop and think about what traps you might be setting for yourself.

Another Greek Drama and Making the Case for the Slow Horse

After a week like we’ve just had, with the S&P 500 pulling back 3.5% to close at its lows and almost given up the 2000 level, I bet you’re starting to think managing your equity allocation ahead of the year end isn’t such a bad idea after all. So where do you think the odds on favorites are going to be found in 2015? Given my known preference for increasing my European equity exposure in 2015, you’re starting to wonder just what the heck the Yinzer Analyst has been up to all week. Maybe spending too much time sampling the goods at our own local micro-distillery?

Why do I feel so optimistic about Europe? Did this week’s almost 5.5% pullback for the iShares MSCI EMU Index (EZU) ETF lower the damper on my fire? To be honest, this pullback helped ease my biggest concern about investing in Europe, that valuations were already sky high as investors anticipated the ECB’s upcoming QE program. First let’s look at the charts to breakdown this week’s price action.

First things first, let’s take a look at a chart of the most common ETF offering pure Greek-exposure, the Global FTSE Greece 20 ETF (GREK.)  Now study the chart carefully and tell me what you see.

GREKCould it be the fact that GREK has been steadily underperforming EZU since last spring?  From the high of June 6th to today, GREK is down 42.96% to the 14.72% loss for EZU.  Yeah, the chart above is the tame one but I like it because it shows the incredible volatility of GREK.  In fact, ETFG had it ranked on 12/5 with close to it’s highest short interest as a % of the free float and implied volatility in it’s history.  This thing, is to quote Gwen Stefani, bananas.  So the fact that Greece is a financial/market basket case is hardly news to anyone who’s been paying attention.

Now getting serious, let’s start off by checking out the hometown team using SPY as our proxy for domestic equity markets.  When I started this post on Thursday night I didn’t think we’d crack $202 so quickly if at all, but SPY plowed right through it late in the day to close just off the low on heavy volume with the price eliminating the divergence that had been forming with a steadily falling CMF (20) score since late November.

SPYIf you think that looks bad, avert your gaze from the drama in Europe where EZU also closed at the lows of the day, breaking through the support line around $37.75 and looking to challenge the downtrend line at $36.  The global risk-off trade didn’t help the situation, but the negative correlation with a rising FXE certainly did it’s part to pull a Harding on EZU.

EZUD

fxeThe situation looks no better on a weekly basis as the global rout signaled everyone holding a long position with a $38-$39 entry point from the fall of 2013 that it was time to take the money and run.  Having cracked the weekly downtrend line, the next likely stop is going to be at $35.75-$35.90.

EZUWeeklyWhat about relative momentum versus SPY?:

REL MOM WEKYou can see that for a brief period this week, EZU outperformed SPY to the point where it broke the downtrend line before concerns over the Greek contagion lead to a hard rout of European stocks. Try looking at the same chart on a daily basis.  You can see that try as it might, EZU can’t quite overcome the 50 day moving average.

50 DAYSo given the glum charts, why am I still so positive on Europe.  First it’s because despite the fact that Baron Rothschild never said anything about buying when there’s blood in the street, it’s still really really good advice to follow.  What do you think is the most important determinant to long-term returns?  It’s not technological growth or demographics or how quickly the money supply is growing, it’s the price you paid for the investment in the first place.

Ever since Draghi’s comments in early November about doing whatever it takes to expand the balance sheet, there’s been a steady stream of positive news reports from the ECB coupled with negative Eurozone economic developments that reinforce the need for additional monetary and fiscal actions to help combat a deflationary environment. The real question is whether the situation in Greece is significant enough to derail 2+ years of progress in combating the prolonged economic weakness Europe has endured. Honestly, doesn’t it feel like a story you’ve already heard before? Political uncertainty in Greece threatens existence of EU? Not quite as old as the Odyssey or even Oedipus Rex, but it has a familiar ring. My own theory is that all its done has been to shake out the weak hands (as much as I hate this expression) and restore valuations to a somewhat more attractive level. At the start of the week EZU has a trailing P/E multiple close to 18 and in the top decile of its prior trade history. According to ETFG the recent rout has pushed it’s valuations closer to historical median but I’d like to see a little more bleeding and improved momentum first.

Before you rush out to buy EZU or broader VGK, the latest Greek tragedy will play out over the rest of December which means that EZU could be retesting the $35-$37 range soon. But my investment thesis on Europe has more to do with long-term trends than technical or valuations.

The Case for the Slow Horse:

I’ve been of the opinion that the EU has been a slow-motion train wreck largely of its own making. Between an unwieldy monetary union, finance ministers who still think currency markets operate the way they did during the era of “golden fetters” and an obsession with debt-to-gdp ratio’s, Europe pretty much got everything wrong between 2008 and 2012. While heavily criticized at the time, the American decision to focus on saving the banking sector in 2009 to avert a loss of confidence following the forced mergers of 2008 proved to be the correct one. Thanks to Fed largesse and a change in mark-to-market accounting, the day of reckoning for American financial institutions was postponed until they were able to successful restructure their balance sheets and restore confidence that they were going concerns. Coupled with the American Recovery and Reinvestment Act of 2009 along with the on-going confidence lift from the QE programs, America was able to limp along until such time as it seemed that economic growth could be self-sustaining.

Contrast this with the situation in Europe where the response to the crisis was modeled on the Japanese approach of the last 20 years, incrementalism and subtly akin to Lyndon Johnson’s approach to Vietnam. Lacking a unified banking regulator, there was no consistent policy in place for backstopping weak financial institutions; instead the focus was on improving their financial condition by eliminating riskier debt and raising additional capital to comply with Basel III choking off what little lending there had been while doing nothing to address the concerns over their financial safety. Now European financial institutions are very well-capitalized, but with low loan demand and no prospect for NIM growth. And without a federal structure, the EU had no ability to effectively deliver stimulus aid where it was needed to resolve fiscal in balances instead forcing highly indebted EU nations to raise taxes and cut spending, the exact opposite of the Keynesian response typically employed during a recession.

As anticipated, economic growth weakened to nothing raising the specter of default, increasing volatility and forcing EU financial institutions to unload supposedly safe sovereign debt, igniting the Euro Bond Crisis of 2012. Only the addition of “Say Anything” Draghi as the head of the European Central Bank and the realization by German politicians of how close to the brink they were helped ease tensions within the Eurozone while also simultaneously restoring confidence. From the low point of the Eurocrisis in 2012 to the this summer, the iShares MSCI EMU index performed in line with the S&P 500.

So why am I taking the time now to dredge up what in this day is considered to be ancient history? Because the policy differences between the U.S. and Europe are set to become even more extreme and this time, the Europeans might be the ones with the better hand to play and that differential could mean all the difference for expected returns going forward.

We don’t need to sit down and derive the Kalecki-Levy profit equation from Macroeconomics 1 to understand that one of the biggest drivers of corporate profits over the last five years has been the Federal budget deficit. Although the steady decline in government hiring and spending has been acting as a drag when figured into GDP calculations, government spending has been a major boost to the economic recovery despite what you might hear on Fox News. Even though there are no truly “closed” economies, remember that government spending becomes private saving so government deficits are a source of revenue to the private sector while the federal surpluses of the late 1990’s withdrew capital from the economy. In fact, the on-going fight over federal spending and the infamous sequestration battle of 20XX were cited by Ben Bernanke as one of the reasons for Quantitative Easing in the first place even though he knew that loose monetary policy could only do so much to counteract fiscal tightening.

How this pertains to our current situation is that even with the recent swap in Congressional leadership, U.S. fiscal deficits are projected to remain fairly narrow at 3% or less of GDP for the next decade, removing a potent source for corporate profit growth. And while they may have narrowed substantially over the years, another source for profit growth, personal savings, is already close to historic lows. In 2012, personal savings bounced back above 7% before running even higher into the end of the year as companies rushed out special dividends ahead of the change in legislation from Bush-era on lower dividend tax rates. Since then, personal savings rates have hovered between a low of 4.1% to 5.3% (October was 5%) offering little hope of further profit stimulus from this quarter.

This leaves dividends and investments to help generate the profit growth necessary for the S&P to continue advancing but with dividend payouts and share buybacks already running at 95% (or over 100% depending on the source) of trailing earnings, there’s little room left for further growth unless earnings accelerate or more debt is added to finance them. But then what capital is available for further investments? Real gross private domestic investment is already running around a 4.9% year-over-year rate of change and while that’s above the 2% lows from late 2012 and early 2013, it’s down from the 8.7% level of 4Q 2013. That only leaves net exports and with a rising dollar and falling oil prices/falling oil demand, what’s the outlook for U.S. exports except for passenger jets and military equipment?

So does that mean there’s going to be zero profit growth in the immediate future? Not at all, if just means that any growth will be more limited for the immediate future. At the close of 2013, analysts surveyed by S&P estimated 2014’s earnings would grow nearly 28%, by 9/30/14 there were estimating instead they would grow 21%. So far, the 3Q/13 to 3Q/14 growth rate has been 12.3% with Factset reporting expectations for 4Q are already declined to 3%. If earnings growth does come in that low, the full 2014 earnings for the year will be less than 9%. Depending on where we close, it’s possible than 100% of the full years return will be driven by earnings growth rather than multiple growth. Where does that leave 2015? If the trailing multiple were simple to go from the current 19.5 to 17 and earnings grow 10%, we’re nearly fully valued for 2015.

European Contrasts:

And is Europe in such a vastly better condition you ask? No, but their position in the business or sentiment cycle is much better than ours. From my point of view:

  1. ECB Commitment to Expanding the Balance Sheet: This is the key, they’ve already agreed to a $1 trillion expansion and I agree with Andrew Smithers at FT, this isn’t nearly enough. Does that mean it’ll fail? No, they will just have to keep committing to more and more programs until it works. Sound familiar? If they did just that, it would be QE 2 and QE 3 all over again.
  2. Euro Destruction: The Euro has already moved south to the tune of 10.4% since May 5th and while the Greek anxiety has some covering short Euro positions waiting for the inevitable announcement of a new backstop to send it higher, any move to expand their balance sheet while the Fed stops expanding theirs could send the Euro lower. Besides improving the short-term Euro outlook, it acts as a major boost on corporate earnings. A Reuters piece on September 5th estimated that the then 5% drop in the Euro could lift corporate earnings 3%-6%.
  3. Loosening up the belt: After years of cutting spending and raising taxes, Eurozone leaders seem to be coming to grasp with the idea that they only way they can maintain target debt-to-GDP ratio’s is to focus on growing GDP and not Germany’s fixation on belt tightening. Never having reached the deficit depths descended to by the U.S., the Eurozone aggregate deficit in 2013 was only 2.9% with only France and Spain exceeding that average for the year. While government finances are relatively stable, the on-going tepid growth of the Eurozone, when contrasted either with the U.S. or the EU nations with a free-floating currency is astounding. While it’s irresponsible to think that this will change overnight, the recent discussions of new infrastructure and stimulus funds is a marked change from the recent past either in Europe or the U.S.

So if you were to ask me why, when presented with the choice of a long-time winner that looks a little sluggish and at terrible odds or a perennially also-ran that’s fighting the trainer and offering better payouts, why wouldn’t I take that bet?

Step 1: Manage Those Expectations

It’s December people and that means it’s time for more than just peppermint lattes and the Charlie Brown Christmas Special. We’re just a few weeks away from sector rotation time when investors of all sizes will revisit their strategic allocations and billions upon billions of dollars will be reallocated. Think of this as your final exam and me, the professor who has woefully underprepared you for this moment. Sort of like John Oliver in Community so for this very special edition of the Sunday Night Recap, we’re going to try and scrap together a few quick ideas on how to think about your investments as you start the process.

As you all know, I’ve been turning into an uber-bull on Europe over the last few months and during a long drive home on Tuesday followed by a few days getting over a head cold, I started working on a longish piece trying to describe my methodology for asset allocation and establishing broad guidelines for return expectations. At the end of the day, as much as people hate it, modern portfolio theory remains the best tool for setting your market return expectations and I rely on it heavily including using a modified version of the Gordon Growth Model. I know, it sounds so quaint but since I have most of the inputs, I can modify the formula to determine whether investors return expectations are in-line with reality. And the coming shift in the interest rate environment here in the U.S. is going to have a major impact on the markets going forward. I’m a firm believer in going where monetary policy is loose and loosening and very shortly, that’s not going to be here at home although I still believe in having the U.S. as a core portion of your portfolio.

But it’s late on a Sunday night and the last thing you need from some yahoo in Pittsburgh is a long lecture on the dividend discount model, although still a huge fan. So instead we’re going to do this in stages and I’m going to explain it to you the same way I used to explain it to the advisers I used to work with; through gambling analogies. There’s a world of difference between investment and speculation and gambling is pure speculation no matter what strategy you try to use for the penny slots, but growing up in a horse racing town you learn there is one thing gamblers, speculators and investors have in common and that is they like to buy when they think they have a sure thing, when the odds are in their favor. At the end of the day, the chances of you knowing something that the rest of the market doesn’t is pretty slim; it’s what you do with the information you have that makes the difference.

Part 1: Domestic Equities: Not Such a Sure Thing?

Let’s start with domestic equities and as always, I’ll use the S&P 500 as my benchmark. After six solid years, the S&P 500 has proven itself to be a sure winner, there’s no doubting that. After the initial bounce from March of 2009 to the end of April 2010, the market took a breather for over a year to digest the gains and let valuations catch up but since the fall of 2011, it’s been nothing but a strong solid advance with only brief pullbacks to cool the tempo and after pushing past the previous highs, any mention of a “cyclical bull” or “secular bear” got dropped by the wayside.

But does that strong performance mean that 2015 will be just like 2014? Projecting the recent past into the future may be a favorite tool of market prognosticators and that’s sure to be exactly what a lot of investors are thinking, but we need to take a deeper dive to see where we go from here. Remember, the problem with being the heavy odds on favorite is that the payouts are often not that great.

  1. Where does your food come from: While cleaning some files I came across something I wrote in late 2013 that used a chart from the pragmatic capitalist.com showing the 2013 equity return breakdown with most of the return coming from multiple expansion rather than earnings growth with the admonition that the only way we could see as strong a year would be for the trailing p/e multiple to climb over 23. I also used the supposed favorite tool of Warren Buffet, total share holders equity to Gross Domestic Product with an updated chart here from dshort.com.  Instead, 2014 has seen close to 100.5% of its return come from earnings growth rather than through multiple expansions. The trailing p/e is still above 19 while the forward p/e ratio has risen to a high level last week not seen since 2005 as earnings expectations dropped another 1%.  And as to Buffet’s favorite tool:Buffett-Indicator-and-SPX
  2. Prior Performance: I know people hate this argument, that because the past performance was so strong, the future is automatically guaranteed to be bleaker. Really it’s not, but when market valuations get as stretched as they are now after a strong run-up, the market likes to take a breather. In my former life I did a study of trailing and forward five year annualized returns and when the trailing five year return for the S&P 500 gets stretched beyond 10% on an annualized basis, the forward five year returns tend to be of the single digit variety at best.
  3. Payouts: Call me old fashioned, but I like having my money in my hand (or brokerage account) and not sitting in some corporate treasury collecting dust and I was certainly not disappointed in 2013. Over the trailing 4 quarters, payouts via dividends and share repurchases hit a new high but how much more room is there for that to grow? Payouts in the 3rd quarter grew 2%, the slowest rate of growth since the 3rd quarter of 2011. According to Factset, most sectors have cash to debt ratio below their 10 year average and the S&P 500 constituents paid out close to 95% of their earnings from 7/1/13-6/30/14 in the form of dividends and buybacks. Debt could continue to rise to finance capex, but internal financing would be cheaper and wouldn’t add to financial leverage. Dividends have also grown far faster than the long term trend which closely matches the median change in GDI of around 4.1%. The time to buy for faster dividend growth was in 2010-2011, not in 2014 with peak margins and already high payouts.
  4. Sentiment: Using that most despised of sentiment surveys, the AAII Investor Sentiment Survey, 2014 is likely to end on a better (less positive) note than 2013. The last reports from 2013 showed the bullish% well above the historical average and the bullish-bearish spread back to levels not seen since late 2010. A similar spike occurred in November after the S&P 500 finally broke through 2000 but has since cooled with neutral and bearish readings climbing slightly. This compares favorably to my own momentum scoring system that’s seen short-term scores cool after the initial rally wore down around mid-November while longer term scores continue to climb back to old highs. Using VOO and ETFG.com, the put/call ratio remains elevated while short interest has fallen to the lower quartile of its historic average.
  5. Technical: I know how much a lot of investors hate using charts for their analysis but remember what we’ve said before on the subject. If a lot of money managers take this seriously, you should at least know the fundamentals. Start with this weekly chart of SPY you can see that at the end of 2013, SPY had been probing the boundary of its uptrend line and the subsequent RSI (14) score was showing a clearly overbought condition with the market in need of cooling off. Fast forward to the present and you’ll see that although the RSI score is below the overbought zone at 70, the CMF score for the trailing 20 weeks has been declining on weaker volume which would indicate that the recent bounce has more to do with a lack of selling pressure rather than strong buying pressure. The previous pattern set in 2012 was also decisively broken and while SPY has pushed hard to get back into the uptrend channel, there is insufficient buying pressure to take it much higher.WeeklySPY
  6. Prime Mover: When you think back to the tech rally of the late 90’s, what do you think of? Tech stocks of course, when companies like eToys.com could go public with hardly any revenue and command a market cap higher than their bricks and mortar counterparts. In the mid 2000’s it was the real estate and financing boom. What sparked this rally? An accommodating Executive Branch and Federal Reserve. Well Congress decided it was time to end the party years ago and the Federal Reserve has made its position on the issue of lower rates for an extended period very clear as Stanley Fischer has been sent on the lecture circuit to spread the news. While the latest GDP report owes a great deal to the temporarily expanding military purse, even Republican dominance of the Legislative branch might not be enough to stop these ridiculous budget issues.

These are just some of the highlights of my process which I hope to expand upon this week and while it’s impossible to assign a specific target for the market with any accuracy that’s never been my goal. There is absolutely nothing here that says the S&P 500 can’t have another positive year in 2015, it can still be positive but the likelihood of another 2013 is very slim. My focus is on trying to determine whether there’s sufficient return to be had for the amount of risk I could be taking on by adding NEW domestic equity positions and either holding them for a year or longer. Remember, the highest purses come with the longest odds and that’s something we’ll pick up on later this week.

Sunday Night Recap: Winter Reallocation is Coming

While you’d think the Yinzer Analyst would be feeling the need to overwhelm you with some serious investment wisdom after the big win in Buffalo this week; he’s managed to come down with something nasty so we’ll be keeping it short tonight.  For the Yinzer Analyst, the focus is now shifting to where we think capital might be redirected in the upcoming annual reallocation.

With November finally in the books, it was all large cap as the S&P 500 managed to churn out a 2.45% gain, a 1.69% gain for the S&P 400 Midcap and a slight -.02% loss for the Russell 2000. I’m still of the opinion that this push has done nothing but move the S&P 500 even more into the overbought territory and leave it at risk for a greater pullback if and when valuations start to matter again. In the meantime we’re continuing to watch the iShares MSCI EMU Index (EZU) ETF which saw its first strong monthly gain since last spring with a 3.88% gain. The strong performance continues to be driven by the more politically and economically stable nations of Northern Europe with the iShares Germany ETF (EWG) up 5.73% in November compared to iShares Italy down -.13%.

Breaking down the charts:

Starting with the daily charts, EZU has plowed through the downtrend line and prior support to push its way back to another prior support from the recent downtrend around $38.50. Pushing towards the 200 day simple moving average at $40.71 would be indicated but looking at the weekly chart, you can see we’re back into the same situation on a weekly basis that we were on a daily basis a few weeks ago. We’ve cleared the downtrend line but have run right up against prior support. This coming week could see us just consolidating if the strength isn’t there to push it higher.

ezu2ezu3On a long-term monthly chart basis, EZU retested prior resistance at $36.50 for the second month and is bouncing higher with a prior leg to the uptrend at $40 and forming a natural resistance point about 2.96% above the monthly close at $38.85.

ezuSwitching gears to look at relative momentum, you can see that EZU broke the relative low point it achieved versus the S&P 500 set way back in July of 2012 but with two weeks of stronger performance from Europe, EZU has cracked above the line and has nothing but air in front of it although EZU still has yet to break out of the relative momentum downtrend line that it has been stuck in since late spring. Until that happens, everything else remains fluid.

EZUSPY2EZUSPYMThe only other major development this week worth getting into at the moment is the return to weakness in the energy sector. The decision by OPEC to leave production quotas unchanged wasn’t a major surprise given their history of focusing on long-term decision making (not to mention bringing the pain to American producers) but had a devastating effect on energy and natural resource stocks. XLE ended the week down 9.81% and erased nearly the entire decent rally off the October lows. While I’m sure that this move lower is going to provoke a lot of discussion about sector rotation but looking at either XLE or the broader materials sector ETF (XLB), neither is showing a lot of strength against the S&P 500 at this point. I’d be really reluctant to add new positions until some signs of strength begin to emerge.

xleMLBAnd finally we have the gold miners, ugh. After cracking it’s summer downtrend line and running smack into the 50 day moving average, the miners sold off strongly at the open in a sympathy move with the materials sector although some strong buying around the close helped keep GDX above the prior downtrend line. Recent buyers should watch this week carefully to make sure any profits off the early November bounce don’t run away on you.

GDX