…And The Rally Hits The Wall

Authored by Lance Roberts via RealInvestmentAdvice.com,

This week is a review of where we have been and a look forward as to what may happen next.

First, let’s rewind the tape to the beginning of March.

“Most importantly, the market is currently in the process of building a consolidation pattern as shown by the ‘red’ triangle below. Whichever direction the market breaks out from this consolidation will dictate the direction of the next intermediate-term move.”

Turning points in the market, if this is one, are extremely difficult to navigate. They are also the juncture where the most investing mistakes are made.”

The market did indeed fail to breakout and on March 23rd, as the market first tested the 200-dma for the first time, we laid out the three possible pathways for the market.

I have repeated those options over the last couple of weeks, so click the link above for specific details.

  • Option 1: The market regains its bullish underpinnings, the correction concludes and the next leg of the current bull market cycle continues.

  • Option 2: The market, given the current oversold condition, provides for a reflexive bounce to the 100-dma and fails. 

  • Option 3: The market struggles higher to the previous “double top” set in February, retraces back to the 100-dma and then moves higher.

In last weekend’s missive, as the rally approached the 100-dma, we recommended that investors use the rally to take action and rebalance risk in portfolios. We also discussed the benefits of holding extra cash.

“Given the recent rally, and overbought conditions, we are using this rally to follow our basic portfolio management rules. As the market approaches the “neighborhood” of the 100-dma we are:

  • Selling laggards and raising cash.

  • Rebalancing remaining long-equity exposure to comply with portfolio target weightings

  • Rebalancing the total allocation model to comply with target exposure levels. (See 401k plan manager below)”

Chart updated through Friday’s close.

That advice turned out to be warranted (a lucky guess) as the market not only failed at resistance, but has now established a third lower top. That failure also pulls the current downtrend line lower as shown in the chart below. This development should not be lightly dismissed.

This week, we are continuing to carry an overweight position in cash. However, we are monitoring the possible actions heading into next week:

  1. With the market on a short-term “buy” signal, there remains a potential for another rally attempt next week. If the market can clear the downtrend, then we will be looking for an opportunity to redeploy cash.

  2. However, the failure at resistance applies more downward pressures to prices in the short-term which keeps risk elevated.  Pathway 2 is becoming much more viable if market action doesn’t improve soon.  

  3. Over the next couple of weeks, it is critically important for the market to regain its footing and not break the 200-day moving average which will likely accelerate the correction process. 

  4. Over the next couple of months, with earnings season still in process, volatility will remain a close companion so we will have to continue monitoring changes on a very short-term basis and adjust accordingly.

However, that brings me to the next point.

Corrections Vs. Bear Markets

It was interesting to note last week the number of emails I received, as the market rallied higher, all asking one primary question:

“Is the bear market over?”

The question is interesting from a couple of perspectives.

First, the recent downward slide in markets was only a “correction” and not a “bear market.”  Both in terms of the percentage decline as well as the lack of reversion in investor psychology.

If the recent decline had been a “bear market,” the primary question would be “should I sell now,” rather than “should I buy?” What the recent correction failed to do was instill any significant level of “real fear” back into the market. High yield spreads remain compressed, the rise in the volatility index was quickly reversed, and investor attitudes were not changed from “greed” to “fear.”

From an investment perspective, those three ingredients are critical for determining longer-term entry points for taking on more aggressive investment postures. “Buy fear, sell greed.”

However, while the market rallied nicely early last week, as noted above, the rally has yet to reverse the current negative trend in the market. This was also noted by Phil’s Stock World earlier this week:

“As you can see from the chart we’re still making one of those triangle squeezy thingy patterns but the top of the down wedge is still at our 2,740 line and it will be three more weeks of this nonsense (while earnings pour in) until it resolves itself but, with the nose of the triangle lower than where we are now (2,717) – the odds favor the short bet on /ES Futures.

As Phil correctly notes, the market is being currently supported by excitement over “tax cut” driven earnings growth. However, while the bottom line is being boosted by tax cuts, revenue remains another issue. More importantly, investors should keep in mind the “tax cut” benefit is only good for this year as starting in 2019 we will be to comparing normalized year-over-year earnings growth.

More importantly, the market currently remains on both a short and intermediate term “sell” signal. While those signals could certainly be reversed in the days and weeks ahead, historically, it has often paid to adhere to what those signals are suggesting. (The purple bars are when the MACD line is negative confirming a “sell signal”)

(I penned an article recently on the 200-day moving average and the primary question was “when do you get back in?”  So, just to clarify, a “sell signal” suggests reducing risk to equities, when the signal reverses you increase risk to equities.  Notice – it is not an “all out” or “all in” thing.)

As noted above, we remain a heavier in cash than normal until the market breaks out of the current downtrend and begins to reverse those signals. If the market breaks below the 200-dma, we will raise more cash and institute further hedges as well.

While holding cash will certainly weigh on short-term performance if the market rallies, I will gladly exchange that for longer-term outperformance by protecting investment capital.

More importantly, the real “bear market” is still coming.

Interest Rates At A Critical Juncture

The bond market may be signaling a more important shift which should not be overlooked. Interest rates have been dismissed by the majority of investors under the premise that as rates rise, money will flow into equities.

While such may be the case early in the investment cycle, in a late-stage economic cycle where rates have risen sharply, the outcome for investors has not been kind. As shown in the chart below, historically speaking, such shifts from extreme oversold, as seen in 2016, to extreme overbought conditions in bonds has tended to be linked with more important market events.

Every. Single. Time.

Interest rates have also hit levels to where it is impacting consumption, and will begin to weigh on economic growth. However, rising interest rates alone are one thing, but when combined with sharply rising oil prices, which is a direct drag on consumer spending, it is quite another.

More importantly, the rise in oil prices has all but wiped out any benefit from the “tax cut” bill that consumers would expect to receive. This puts economic growth going forward further at risk as input costs rise to manufacturers which cannot be passed on directly to consumers. As higher input cost erodes profits, companies look to suppress wage growth. See the problem here?

Furthermore, since the rise in oil prices has been a primary driver of the “inflation” story, which has been bolstered by a sharp decline in the U.S. dollar, and rising interest rates, this “triple whammy” puts a rather bleak outlook on forward equity returns.

With both oil prices extremely overbought on a weekly basis, and the dollar exceedingly oversold, it is quite likely a strong reversal will occur. If such is the case, it will coincide with a much broader and deeper correction in the financial markets.

Sure, this time could be different.  It just historically hasn’t been.

Is a “bear market” emerging? There is absolutely a case that one could be and the outcomes of such are not palatable to long-term financial goals.

Yes, this could all pass by very quickly and the bull market could surge back to life.

But what is your plan if it doesn’t?

As I noted previously, missing out on a rally in the market is extremely easy to make up. Recouping lost capital is an entirely different matter.

Let’s see what happens next week.

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