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Trading  | October 9, 2018

Authored by Lance Roberts via,

In this past weekend’s newsletter, I discussed the fact the markets had finally awoken to the reality that rates have once again broken above 3%.

“Speaking of rates, each time rates have climbed towards 3%, the market has stumbled.”

However, I also noted that on a very short-term basis, the market was oversold enough to generate a bounce. Importantly, with market testing the January breakout highs this is a “make or break” point for the markets. There are two things currently that are worth paying attention to from a portfolio management standpoint.

  1. There is a defined trendline the market has held since the April lows. (Blacked dashed line) In July, the market broke that trendline but quickly recovered. A failure to get back above that trendline on this bounce, and a failure to attain new highs, will continue what appears to be an early topping pattern. 

  2. The momentum sell signal, which signaled a “risk off” market in early February, is very close to triggering. As shown this signal was very close to triggering in July but the market rallied strongly enough to keep that from occurring. Can it do the same this time?

If we add interest rates to the equation we can see where rising rates have contributed to a pickup in volatility in the equity market.

So far, the markets have been able to fend off the impact of higher rates and tariffs on the back of strong earnings results and the strength in the economic data.

However, those two things are coming to an end.

As I discussed in “Debts & Deficits”, much of the economic “boom” has been derived from a massive boost in fiscal spending due to a series of natural disasters last year.

“While the markets have been the beneficiary of the tax cut legislation, which gave a short-term boost to corporate profitability, the economy has enjoyed a boost from the massive increases to spending from what should have been more aptly termed the ‘Bipartisan Non-Budget Act of 2018.’ Spending on natural disasters and defense spending increases ‘pull forward’ future economic growth which is an illusion of an economic turn.

 Currently, the government is running one of the largest deficits, in both dollar terms, and as a percentage of GDP, in history.”

As the spending on natural disasters slows down by the end of the year, the surge in the deficit will begin to erode economic growth going into 2019. With the rise in rates, combined with higher oil prices, weighing on consumption growth, particularly as higher rates slow housing, auto sales, and increases debt payments, the impact to the economy will likely show up sooner than anticipated.

Secondly, higher rates and tariffs are already impacting the forward outlook for earnings estimates. Since the beginning of this year, forward expectations have already started falling as economic realities continue to impede overly optimistic projections. However, just since May, estimates for the end of 2018 have fallen by more than $10/share.

But it isn’t just this year where estimates are falling, but into 2019 as well. The chart below shows the changes in estimates a bit more clearly. It compares where estimates were on January 1st versus April, June and September 1st. Currently, optimism is exceedingly “optimistic” for the end of 2019.

As stated, the risk to current estimates remains higher rates, tighter monetary accommodation, and trade wars. More importantly, year over year comparisons are going to become markedly more troublesome even as expectations for the S&P 500 index continues to rise.

With the number of S&P 500 companies issuing negative EPS guidance is now the highest since 2016, it is only a function of time until we see forward estimates into 2019 begin to revised substantially lower.

Given a large bulk of the surge in earnings was due to the “one-time” repatriation of overseas profits of $300 billion which flowed directly into share buybacks. Going forward, earnings growth will be more muted.

“Balance of payments data show that U.S. firms repatriated just over $300 billion in 2018:Q1, roughly 30 percent of the estimated stock of offshore cash holdings. For reference, the 2004 tax holiday, which provided a temporary one-year reduction in the repatriation tax rate, resulted in $312 billion repatriated in 2005, of an estimated $750 billion held abroad.”

The chart below shows the dramatic decline in shares outstanding as compared to the rise in reported EPS. As of the end of Q3, total shares outstanding have continued to decline.

While the bull market thesis continues to be that earnings expansion will justify higher valuations, such may not be the case. The rise in rates, a strong dollar, and the impact of tariffs could derail much of the earnings “Cinderella”story in the months ahead.

Becoming More Cautious

As shown in the first chart above, the recent sell-off has likely exhausted much of the short-term downside risk. While the market opened lower this morning, it is where the market finishes the week which is most critical.

The chart below is a WEEKLY chart going back to the 2015-2016 lows.

While there is certainly a pick up in volatility as rates have spiked higher as of late, the longer-term bullish trend clearly remains intact.

At the moment, there is nothing signaling that a change to the market trend is imminent and the pickup in market volatility was previously addressed:

“While we are long-biased in our portfolios currently, such doesn’t remain there is no risk to portfolios currently. With ongoing ‘trade war’ rhetoric, political intrigue at the White House, and interest rates pushing back up to 3%, there is much which could spook the markets over the next 45-days.”

Well, that has certainly been the case. With the market trying to cling to support at the previous breakout levels, we are also sitting on support at the short-term moving average. That moving average also coincides with the January highs. The next chart zooms in for a closer look at the details.

The vertical red and green lines were very short-term buy/sell signals which show when price momentum is favorable for increasing or reducing equity-related risk. While that signal is currently on a “buy” it is deteriorating and suggests it may not be optimal to increase equity risk currently.

It will be imperative the market maintains support and musters a rally by the end of the week. Otherwise, there is a high probability the market will retest the bullish trend line from the 2016 lows. With the longer-term moving average currently running along that trend line, a break below that level changes the entire dynamic of the market to a “risk off” mode. 

With that said, and while many will just simply assume I am “bearish,” I want to remind you the trend of the market is still “bullish.” This is why our portfolios still remain primarily fully exposed to the market with respect to equity-related risk. 

However, being exposed to the market also means we are:

  1. Are managing our exposure levels,

  2. Maintaining trailing stop-loss levels; and

  3. Taking profits by reducing overweight allocations back to portfolio weights.

It also does not mean our allocations will not be aggressively adjusted downward at some point; it is just not needed as of yet.

As noted in the final chart below, the bullish trends of the previous two bear markets were violated relatively early in the reversion process. For those paying attention, there was plenty of opportunities to exit the markets while retaining a bulk of the previous gains. As noted, the current bullish trend has not been violated as of yet which keeps portfolios currently allocated toward risk.

As I have repeatedly discussed over the last several weeks, prudent portfolio management practices reduce inherent portfolio risk thereby increasing the odds of long-term success. Any rally that occurs over the next few days from the current levels should be used as a “sellable rally” to rebalance portfolios and related risk. These practices align with the most basic investment rules/philosophies that have been followed by every great investor/trader in history. To wit:

  • Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.

  • Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.

  • Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

There is no magic formula for long-term investment success. It has always been achieved by following simple processes and disciplines that have managed investment risk thereby reducing emotionally driven decisions during times of increased volatility.

As Warren Buffett once quipped:

“There are two rules to investment success

1) Never lose money;

2) Refer to rule #1.”

It really doesn’t get much simpler than that.

A revolutionary initiative is helping average Americans find quick and lasting stock market success.

275% in one week on XLF - an index fund for the financial sector. Even 583%, in 7 days on XHB… an ETF of homebuilding companies in the S&P 500. 

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