Data suggests more upside

Coming off a weekend of political disappointment, it’s easy to get caught up in the emotions of it all. As I pointed out, the market was due for a pullback, and it got a reason to. We can “beat a dead horse” and dissect all of the “what-if” scenarios and implications of the failure. But none of this will be fruitful for your investment decisions. We know that pullbacks and corrections are an inevitable part of investing. And once in awhile we get a major decline, usually due to a recession. The key question is does the data suggest a business cycle peak?

The short answer is no.

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Consumer confidence numbers just came out at a high not seen since November 2000.

Small business optimism

Scott Grannis points out that Small Business Optimism has soared post election and is near all time highs.

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Earnings growth is finally back and is projected to be around 9-11% for 2017. This would be the largest annual increase in earnings since 2011. And this doesn’t even factor in the potential for tax reform and repatriation.

And interest rates are still very low. The earnings yield on the S&P 500 is currently 5.59%, while the 10 year treasury bond yield sits at 2.38%. Even the Fed’s overly optimistic projection suggests the real Federal Funds rate won’t even turn positive until another two years or so. So, even though valuations are on the high side and interest rates have risen quite a bit post elections, stocks still present an attractive risk premium.

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An interesting chart to follow going forward is the ten year yield. Post election the 10 year yield has risen on the assumption of pro-growth policies of the new administration. Since then a trading range between 2.3% and 2.62% has been formed. An upside breakout suggests all is clear, while a breakdown suggests that more of the President’s agenda may be in jeopardy.

Time will tell. But for now, things are looking pretty good to me. But I parse this by saying we’re probably closer to the end of the bull market, than we are to the beginning. The stock market and the economy don’t always correlate. We’ve had great performance in stocks over the last 8 years, while the economy largely under-performed. I wouldn’t be surprised if, going forward, we experience a situation where the economy starts to outperform, while stock performance slows down to an eventual crawl.

The great thing about diversification and asset allocation is that we don’t have to be prophetic. We stick to our strategy and re-balance when necessary. It’s that simple, but certainly not easy.

How low can the S+P go?…

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As I type this the S+P 500 is down about 11.50% from it’s highs. All four major market averages are below their 50 and 200 day moving averages. And the cumulative advance – decline line is also below its 50 and 200 day moving averages. A caution sign if there ever was one, as it has been about four years since we last saw this level of volatility. Let’s take a look at the technical scenarios to look for in the days and months ahead.

The chart above shows trading in the S+P 500 since the 2011 correction. That correction caused a drop in the S+P 500 of 295 points or 21%. After the smoke cleared, the S+P would increase 100% over the next four years.

On the way up there were six minor corrections that were all in the 120-150 point variety, with the exception of the fall 2014 correction that happened to be 199 points. That pattern has broken after the dismal August performance in equities. But there is reason to believe we may be nearing a bottom, at least in the short term.

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We talked about the potential of revisiting the August lows, and it appears that is what the market is attempting to do. However, there looks to be a confluence of support between 1820-1850. As there is a prior swing high at 1850, 1838 would match the size of the 2011 correction (295 points) and the fall 2014 swing low @ 1820.  I have no idea if the final low will come in this vicinity, but I am anticipating some buying reaction here. Given the macro environment, I believe this is the more probable outcome.


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However it’s always good to be prepared for multiple outcomes. So in the case that the market spends much time below 1820, I would have to conclude that a full 20% correction would then be the most likely scenario. This would equate to about 1700 on the S+P 500. We have a swing high in the 1680 area and the 2000 and 2008 bull market tops between 1550 – 1575 could be a likely target if this scenario were to play out.

I would say the majority of the concern is coming from lack of earnings growth. Earnings for the 3rd quarter are estimated to fall 4.5% amidst global growth concerns. If this were to occur, it would be the first time since 2009 that earnings declined in back to back quarters. Couple that with the concern of rising short term rates into a weak earnings cycle, and you have a recipe for volatility and contraction.

Since I also believe there is low risk of recession in the near term. I believe that this recent earnings losing streak will eventually dissipate. At the very least I think it’s unlikely that we see the high level of Earnings contraction that accompanies a recession. And if we are to believe that the Fed will take a very modest and gradual approach to raising rates, it is likely that equities will soon find solid footing once.

Without QE it’s possible we don’t see the level of equity market gains that we have seen in the past. But that doesn’t mean that investors won’t be rewarded either.

Want to learn how to trade and analyze the markets? Whether your a day/swing trader or investor wanting to learn how to analyze trends in the financial markets, there is something in The Trading Playbook for everyone. 

Tough market…

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Investors have had to learn patience this year. After two very good years of returns in 2013 and 2014, 2015 so far has been lackluster to say the least. The Dow Jones Industrial Average has turned negative for the year to date as we have seen mostly range bound trading in stocks.

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The S+P 500 has experienced numerous pullbacks of about 4% and the new highs are becoming shallower.

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To add insult to injury the bond market has experienced an increased level of volatility as the yield on 10 year US treasuries has gone from 1.675% in February to 2.4% today, or roughly 43% increase.

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The increase in yields puts downside pressure on the market price of bonds, so as we see the aggregate bond index has also turned negative year to date.

This combination has made it difficult to find returns in this environment. These are the times when our behavioral tendencies tend to get us into trouble. We begin to question our asset allocation, feel inclined to abandon our plan and look for the best performing investments and jump into those instead. However this is almost always a bad decision.

It’s important to always keep these events and price action into perspective of your goals. For example, if someone has the goal of funding their retirement and a time horizon of 10+ years, then you know that your new purchases will be at lower prices if the market does pullback and correct, which means higher dividend yields and higher future expected returns. Thinking in those terms may help you refocus on your goals.

The important thing is to determine an asset allocation plan that you feel comfortable with. An advisor can certainly help you with that along with helping you remain focused on your goals.

A look at Interest Rates and bond market year to date…

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After a fairly strong start to 2015 for bond market returns, interest rates have seemed to settle in lately. It’s possible that the bond market is beginning to price in a Fed Funds rate increase sometime in the near future. The chart above is a one year daily chart of the 10 year treasury interest rate index (TNX). The 10 year interest rate is close to turning positive for the year to date after being down at one point by 24%.

A measured move target comes into play at 24.50 with the year to date break even and March highs as potential deterrents. This is equated by taking the length of the rally off the February lows to March highs and adding that amount to the lows that were formed in April. It is important to note that this index is 10x the actual interest rate. So a target of 24.50 on TNX, would equate to a yield of 2.45%.

Why is this important to bond investors? I must preface that any short term movements have little if any importance to investors. However for educational purposes this “Bond see-saw” (as I’ve heard it explained as) means when interest rates rise, the market price of bond holdings decline (and vice-versa).

So let’s say for example you purchase a bond that pays 2% in interest annually. If after your purchase, rates drop to 1%, all of a sudden your bond that pays you 2% interest will look very attractive. The attractive rate will increase demand and in turn the market price of your bond will increase in market value.

Now let’s say that after purchasing your 2% bond, rates increase to 4%. In this case someone would look at your bond paying 2% and ask why they should purchase your bond when they can buy a new bond that pays them 4%. This decrease in demand will cause the market value to drop.

The consensus has suggested that rates will rise soon, the problem here is that they have been saying this for years. Interest rates will eventual move higher but no one knows the timing with any certainty.

However this market timing message I believe misses the whole point when it comes to bond investing. Bonds are there to help soften the blow when the eventually market panics settle in and to provide some fixed income that one can either use to purchase stocks on a dip or pay off expenses and liabilities. They really shouldn’t be seen as something that you jump in and jump out, or get scared out of for that matter. A bear market in bonds is quite different than a bear market in stocks.

The most important thing is to create your asset allocation that suites your time-frame, risk tolerance and temperament. It has little to do with where interest rates are currently at and where you believe they will go. A Financial Advisor can certainly help you create your personalized asset allocation plan if it feels overwhelming to you.

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This chart shows the total returns for a few of the bond sectors year to date. US treasury bonds (red line) opened the year off quite well but have since entered negative territory. Corporate bonds (blue) have done a little bit better with a gain of around 0.75% year to date. While high yield or junk bonds (green) sport the best performance so far around 4% year to date. This is relatively commonplace with a somewhat rising stock market.

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Stocks generally do pretty well at the beginning stages of a Fed Funds rate increase cycle. It’s usually, though not always, not until the short term rates get close or above the rates of longer term rates that we see an increased chance of slowdown and recessions.

In the chart above I have simply subtracted the interest rate on the 2 year US treasury bonds to the interest rate on 10 year treasury bonds. As you can see this running total fell this year to the lows of last year before starting to rebound. Rates are low but still far from inverting.

Bond Market Update

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On the Bond side of the equation, I’ll be watching the price action via TLT, an exchange traded fund that tracks the long duration US treasury Bonds. In the daily chart above, going back to the last swing high in the year 2012, I’ve highlighted each retrace rally we’ve seen. The previous two rallies, one in late 2012 and one in mid 2013, took the TLT index up a little more than $9 points each.

Now we fast forward to 2014 and this latest rally in TLT is now about equal to the prior two in length. Now we pointed out the trading range in the 10 year yield in the broad market update, it may all come down to what direction rates breakout. However I believe strength above last week’s high would signal the potential for a much bigger rally, back to $115 would be a logical target and possibly as high as $120.

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Earlier this month, Ryan Detrick had a fantastic post quantifying the historical results of the “death cross” on the ten year treasury yield. For those who don’t know, the “death cross” is a technical analysis term used to describe when the faster moving 50 day moving average moves below the slower moving 200 day moving average. The statistics seem to suggest that yields may struggle in the near term, this in turn would be a positive for bond prices and the TLT.

Please check out the entire post here.

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I’m also following the spread between high yield corporate bonds and US treasury bonds in the chart above. It’s a good simple gauge of the near term demand for risk. This chart highlights a potential slow down as it has trading below it’s trend line from 2012. This suggests more traders and investors are buying treasuries as opposed to higher yielding and more risky lower grade corporate bonds. Something to watch going forward.