I attended a holiday gathering for one of my advisor clients on Friday evening. While everyone appeared to be in the spirit of the season, when the conversation eventually turned to the market action, the mood quickly changed.
In talking with fellow financial professionals throughout the evening, the theme of the conversations was consistent. To a man, everyone agreed that (a) this was the worst market they'd seen in a VERY long time, (b) the action "felt" like an old-school bear (relentless selling, no lift, no obvious catalysts), and perhaps more importantly, (c) there is more going on here than meets the eye.
The latter is a lesson we learned from the 2007-09 financial crisis. Honestly, before then, very few investment managers (including yours truly) had ever heard of the now-famous alphabet soup of derivative securities or the "mark to market" rule that combined to nearly crush the global banking system.
Today, we all know that "forced selling" (fund blowups, margin calls, and a myriad of programmatic systems) can cause markets to collapse into a vacuum as buyers simply stand aside when the algos begin to roll and/or folks "need" to sell at any price.
But, on Friday evening, everyone agreed that this market definitely feels different. The point is that since 2011 - the time when many believe that high speed algo trading began to dominate the market landscape - all episodes of "forced selling" eventually ended and after a couple of days, a "face ripping" rallied tended to ensue. But this time, as the group said in unison, "there is NO LIFT at all." ALL intraday rallies are sold into - within minutes.
The group further opined that this market appears to be different than even the 2011 whipsaw party, where the market moved up and down and down and up in what Tony Romo might call large chunks. The difference was that those trends moved in a straight line and then reversed and went the other way - with reckless abandon in both directions. In my humble opinion, this was news-driven (U.S. debt downgrade, Europe crisis, etc.), high-speed trend-following at its finest. But again, the current action feels different.
Since December 3rd, the market has indeed moved in a straight line, becoming what is referred to as a "waterfall decline" in the process. But, there are no headlines to trigger the moves. No, something else appears to be at work here. And the real problem is no one is really sure what that "something" is.
So, this morning, I thought I'd run through some of the possibilities kicking around in my head. There are three.
Premise #1: It's the Earnings, Stupid
One narrative being bandied about is the slowdown in earnings growth could be worse than anticipated - especially given what is happening to oil again.
Mathematically, it is obvious that EPS growth for the S&P 500 had to fall given the 25%+ growth we saw in 2018. Everybody knows that a healthy chunk of that growth was attributable to the tax cuts and as such, won't recur. This isn't the problem. Remember, something everybody knows, isn't really worth knowing in this business (because it's already priced into the market).
I think the real problem is that EPS could fall significantly more than the market has been expecting. Think about it... Higher interest rates. Tariffs. Rising wages. Economic slowdown. Any of these - and especially a combination of these - could impact corporate profits (and not in a good way).
As Exhibit A in my thesis, below is a chart of Consensus Estimates for S&P GAAP EPS.
View Full Size Chart Online
Source: Ned Davis Research
Note the accelerated decline of the salmon-colored line in the upper right. This shows that the GAAP (generally accepted accounting principles) version of EPS estimates are falling - fast.
From my seat, the real problem is that these estimates may need to fall even more - and even faster.
The reasons? #Oil and #GrowthSlowing.
Oil's Dance To The Downside
Don't look now fans, but oil is cratering again. Not like it did in 2014/15, but the USO (United States Oil Fund ETF) has plunged -41% since October 3rd. Yowza - talk about moving in a straight line!
US Oil Fund ETF (USO) - Daily
View Larger Chart
The obvious question here is, what's up with oil? In the beginning of this move, there was a lot of talk about supply being the culprit for the precipitous decline. However, as the dive has progressed, traders have come to the conclusion that the real issue appears to be demand. As in slowing global growth means less demand for oil. Ugh.
So, if oil is flat-out plunging due to the perception of slowing global demand, how long will it be before demand for other stuff starts to slow? Exactly.
Premise #2: The Fed Overshoot Is On "Autopilot"
Another issue that I need to credit analyst extraordinaire Larry McDonald for is the idea that despite all the yammering from Fed officials, the markets are "really" staring at the equivalent of at least 7 rate hikes in 2019. Wait, what?
Here's the deal. The Fed is in the process of "unwinding" their balance sheet. I.E. Selling off all the stuff they bought during nearly a decade of QE. In English, the Fed is selling $50 billion a month of the bonds and other securities it has on its "balance sheet." My quick math mind says that's $600 billion a year. Every year.
The goal is to return the Fed's balance sheet back toward "normal." I get it. Makes sense.
The problem is this has NEVER been done before. Oh, and this process amounts to a little something called "QT" (quantitative tightening). As the moniker suggests, the selling of bonds effectively represents a "tightening" of monetary conditions. Whether it was intended to or not.
To put this into perspective, let's remember that $600 billion represents approximately 75% of the total amount of bonds on the Fed's balance sheet pre-crisis. And they are going to be selling this amount each and every year. Hmmm...
Here Comes The Big Point
McDonald estimates that the selling of approximately $85 billion in bonds is the equivalent of a 0.25% hike in the Fed Funds Rate. So, if my calculator is correct, the Fed's "runoff" plan (the selling of $50 billion in bonds each month) will become the equivalent of 6.9 rate hikes in 2019. Yikes.
Perhaps the biggest issue here is Jay Powell has told us that the "runoff" is on "autopilot." The impression is that the quantitative tightening, which represents significantly more tightening that the Fed has implemented over the past two years, is not up for discussion.
This, dear readers, is a problem. A big problem. Because one of the baseline fears of this bear market is the Fed would overshoot - like they always have in the past - and wind up pushing the economy into recession. And while folks like me argued that the Fed wouldn't be dumb enough to go "too far," this "autopilot" QT thing could easily become the "unintended consequence" of the great post-crisis QE experiment.
Now let's add in the 2 actual hikes that Powell & Co. are talking about. It quickly becomes clear that the fear of a "Fed Overshoot" is well, real. And I'll bet dollars to donuts that this a point very few investors or financial pros are aware of. But apparently the algos are.
But Wait, There's More...
Now couple the Fed's balance sheet reduction plan with the massive increase in low quality debt issued in recent years, the $1 trillion in government bonds the U.S. needs to sell in 2019, the instability of banks Europe (have you seen a chart of DB lately?) and the fact that QE is ending everywhere (except Japan, of course). And while I consider myself a card-carrying member of the-market's-glass-is-half-full club, even I must admit to the possibility that another credit crisis could be lurking.
So... Cue the 500-point temper tantrums in the stock market and the dive in bond yields over the Fed's current course.
The good news is that in a CNBC interview Friday morning, New York Fed President, John Williams suggested that the Fed's current plan to sell $50 billion in bonds each month is not set in stone and that the Fed can be flexible if need be. The headline sparked a rally and the Dow surged more than 300 points in the next 9 minutes. This was certainly encouraging. Well, for about 10 minutes anyway, as the selling then resumed in earnest and continued throughout the day and into the close.
Since the Dow finished down 414 on the day (representing a reversal of more than 800 points), one can argue that markets want more than "hints" or "jawboning" on this subject. Especially since the "autopilot" verbiage had been used by the Fed Chair just two days prior.
Premise #3: What If...
And finally, there is the underappreciated worry behind door number 3. This one comes from the Wall Street Journal's Greg Ip. During a CNBC segment Friday afternoon, Ip pondered aloud the following: What if 2018's 3% growth in the U.S. economy was a "head fake?"
Ip pointed out that up until 2018, the U.S. economy had been muddling along at what First Trust's Brian Wesbury dubbed a "plow horse" pace. And if one mixes in the slowdown in global growth (remember, Germany, Japan, and Switzerland already have one quarter of negative GDP growth under their belt), the trade war, the potential for political risk in D.C., etc., it isn't much of a stretch to think that the U.S. economic growth, like earnings, could slow more than the markets have been anticipating. Super.
But Near-Term, A Bounce is Due
From my seat, these three underappreciated fears help "esplain" the waterfall decline in the stock market and are reasons that the bears could stick around for a while (I'm thinking 3-6 months).
But let's keep in mind that the current dance to the downside has clearly gotten out of hand. For example, the S&P 500 fell -7% last week alone, qualifying as the worst week since 2008. This is now the worst December since 1931. The NASDAQ is now -21.9% off its high and into what the press calls a bear market.
The key is the December destruction has created a seriously oversold condition on all major time-frames, put negative sentiment at extreme levels, and created what could be construed as a "washout" on Friday with the VIX climbing over the all-important 30-level.
On this front, an argument that extreme sentiment levels have set in comes from SentimenTrader. The tweet below suggests that smaller investors were panicking last week and that stocks tend to rally nicely going forward...
This past week, the smallest of options traders bought to open 2.9 mln put options. That's 27% of their options volume. Since January 2000, only five other weeks saw them panic this much. pic.twitter.com/mrN1AA3eus— SentimenTrader (@sentimentrader) December 22, 2018
As the table points out, the market has rallied +4.84% on average over the next week and +7.46% over the next two weeks after cases of smaller investors panicking to buy put options.
There is similar research from Bespoke Investment Group. The chart below shows what happens to the S&P 500 after quarters in which the index has fallen 10% or more.
View Chart Online
Source: Bespoke Investment Group
And to finish off the topic, here are some stats to consider from Ned Davis Research. Since 2000, when S&P is down -13% or more over 63 trading days (there have been 5 prior occurrences), the market has moved higher 4 out of 5 times over the next 5 and 10 days. The average gain for the S&P has been +3.48% over next 5 days and +1.6% over the next 10 days. Over ensuing 21 and 63 days, the index has moved up 3 out of 5 times with an average gain of +1.4% over the next 21 days and +2.5% over the next 63 days.
As such, it is easy to say the bulls are due. Really due.
Here's wishing everyone a very Merry Christmas!
Now let's turn to the weekly review of my favorite indicators and market models...
The State of the Big-Picture Market Models
I like to start each week with a review of the state of my favorite big-picture market models, which are designed to help me determine which team is in control of the primary trend.
The Bottom Line:
- There were more important changes to the Primary Cycle board this week. First, the Leading Indicators model flashed a sell signal early in the week. Next, the reading of our long-term "State of the Market" model (which is designed to call major bulls/bears), fell out of the positive zone. In addition, the historical average annualized return of the market fell further, currently standing at -9%.
The bottom line message from this board is clear: It's a bear market that is likely to persist for several months.
This week's mean percentage score of my 6 favorite models declined to 41.9 (from 47.8, 2 weeks ago: 53.6%, 3 weeks ago: 57.9%, 4 weeks ago: 64.5%) while the median fell to 44.2% (from 45%, 2 weeks ago: 55%, 3 weeks ago: 52.5%, 4 weeks ago: 65%).
The State of the Trend
Once I've reviewed the big picture, I then turn to the "state of the trend." These indicators are designed to give us a feel for the overall health of the current short- and intermediate-term trend models.
The Bottom Line:
- One glance at the Trend board really says it all. Although the seasonal cycles point higher next week, the rest of the board sports a bright shade of red. Last week, we opined that if the S&P 500 should break and hold below the February lows for more than a couple days, the odds that the current corrective phase will morph into a cyclical bear would increase dramatically. I believe we can make a check mark here and declare this an overwhelmingly negative environment.
The State of Internal Momentum
Next up are the momentum indicators, which are designed to tell us whether there is any "oomph" behind the current trend.
The Bottom Line:
- To be clear, the unanimous negative readings seen in the Momentum board are first, rare, and second, confirmation of the fact that conditions are extremely weak. As I wrote last week, the good news is that this type of condition tends to lead to countertrend rallies. Historically, the odds of a strong rally in the near-term are now very strong. But the bad news is the severity of the damage done means it will take time for the market to recover. Thus, we should expect several months of basing action (i.e. violent rallies and retests) before the tide will turn.
The State of the "Trade"
We also focus each week on the "early warning" board, which is designed to indicate when traders might start to "go the other way" -- for a trade.
The Bottom Line:
- Last week I opined that from a shorter-term perspective, the "Early Warning" board is now sending a clear signal that a countertrend rally could begin at any time. And yet with the market experiencing a waterfall decline, the board sports less green this week. While it may sound counterintuitive, it is important to keep in mind that the key to mean reversion indicators is for them to first reach an extreme reading and then - and this is the important part - reverse. Last week's decline pushed several indicators farther into the extreme reading zones and out of the "reversals" that had been apparent the week before.
The bottom line here is the table remains set for a strong countertrend rally.
The State of the Macro Picture
Now let's move on to the market's "environmental factors" - the indicators designed to tell us the state of the big-picture market drivers including monetary conditions, the economy, inflation, and valuations.
The Bottom Line:
- There are no obvious changes to the External Factors board this week. However, under the surface, there is some movement. First, we see improvement brewing in the monetary models as rates pull back from their highs and the Inflation Composite continued to move lower last week, suggesting that inflation is NOT a concern. However, it is worth noting that the earnings component, while still in the green zone, is starting to move lower as earnings estimates for both 2018 and 2019 are moving lower at a fairly steep rate. This is likely one of the market's primary concerns from a macro perspective.
Thought For The Day:
The less you know, the more you believe. -Bono
Wishing you green screens and all the best for a great day,
Each year, NAAIM (National Association of Active Investment Managers) hosts a competition to identify the best actively managed investment strategies. In April, HCR's Dave Moenning took home first place for his flagship risk management strategy.
At the time of publication, Mr. Moenning held long positions in the following securities mentioned: none - Note that positions may change at any time.
Short-Term Trend-and-Breadth Signal Explained: History shows the most reliable market moves tend to occur when the breadth indices are in gear with the major market averages. When the breadth measures diverge, investors should take note that a trend reversal may be at hand. This indicator incorporates NDR's All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 5-day smoothing and the All-Cap Equal Weighted Equity Series is above its 25-day smoothing, the equity index has gained at a rate of +32.5% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +13.3% per year. And when both are below, the equity index has lost +23.6% per year.
Channel Breakout System Explained: The short-term and intermediate-term Channel Breakout Systems are modified versions of the Donchian Channel indicator. According to Wikipedia, "The Donchian channel is an indicator used in market trading developed by Richard Donchian. It is formed by taking the highest high and the lowest low of the last n periods. The area between the high and the low is the channel for the period chosen."
Intermediate-Term Trend-and-Breadth Signal Explained: This indicator incorporates NDR's All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 45-day smoothing and the All-Cap Equal Weighted Equity Series is above its 45-day smoothing, the equity index has gained at a rate of +17.6% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +6.5% per year. And when both are below, the equity index has lost -1.3% per year.
Cycle Composite Projections: The cycle composite combines the 1-year Seasonal, 4-year Presidential, and 10-year Decennial cycles. The indicator reading shown uses the cycle projection for the upcoming week.
Trading Mode Indicator: This indicator attempts to identify whether the current trading environment is "trending" or "mean reverting." The indicator takes the composite reading of the Efficiency Ratio, the Average Correlation Coefficient, and Trend Strength models.
Volume Relationship Models: These models review the relationship between "supply" and "demand" volume over the short- and intermediate-term time frames.
Price Thrust Model Explained: This indicator measures the 3-day rate of change of the Value Line Composite relative to the standard deviation of the 30-day average. When the Value Line's 3-day rate of change have moved above 0.5 standard deviation of the 30-day average ROC, a "thrust" occurs and since 2000, the Value Line Composite has gained ground at a rate of +20.6% per year. When the indicator is below 0.5 standard deviation of the 30-day, the Value Line has lost ground at a rate of -10.0% per year. And when neutral, the Value Line has gained at a rate of +5.9% per year.
Volume Thrust Model Explained: This indicator uses NASDAQ volume data to indicate bullish and bearish conditions for the NASDAQ Composite Index. The indicator plots the ratio of the 10-day total of NASDAQ daily advancing volume (i.e., the total volume traded in stocks which rose in price each day) to the 10-day total of daily declining volume (volume traded in stocks which fell each day). This ratio indicates when advancing stocks are attracting the majority of the volume (readings above 1.0) and when declining stocks are seeing the heaviest trading (readings below 1.0). This indicator thus supports the case that a rising market supported by heavier volume in the advancing issues tends to be the most bullish condition, while a declining market with downside volume dominating confirms bearish conditions. When in a positive mode, the NASDAQ Composite has gained at a rate of +38.3% per year, When neutral, the NASDAQ has gained at a rate of +13.3% per year. And when negative, the NASDAQ has lost at a rate of -12.22% per year.
Breadth Thrust Model Explained: This indicator uses the number of NASDAQ-listed stocks advancing and declining to indicate bullish or bearish breadth conditions for the NASDAQ Composite. The indicator plots the ratio of the 10-day total of the number of stocks rising on the NASDAQ each day to the 10-day total of the number of stocks declining each day. Using 10-day totals smooths the random daily fluctuations and gives indications on an intermediate-term basis. As expected, the NASDAQ Composite performs much better when the 10-day A/D ratio is high (strong breadth) and worse when the indicator is in its lower mode (weak breadth). The most bullish conditions for the NASDAQ when the 10-day A/D indicator is not only high, but has recently posted an extreme high reading and thus indicated a thrust of upside momentum. Bearish conditions are confirmed when the indicator is low and has recently signaled a downside breadth thrust. In positive mode, the NASDAQ has gained at a rate of +22.1% per year since 1981. In a neutral mode, the NASDAQ has gained at a rate of +14.5% per year. And when in a negative mode, the NASDAQ has lost at a rate of -6.4% per year.
Short-Term Overbought/sold Indicator: This indicator is the current reading of the 14,1,3 stochastic oscillator. When the oscillator is above 80 and the %K is above the %D, the indicator gives an overbought reading. Conversely, when the oscillator is below 20 and %K is below its %D, the indicator is oversold.
Intermediate-Term Overbought/sold Indicator: This indicator is a 40-day RSI reading. When above 57.5, the indicator is considered overbought and when below 45 it is oversold.
Mean Reversion Model: This is a diffusion model consisting of five indicators that can produce buy and sell signals based on overbought/sold conditions.
VIX Indicator: This indicator looks at the current reading of the VIX relative to standard deviation bands. When the indicator reaches an extreme reading in either direction, it is an indication that a market trend could reverse in the near-term.
Short-Term Sentiment Indicator: This is a model-of-models composed of 18 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a short-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.
Intermediate-Term Sentiment Indicator: This is a model-of-models composed of 7 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from an intermediate-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.
Long-Term Sentiment Indicator: This is a model-of-models composed of 6 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a long-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.
Absolute Monetary Model Explained: The popular cliché, "Don't fight the Fed" is really a testament to the profound impact that interest rates and Fed policy have on the market. It is a proven fact that monetary conditions are one of the most powerful influences on the direction of stock prices. The Absolute Monetary Model looks at the current level of interest rates relative to historical levels and Fed policy.
Relative Monetary Model Explained: The "relative" monetary model looks at monetary indicators relative to recent levels as well as rates of change and Fed Policy.
Economic Model Explained: During the middle of bull and bear markets, understanding the overall health of the economy and how it impacts the stock market is one of the few truly logical aspects of the stock market. When our Economic model sports a "positive" reading, history (beginning in 1965) shows that stocks enjoy returns in excess of 21% per year. Yet, when the model's reading falls into the "negative" zone, the S&P has lost nearly -25% per year. However, it is vital to understand that there are times when good economic news is actually bad for stocks and vice versa. Thus, the Economic model can help investors stay in tune with where we are in the overall economic cycle.
Inflation Model Explained: They say that "the tape tells all." However, one of the best "big picture" indicators of what the market is expected to do next is inflation. Simply put, since 1962, when the model indicates that inflationary pressures are strong, stocks have lost ground. Yet, when inflationary pressures are low, the S&P 500 has gained ground at a rate in excess of 13%. The bottom line is inflation is one of the primary drivers of stock market returns.
Valuation Model Explained: If you want to get analysts really riled up, you need only to begin a discussion of market valuation. While the question of whether stocks are overvalued or undervalued appears to be a simple one, the subject is extremely complex. To simplify the subject dramatically, investors must first determine if they should focus on relative valuation (which include the current level of interest rates) or absolute valuation measures (the more traditional readings of Price/Earnings, Price/Dividend, and Price/Book Value). We believe that it is important to recognize that environments change. And as such, the market's focus and corresponding view of valuations are likely to change as well. Thus, we depend on our Valuation Models to help us keep our eye on the ball.
The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.
Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.
Mr. Moenning may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time.
The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.
Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.