Things That Keep Me Up At Night
Speaking at a broker-dealer conference last week, I asked the audience if there were reasons to worry about the state of the U.S. stock market. As you might expect, the answer was almost unequivocally yes and the list of potential potholes for this market wound up being quite lengthy.
However, one of the things that keeps me up at night, so to speak, has nothing to do with the stock market. No, it is the bond market in general and the European bond market in particular that causes me angst.
You see, volatility in the bond market is on the rise - in a big way. For example, while most investors probably aren't even aware the event occurred, there was a "flash crash" in the bond market back on October 15, 2014. As was the case with most of these "flash" events, the market recovered quickly and in effect, all's well that ended well, right?
However, there two nagging questions here. First, since there has been no real explanation of the event, why did yields in the U.S. bond market suddenly dive and then recover on that day? And second, how is such an event even possible in what can be considered one of the most liquid markets on the planet?
Liquidity (or Lack Thereof) Is The Issue
Early last month, a NYT DealBook article talked about the growing concerns by both bankers and regulators relating to the increase in bond market volatility. In essence, the article suggested that a "surprise" in the bond market such as an unexpected rate hike or an external event would likely cause liquidity to dry up dramatically. And in case you've forgotten, it was the abject lack of buyers during the 2008 credit crisis that created much of the damage.
Part of the problem here has to do with the growing popularity of ETFs as the weapon of choice for many investors/traders. In fact, ETF assets now represent nearly 10% of the total bond fund assets out there. And the simple truth is that these vehicles do not have enough cash sitting around to meet redemptions if a serious downturn develops.
It is also worth noting that trading volumes in the corporate bond market have shrunk significantly in the last 5-10 years. According to Ned Davis Research, the average daily trading volume of corporate bonds was $238 billion at the end of 2007. But today that number is just $108 billion. This means that trading volume is down 55% from pre-crisis levels.
In addition, dealer positions in the corporate bond market have been slashed. Prior to the crisis, primary bond dealers held what was then a record $286 billion in bond positions. However, those positions are now down more than 90% and stand at just $23 billion. Yikes.
The Problem Is...
In other words, the liquidity in the bond market just isn't what it used to be - not by a long shot. So, the question becomes, what happens to bond prices when/if fund managers are forced to reduce their positions? What happens to the daily liquidity with computers controlling the flow? And what will happen to all those bond fund investors if something bad actually happens in the bond market?
The short answer is, nothing good.
Long Live QE
Why aren't people worried about this, you ask? At least part of the reason is that the global central banks of the world continue to pump liquidity into the markets. Remember, the Bank of Japan and the European Central Bank are running their printing presses 24/7 these days. And as long as that flow of fresh cash continues then liquidity isn't likely to be much of a problem.
However, at some point, the world's central bankers will run out of reasons to print money. And it is also conceivable that at some point the major economies of the world won't need the "life support" the central bankers have been providing. What happens to bond prices then?
Now let's take this one step farther. Remember, after two brutal bear markets in stocks between 2000 and 2008, the investing public moved a big slug of their assets from the insanity of the stock market into the relative safety of bond funds. But again, what happens to the value of those bond funds when rates rise? What will investors do when they see their so-called "safe" holdings start to dive - perhaps in a flash?
Yep, that's right, those investors are going to sell some of those bond funds. And in turn, the bond fund managers are going to have to sell holdings. But the question could easily become: Sell? Sell to whom?
Yep, this is definitely one of the things that keeps me up at night and one of the primary reasons that I believe in an active, risk-managed approach to the markets.
Publishing Note: I am traveling the remainder of the week and will publish morning reports as time permit.
This Morning's Pre-Game Indicators
Here are the Pre-Market indicators we review each morning before the opening bell...
Major Foreign Markets:
Hong Kong: -0.47%
Crude Oil Futures: +$0.78 to $60.98
Gold: +$2.70 at $1191.40
Dollar: higher against the yen and pound, lower vs. euro
10-Year Bond Yield: Currently trading at 2.223%
Stock Indices in U.S. (relative to fair value):
S&P 500: -6.93
Dow Jones Industrial Average: -43
NASDAQ Composite: -14.44
Thought For The Day:
"Excellence is not a singular act, but a habit. You are what you repeatedly do." -Shaquille Oneal
Current Market Drivers
We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).
1. The State of the U.S. Economy
2. The State of Fed/ECB/PBoC Policy
3. The State of Interest Rates
4. The State of the U.S. Dollar
The State of the Trend
We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:
Short-Term Trend: Neutral
(Chart below is S&P 500 daily over past 1 month)
Intermediate-Term Trend: Moderately Positive
(Chart below is S&P 500 daily over past 6 months)
Long-Term Trend: Positive
(Chart below is S&P 500 daily over past 2 years)
Key Technical Areas:
Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:
- Key Near-Term Support Zone(s) for S&P 500: 2100
- Key Near-Term Resistance Zone(s): 2135
The State of the Tape
Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...
- Trend and Breadth Confirmation Indicator (Short-Term): Negative
- Price Thrust Indicator: Negative
- Volume Thrust Indicator: Neutral
- Breadth Thrust Indicator: Neutral
- Intermediate-Term Bull/Bear Volume Relationship: Moderately Positive
- Technical Health of 100+ Industry Groups: Moderately Positive
The Early Warning Indicators
Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.
- S&P 500 Overbought/Oversold Conditions:
- Short-Term: Neutral
- Intermediate-Term: Neutral
- Market Sentiment: Our primary sentiment model is Neutral .
The State of the Market Environment
One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.
- Weekly Market Environment Model Reading: Neutral
Wishing you green screens and all the best for a great day,
David D. Moenning
Founder and Chief Investment Strategist
Heritage Capital Research
Trend and Breadth Confirmation Indicator (Short-Term) 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 an 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.
Price Thrust Indicator 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 Indicator 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 -8.5% per year.
Breadth Thrust Indicator 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.
Bull/Bear Volume Relationship Explained: This indicator plots both "supply" and "demand" volume lines. When the Demand Volume line is above the Supply Volume line, the indicator is bullish. From 1981, the stock market has gained at an average annual rate of +11.7% per year when in a bullish mode. When the Demand Volume line is below the Supply Volume line, the indicator is bearish. When the indicator has been bearish, the market has lost ground at a rate of -6.1% per year.
Technical Health of 100 Industry Groups Explained: Designed to provide a reading on the technical health of the overall market, this indicator takes the technical temperature of more than 100 industry sectors each week. Looking back to early 1980, when the model is rated as "positive," the S&P has averaged returns in excess of 23% per year. When the model carries a "neutral" reading, the S&P has returned over 11% per year. But when the model is rated "negative," stocks fall by more than -13% a year on average.
Weekly State of the Market Model Reading Explained:Different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Market Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.
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 nor any Portfolio 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.
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.
David D. Moenning, an advisor representative of CONCERT Wealth Management Inc. (CONCERT), is founder of Heritage Capital Advisors LLC, a legal business entity doing business as Heritage Capital Research (Heritage). Advisory services are offered through CONCERT Wealth Management, Inc., a registered investment advisor. For a complete description of investment risks, fees and services review the CONCERT firm brochure (ADV Part 2) which is available from your Investment Representative or by contacting Heritage or CONCERT.
Mr. Moenning is also the owner of Heritage Capital Management (HCM) a state-registered investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Neither HCM, Heritage, or CONCERT is registered as a broker-dealer.
Employees and affiliates of Heritage and HCM may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or Heritage/HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.
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.