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Zero Hedge

'Squirrels' Everywhere - Distract, Distract, Distract

Authored by Lance Roberts via RealInvestmentAdvice.com,

Squirrels

I had suggested last week that a retest of support at 2800 would be a possibility as the market had gotten very overbought as it approached the January highs.

“With moving averages rising, this shifts Pathway #2a and #2b further out into the August and September time frames. The potential for a correction back to support before a second attempt at all-time highs would align with normal seasonal weakness heading into the Fall.

As shown in the updated “pathway chart” above, the market did indeed attempt to test all-time highs in the market. But, as I noted, the overbought condition provided the fuel for a correction given the right catalyst.

That catalyst appeared on Friday as the Lira plunged and Turkey edged closer to an economic crisis.”

The market continued to stumble early last week and quickly fell to retest the 2800 level as concerns over Turkey rattled markets globally. However, with the algo’s eyeing that 2800 support level, when news was floated on Thursday and Friday that China is discussing “coming to the table” to resolve the trade dispute, that was the news needed to spark a robot-driven “buying” spree.

It reminded of the movie “Up,” and how easily distracted markets have become.

The “bulls” are hard pressed to NOT give up on this market. Over the last several years, investors have been trained repeatedly to “buy dips” regardless of the “squirrels” that may scamper by. Such works…until it doesn’t.

Don’t get me wrong…we are right in there as well buying opportunity when we see it.

However, we are also well aware of the risk and manage it accordingly. Currently, there is a serious rotation occurring in the market currently which should not be dismissed. As David Rosenberg noted on Friday (courtesy of ZeroHedge):

“Is the stock market flashing an anti-growth signal?”

Simply put, recent market strength is being driven by the S&P 500 Index’s industry groups that are least affected by slower economic growth.

An index tracking four defensive areas – consumer staples, health care, telecom, and utilities – climbed 10.3% in the three months ended Thursday. A similar gauge of economically sensitive groups – consumer discretionary, energy, industrials and raw materials – gained just 0.5%.

With the incessant flattening of the US Treasury yield curve standing in direct opposition to the rise in US equity indices, 

, ‘I’m asked what the Treasury market sees that the stock market doesn’t.’

His answer explains it all (now that the chart above has exposed reality):

‘They both see the same thing – a return to stall-speed growth. Look at how the cyclical stocks are faring against the defensives, like Consumer Staples vs Discretionary. Not exactly the prettiest of pictures…'”

While the bulls have been quick to “price in” geopolitical and economic “squirrels,” the risk currently is a market which remains steeply overvalued, heading into a period of much tougher annual comparisons, and will likely see a contraction in economic growth rates. The data coming through already suggests the latter is likely. More importantly, the year-over-year rate of change in the leading economic index has also peaked suggesting the same.

(The chart below shows a projection at current growth rates out through 2020. Even if the LEI index grows from one month to the next, the rate of growth will slow due to annual comparison issues.)

With one of the broadest measures of economic activity already showing some weakness, a downturn in both the LEI and corporate profits should be expected.

All of this suggests that while the bias has been to the upside, there is evidence of a potential topping process at play.

The chart below is the S&P 500 index over the last several weeks. While this is a very short-term view, there is a potential “head and shoulder” formation in process. If completed, a subsequent retest of the 2800 level and a continuation of Pathway #2a, as shown above, is likely. A move higher next week that takes out recent highs would negate this process.

However, a retest could happen next week as the Turkey crisis continues to develop. With the late day downgrade of Turkey on Friday to junk status by all three rating agencies, the risk of a further contagion will continue to develop.

If we step back further there is the potential for a broadening topping process as well. Such would potentially culminate in a retest of previous support around 2700. A break below 2700 and we are going to be discussing reducing equity risk in portfolios.

Both of these layouts could resolve themselves in a million different ways, however, given we are moving into a seasonally weak period of the year, following a strong July advance, a correctionary period is a real possibility.

How the market resolves itself in the coming weeks will be paramount to portfolio positioning going into the end of the year. With portfolios still primarily weighted towards equity, and slightly overweight cash, a pullback which holds support levels will provide an opportunity to raise equity exposure for a tradeable rally through the end of the year.

As we head into 2019, the odds of a recessionary drawdown in the markets rises markedly. We remain long bonds in portfolios as a hedge against equity risk and will overweight bonds on any important break of support in the S&P 500.

As shown below, on a QUARTERLY basis, the market is currently at one of the most overbought, extended and deviated levels in history going back 75 years. Every previous period has led to a correction of some magnitude. The only difference between a correction, and a more serious crash, was the level of valuations at the time.

While this certainly doesn’t mean the market will mean revert tomorrow, it does imply that forward returns for current levels will be substantially lower than they have been over the last several years.

Here are the biggest threats to the markets over the next 6-12 months we are watching closely:

  • Technical deviations

  • Emerging market debt and economic stabilities

  • U.S. dollar strength

  • Oil prices (below $60)

  • Interest rates (Fed)

  • Economic strength

  • Earnings 

  • Leverage (Margin)

The issue isn’t any one of them in particular but the linkages between all of them that is important to watch. Here is how a linked scenario could well play out:

  • A continued rise in the dollar impacts exporters which reduces profitability and drags on earnings.

  • A rising dollar also weighs on oil prices which is highly correlated to the economic growth and inflationary pressures.

  • As the Fed continues to hike rates into a slowing economic growth rate, the downward pressure is exacerbated as higher rates reduces CapEx and consumption.

  • As the emerging market rout intensifies, debt related issues become much more prevalent and the Fed’s rate hikes eventually trigger a credit-related event.

  • The combination of these events weighs on asset prices which trigger an “algorithmic” sell-off and sparks a broad-based sell-off leading to margin calls. 

  • As the sell off intensifies, and margin liquidation causes a liquidity issue in the ETF complex, investors eventually “panic sell” the next low. 

While that scenario is purely hypothetical, and is only one of the multitude of possibilities which could play out, the point to be made is that it is never just “one thing” that causes a reversion. Rather, it is the “one thing” that triggers the cascade of dominoes to fall.

Unfortunately, we generally never know what the “one thing” is until after the fact. This is why having a plan to manage risk, a discipline to act and the process to follow is critically important to long-term investing success.

Or, you can just keep getting distracted by “Squirrels.”