Why Should You Care About The Energy Sector?

The collapse in energy prices has been one of the more sensationalistic headlines in the financial media during the last few months. The continued month over month declines in crude oil, natural gas, energy stocks, and other associated industries has been quite remarkable. The entire sector has defied calls for a bottom and continues to trade with extreme oversold readings.

A simple look at the United States Oil Fund (USO) shows just how deep this correction has been since hitting a high last June. This ETF tracks the daily spot price of West Texas Intermediate Light Sweet Crude Oil futures contracts and has declined nearly 60% from its 2014 peak.

Source: Stockchart

So what macro factors are behind such a large price slippage?

First and foremost, global growth is slowing. Central banks over the world are experimenting different types of unconventional monetary stimulus programs to fight this trend but as of today with no success. A new worrisome chart is circulating this week on social media: The Baltic Dry Index, a composite of various global shipping rates tied to the movement of raw materials hits a 30 years low. The price of the BDI is an indicator of the level of global demand for shipping raw materials, specifically. It is also considered by many to be an indicator of the level of global economic growth, in general.

Source: Zerohedge

Second, it is important to understand Saudi Arabia's decision not to cut oil production, despite crashing prices. It marks the beginning of an incredibly important change, with near-term and obvious implications for oil markets and global economies. 

For decades, Saudi Arabia, backed by the Persian Gulf emirates, was described as the “swing producer.” With its immense production capacity, it could raise or lower its output to help the global market adjust to shortages or surpluses. But on Nov. 27, at the OPEC meeting in Vienna, Saudi Arabia effectively resigned from that role and handed over all responsibility for oil prices to the market, which the Saudi oil minister, Ali Al-Naimi, predicted would “stabilize itself eventually.” 

OPEC’s decision was hardly unanimous. Venezuela and Iran, their economies in deep trouble, lobbied hard for production cutbacks, to no avail. Afterward, Iran accused Saudi Arabia of waging an “oil war” and being part of a “plot” against it.

But Ali Al-Naimi reiterated Saudi stance just a few days before Christmas, with this shocking statement:

“It is not in the interest of OPEC producers to cut their production, whatever the price is… Whether it goes down to $20, $40, $50, $60, it is irrelevant.”

Economics of this thing are simple. Saudi Arabia has the lowest production costs in the world (see chart below). Saudi Arabia also has roughly $900 billion in reserves, give or take, which means they have the savings to absorb government budget deficits for years and years.

Source: FT

So it is not hard to understand that Saudi Arabia want to shake the weak production out of the market. This strategy would undermine the economic viability of a meaningful amount of global production. Following the correction there will be a return to business as usual along with higher prices, but with Saudi Arabia commanding a relatively larger share of that market. 

So, do not expect the start of a meaningful reversal any time soon, even more considering the trap some of the producers in the world find themselves in at this time...

Take for example american shale oil, probably Saudi's most wanted competitor, that has become the decisive new factor in the world oil market in a way that could not have been imagined five years ago. It has proved to be a truly disruptive technology. But will that impact continue in a world of low prices?  

Oil is now below $50 a barrel, a price too low for a good deal of the new shale oil development to make economic sense. Yet output is likely to continue to rise by another 500,000 barrels per day in the first half of 2015 because of sheer momentum and commitments already made.

The pent up appetite for yield due to persistently low interest rates, have seen capital, including tremendous amounts of high-yield debt, flood into oil companies. As john Dizard writes for the FT:

“Much of the lending that supported the US unconventional resource (aka “shale”) boom long after the operational cash flow became inadequate was done by people who believed they were taking little risk. Institutional investors were not, for the most part, buying unlisted equity from inexperienced operators. Tens or even hundreds of billions of dollars of capital came from non-bank participations in leveraged loans to exploration and production companies”

The oil business thus has the WORST combination of economics now possible: A structural drop-off in demand (due to widespread global slowdown)… a vicious commodity price war (with well-funded players behind it)… and economics as such that even the dying losers will take quite a long while to fully die off (and may even keep pumping to pay debt).

Now you should start to understand the reason why I shorted the Energy Sector ETF (XLE) after what looked like a typical first wave in bear market. As already advised on this blog, I sold in early December just after the large breakout gap seen on the chart. My target remains 70$.

Source: Stockchart

But I would like to make the point that developments in this part of the market could have large ramification and should note be consider in isolation. For investors that are saying «That is confined to energy, it is a pocket of the economy, everything else is OK and insulated.», remember that this argument usually does not work. When the housing market started to get weak in the subprime category, even Ben Bernanke said: «That does not matter, it is just subprime.» But things are linked together.

This is why we should all care about the energy sector and follow price developments of Oil, XLE ETF, Emerging market, commodity currencies (in particular CAD) and the high-yield bond market for any risk of contagion.

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Dollar Index Breaking Through Long Term Support

We are experiencing a very important market event this month, as the US dollar is breaking through a significant long term support. Such a move, if sustained, is very important for market participants because the USD is one of the most important asset class in macroeconomics. I can give many reasons of the utmost importance dollar has in the global economy, like it being the world reserve currency, but it is not the subject of this article. In the next few lines, I would like to review some strategic implications implied by this important market event, and give a trade recommendation in conclusion.     

First, let’s take a look at a 5 years chart of the US Dollar Index:

During the past 2 years and a half the strong support I am talking about (in green) supported price no less than 6 times. In technical analysis, the longer a support hold and the more times price rebound from it, the more significant it is. A break of that important support should not be taken lightly by market participants in the face of its potential market forces.  

A weak dollar has many inter-market resonances of which the most important one is for me its impact on commodity prices. Due to many of them being priced in dollar terms, a strong inverse relationship exist between the two assets.

As can be seen on the chart above, the CRB commodity index broke out of its recent 3 years downtrend last February. A dollar breakout will therefore be further evidence confirming this nascent uptrend.  

In addition, it is also important to understand that a falling USD is bullish for the relative performance of foreign stocks (see relative performance of the iShares MSCI EAFA ETF vs USD in the chart below). The prevalent under-performance to US stocks before this year stopped, but have yet to decisively turn the other way. I expect this important USD breakout to be the catalyst for a foreign stocks out-performance.

Combining all the above, countries that produce commodities stand to benefit even more from a weaker US Dollar. Not surprisingly, we have seen developed countries commodity producers like Canada and Australia see their stock markets hitting new multi-year highs lately. But from a contrarian point of view, I am very interested in Brazil, another big commodity producer, that have been beaten down lately by the negative sentiment surrounding Emerging Markets in general.

Technically speaking, the iShares Brazil ETF (EWZ) is strong, breaking out of a triangle consolidation pattern to the upside. Since the start of last month, it is performing better than the S&P500 on a relative basis which is confirming the thesis presented above. 

I believe it is a smart idea to begin or to increase exposure on this market as long as the USD is confirming its downtrend.

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Time To Hedge Long-Term Core Equity Exposure

Major US equity indexes all entered in all-time high territory last year. That in itself was a very bullish indication, as it showed the past of least resistance still remains to the upside. Last month, everyone on twitter, financial newspapers, market news websites was celebrating the fifth year anniversary of the current bull market, and let’s face it, market sentiment seems very bullish today… maybe too complacent?

To answer this question, let’s review some of the technical, internal and sentimental perspectives of the current bull market...

I first want to tackle the "too complacent" argument that a lot of market commentators - mainly from the contrarian or perma-bear category (think ZeroHedge) - bring to the table since early 2013 to predict the theoretical impending stock market crash. Even if the argument can seem logical, orderflow traders understand that a very bullish sentiment is not enough to predict a market down turn, even less a market crash. “The Market can stay irrational longer than you can stay solvent” as John Maynard Keynes is known to comment. I agree that sentiment extremes are important warning signal for traders. What many contrarians fail to understand is without any catalyst or reason for the sentiment state to be shaken, the turn will never happen by and of itself.

That’s the reason why many missed the 2013 rally, afraid by the extreme bullish sentiment signals provided by indicators like NAAIM & AAII surveys*. Take a look at the three failed sell signals in the chart below (blue circles). Those contrarians were blind to the major sentiment driver that was QE3, which along precedent FED monetary stimulus launch (QE1, QE2, OT), was a strong bullish signal for risky assets. As the old Wall Street adage goes: “Never fight the FED”.

Then, let’s now review the other sell signals, the two most successful ones. It is important to note that they both coincided with “changes in the rules of the game” (George Soros quote) via the end of QE1 in 2010 and QE2 in 2011. Those signals predicted the two major corrections (-17% and -19% respectively) of the current bull market. You will notice the similarity with current conditions where we will see the end of QE3 in the next few months (around September 2014 per consensus projections). Will history repeat or this time is different?

If you remember from my previous article on market cycles, seasonality is very challenging for stocks in 2014, and some other technical indicators are pointing out to weaknesses. For example, see the below S&P500 monthly chart. The RSI is showing a bearish divergence in overbought territory, a strong TA warning similar to what occurred at both 2001 and 2007 tops.

Looking at the shorter time frame, we can see one more bearish divergence on the daily RSI indicator as well as on the On-Balance-Volume (OBV). The price is building a rectangle consolidation pattern in a kind of rounding top, two well-known distribution chart patterns. This information, combined with confirming volume behaviour (increasing on down days) and yesterday bearish close below the rectangle support and the 50 DMA are more technical damages that warn we are close to seeing a top.

Finally, an interesting phenomenon is happening in terms of sectors rotation. It is clear that market participants are turning to a less aggressive risk taking stance. Take a look at how money flows from risky cyclical stocks (XLY) into safer, more defensive sectors like utilities and consumer staples (XLP, XLU) in the chart below.

Seasonal, technical, internal and sentimental evidences are too many warnings for me not to turn more cautious. 

Let me be clear here, I am a trend follower. As such, I will paraphrase the old Mr Patridge from "Reminiscence of a stock operator":  Well, you know this is a bull market!

I am not saying we are seeing the final top of the current five years bull run. I have many reasons to think it is not (that goes from fundamental to market breadth analysis) and I will cover them in my next article, but the main one is I always assume a trend will continue until proven otherwise. Top and bottom picking is the game of uninformed, loosing traders, and I recommend to play the downside only after a Dow bear market signal. Furthermore, US equities is the best asset class performer and as such I strongly advise being exposed to it. 

That being said I can easily see the market offer future buying opportunities at better prices for the many reasons presented above. An easing to the first obvious support zone near 1730 and maybe deeper into the very big support 1550 (old all-time high and 38% Fibonacci retracement of the current 2,5 years up-leg) will offer such opportunities.

That is why I would also advice in the meantime buying protection through the acquisition of puts. We all buy fire insurance and hope it is never needed.  I’m suggesting the same today for your stock exposure.

*NAAIM member firms are asked to provide a number which represents their overall equity exposure at market close on a specific day each week. Responses are processed to provide the average short (or long) position of all NAAIM managers as a group. The responses can range from 200% fully leveraged short to 200% fully leveraged long position.

The AAII Sentiment Survey is a weekly survey of its members which asks if they are "Bullish," "Bearish," or "Neutral" on the stock market over the next six months. AAII first conducted this survey in 1987 via standard mail. In 2000, the survey was moved to AAII's website.

RPS: Sell signals are generated when the two surveys indicate complacency.

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Cycles Within Cycles

Seeing how investors psychology affect all security prices through the boom/burst cycle of optimism and fear, technical analysts are devoting an entire field using cycles theory to predict this repeated pattern. Similar to natural scientists, they identify reliable temporal patterns and cycles that have stood the test of time. I would like to review those cycles in this article, but first I need to warn that this analysis is not something to depend stricly upon, for the simple fact that they are not as strong order flow generators as macro factors can be for example. That being said they are consistent enough to be considered by technical analysts when they time long-term investments, so I still find interesting to look at them.

The longest cycle I want to review is the well-known Kondratieff or K-wave cycle. A large academic body of knowledge is attached to this theory, but even if it is an intellectually stimulating topic, it is not really actionable. It is too long in duration to be important for trading purposes, averaging around 60 years in time, but more importantly have not enough history to be statistically relevant. It is also vital to understand that not every researchers agree on the dates of peaks and troughs. An acceptable dating is the one proposed by George Modelski and William Thompson which validate the last troughs in 1792, 1850, 1914 and 1973. The next projected low is expected around 2020/25 which confirm the projections of the US birthrate theory that project it in 2020. In fact researchers have found a strong correlation between the stock market and US birthrate advanced 45 years:

Next come the famous secular trend which last for about 34 years, a 17 year period of dormancy followed by a 17 year period of intensity. I say famous because I believe it is the most popular cycle that analysts are refering to in the common media. It is statistically more reliable than the Kondratieff one, and it is interesting to note that commodities are also linked to this cycle as when stocks go through the dormancy period, commodities rallies and vice versa. The next major low projected by this cycle come around 2017-18. (I would likely review this cycle in latter articles because many interesting studies and theories revolve around it).

Next come an important part of cycle analysis that is referred to by technical analysts as seasonality. 

Taking a look at the decennial pattern, commonly use due to the price tendency in the stock market to have similar characteristics every ten years, it appears clearly how this decay is following its predecessors pattern. It is important to remember when studying seasonality that direction is more important than levels. True, this decay start is better than its historical averages and can even be consider a little overbought, but the direction seems to be repeated again. Interestingly enough, if the pattern continue to fit past history, this uptrend will continue until August 2017. I would like you to notice that it is also predicting some kind of range trading this year that fit with the presidential pattern, our next topic. 

The presidential cycle is likely the most well-known temporal pattern in the market today. It is reliable and backed by many studies on a long enough time span to be  classified as statistically relevant. This pattern is signaling a correction for the stock market in 2014 from mid-April to the start of October. I find very interesting the fact that it fits with the range trading we identified on the decennial pattern. After this unfavorable time passed, stocks are forecasted to rally until the next election in November 2016. When the next presidential cycle first two years under performance kicks-in this will be in agreement with the slightly up but still flatish end of decay usual average.  

Putting all the pieces together, we can summarize that following technical analysts cycle theories, stock market should keep the uptrend ongoing till the next presidential election after this year dangerous time window has passed. The end of this decay should then produce a major low for stocks that is in line with the secular and Kondratieff projections, ence the title of this post: "Cycles within cycles".

To conclude I just want to repeat that one problem with the theory is that a large enough sample is not possible yet, and that such projections could be the result of chance. It is something to keep in the back of an investor’s mind but not something to use alone to commit funds to the stock market.

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Dow Theory Remains In Buy Mode

The most well known 'mechanical' system in the world of technical analysis is still in buy mode since December of 2011. The Dow theory, formulated from a series of Wall Street Journal editorials authored by Charles H. Dow, is the grandaddy of all technical market studies. 

Although it is frequently criticized for being "too late", it is known by name to nearly everyone who has had any association with the stock market, and respected by most. The track record is certainly impressive, and continue to provide its user an advantage over the unaware Buy-and-Hold investor. 

According to "Technical Analysis of Stock Trends, Ninth Edition / Edwards & Magee" an investment of 100$ following the theory recommendations from 1897 would have grown $345'781.94 by December 21,2005 just from the long side. By contrast, the investment of $100, if bought at the low, 29.64, and sold at the historic high, 11762.71, in January 2000 would have grown to $39,685.03.

I always like to know what the Dow theory say about the current market environnement as I think it is the best major technical trend indicator at the US equities trader disposal. Below is the current record of the major trend (click to enlarge):

Dow theory not only provide buy and sell signals, it also advise on the current stage of the Bull or Bear market. Of the 3 stages presented by the theory, my guess is that we stand in the second phase, approaching the dangerous third face where the "public" enter the scene and where the financial news is extremely good. But we are not there yet!

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Money Managers Aren’t Paid to Forecast; They’re Paid to Adapt

It seems we can’t go a week without someone predicting the end of the world and stirring up everyone’s fears of a market meltdown. These apocalyptic warnings are becoming routine and the sad thing is that it does cause the squeamish individual investor to run for the hills and liquidate their investment portfolio. Just look at the market calls for a crash over the last few years:

• Dow Could Crash to 3,000 in 2013 — Harry Dent (09/12/2011)
• Dow Dropping to 5000 Starting This Year: Charles Nenner (03/04/2013)
• S&P 500 May Fall More Than 40% By Fall: Chris Martenson (04/10/2013)
• Look Out! A 1987-Style Crash is Coming — Marc Faber (08/08/2013)
• The Case for a Crash: And for Staying in Cash Until 2015 — Charles Hugh Smith (12/10/2013)
• The Next Two to Three Days Are ‘Extremely Critical’ For The Stock Market — It May Crash 40% - Tom DeMark (02/5/2014)
• Get Ready for the Dow at 6,000 by 2016 — Harry Dent (03/03/2014)

Whenever a client refers me to an article of someone calling for a crash I like to respond with a question: How many crashes can you list over the last century? I’m not talking about a 20%+ bear market, but a market crash as defined by Investopedia:

Definition of 'Stock Market Crash'

A rapid and often unanticipated drop in stock prices. A stock market crash can be the result of major catastrophic events, economic crisis or the collapse of a long-term speculative bubble. Well-known U.S. stock market crashes include the market crash of 1929 and Black Monday (1987).

Think about that, we have had two real market crashes occur in the last 100 years, which works out to about one every 50 years. If they are so infrequent, then why do we hear so much about them? I'll give two reasons: One, people often crave attention and can easily gain it by making bold forecasts (whether they turn out incorrect or not) and, two, people assign a higher probability to market crashes now than they have in the past.

For example, shown below is the S&P 500 along with a Bloomberg story count for articles that have the words “market crash” in them. Since the early 1990s, we saw a spike on the 10-year anniversary of the 1987 market crash, then another around the September 11th 2001 terrorist attacks, and then again on the big October swoon of 2008. I want to draw your attention to the first two spikes in 1997 and 2001 and point out that, once they calmed down, fears over a “market crash” returned to normal levels. However, after 2008, there has been a continual and ongoing spike in calls for a market crash unlike anything we've seen over the prior two decades. 

Source: Bloomberg

This brings up an important point—a theme really—that I try to stress again and again: To be successful as investors we can’t fixate on the recent past, nor complain about what should be happening, but rather focus on what is taking place and why.

I typically write one to two articles a year on the subject of being flexible and want to include an excerpt from an article I wrote back in 2009:

Where Is the Humility? (12/09/2009)

All investors will be wrong at some point and the trick is to admit your error in judgment early rather than being a broken clock that is eventually right well down the road. Being wrong is human; being stubborn in the face of changing facts is foolishness. Another pearl of wisdom summing up this thought comes from famous investor Peter Bernstein who said the following after a long and successful investment career (emphasis added):

After 28 years at this post and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown. Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have since disappeared from the scene.

Remain Bullish Until the Market and Economy Undergo an "Identity Crisis"

In light of the above, it is important not to extropolate out too far in the future, but to focus on how fundamental drivers of the stock market and economy are changing on a daily, weekly, and monthly basis. For example, if the majority of stocks are in strong uptrends across most time-frames (as measured by short to long moving averages), I have to conclude the bull market in stocks is alive and well. Similarly, if the bulk of U.S. states are showing increasing economic growth, it’s logical to assume the economic recovery remains in place. What investors must understand is that market tops and economic peaks are a process and do not occur overnight. Rather, there is a period of time in which fewer and fewer stocks participate in the bull market and fewer and fewer states showing increasing economic growth.

There comes a point where the number of stocks rallying versus the number of stocks in their own private bear markets is roughly equal. The same is true for the economy where eventually there are an equal number of states participating in a recovery versus those that are not. This is the identity crisis point in which you have the potential transition from a bull to a bear market and from an economic recovery to a recession. However, until you reach the identity crisis point you have to adhere to the Wall Street maxims, “The trend is your friend” or “Don’t fight the tape.”

Consequently, much of my research is focused on looking for clues as to how close we are to that identity crisis point. On Fridays, I throw the stock market under the microscope with my “Weekly Bill of Health” report to gauge the level of participation in the bull market; as long as the bulls have the upper hand I remain bullish. An example of this is by looking at the percentage of stocks within the S&P 1500 that are within 2% of their 52-week highs versus those that are down more than 20% from their 52-week highs. This builds on the study done by Lowry Research Corp. in which they found that at major bull market tops, on average, only 16.54% of stocks were within 2% of their 52-week highs while 22.26% of stocks were 20% or more below their 52-week highs. This highlights the fact that market tops have an identity crisis when they peak as there are roughly an equal percentage of stocks near new highs as those already in bear markets.

Below is data from Lowry’s showing the average breadth of stocks at market tops compared to the 2007 top and the recent breakout to new highs on February 28th in the S&P 1500 (the S&P 1500 encompasses nearly 92% of the entire US market cap). As we can clearly see from the columns on the far right, there is absolutely no identity crisis present in the markets as bullish stocks clearly outnumber bearish stocks, with overall breadth quite healthy.

Given the bulls clearly have control of the stock market it makes sense that the economic bulls hold control of the economy. This can be seen when looking at the Philadelphia Fed’s Coincident Diffusion Index for all 50 states. Referring back to the identity crisis moment I mentioned, typically we see the onset of a recession when the Philly Fed’s Diffusion Index is zero, meaning there is an equal number of states expanding as those contracting. These periods are highlighted by the blue arrows below and what is most important is the fact that the Philly Fed Diffusion Index rested at 74 as of the end of December, well above the zero line associated with recessions.

Given the strong economic breadth seen in the Philly Fed data, it comes as no surprise that our own recession probability model shows only a 4% chance the U.S. is in or near a recession.

We truly live in interesting times and we need to open our minds to make sense of how to navigate as an investor while also avoiding falling into the "perma-bear" or "perma-bull" camp. If we are to succeed and thrive in this climate we have to be able to adapt and remain flexible, which was a key concept in a great book written by Louis-Vincent Gave, “Too Different For Comfort.” Louis was recently interviewed by Jim Puplava on the Financial Sense Newshourand you can listen in to the four key themes Louis believes will drive the markets over the coming years by clicking on the following link:

Louis-Vincent Gave: Four Macro Changes Investors Must Deal With - Global Central Banks Waging War Against a Deflationary Outcome

I’d like to end this article with the concluding remarks by Mr. Gave in his book, which are as priceless as they are timely:

This leads me to conclude with the words of my departed friend Clay Allen: “Remember Louis, money managers are not paid to forecast. Money managers are paid to adapt.” Unfortunately, adapting to this ever-more rapidly changing world is not always easy — but there is no other recipe for making money in today’s world.

http://www.financialsense.com/contributors/chris-puplava/money-managers-not-paid-forecast-paid-adapt

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Short Interest Surges To New High

Incredibly, the recent short interest data showed the total cumulative short interest on SPX components surged 4% to it’s highest point since mid-2012.

We keep hearing how there are signs of ‘froth’ and everyone is bullish.  I don’t totally agree, but there are some warnings signs – sure.  Yet, when I see the shorts continue to pile on, I find that very bullish.

Let’s get one thing straight, those shorts very well could just be hedges and not outright bearish plays.  None the less, keeping things very simple, going back the past few years – high short interest hasn’t been bearish.  Late 2011 and Summer 2012 were great times to stay long.  They were also the last two times short interest was this high.  Could it happen again?  I wouldn’t bet against it.

Considering the last time short interest was this high the SPX was around 1,350 (or 37% ago), that very well could represent some major potential buying pressure for this rally to continue.

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Seasonality Approaching Its Worst Point

We have entered the Mid-Term cycle in the Quadrennial Presidential Cycle, in which the months April through to September typically represent the worst SP-500 seasonal period for the entire 4 year cycle. The current cycle which commenced in 2012 has performed way above average so far, as shown below with the black dotted line:

However it is plain to see from the chart above that the average gains through the 4-year cycle are composed of cycles that vary quite a bit around the mean. We also note that despite the hugely above-average performance so far in this cycle, we are by no means out of boundaries set in prior cycles.

Due to wide dispersion around the mean since 1956, we find it more illuminating to rather compare the current cycle with all prior cycles that are showing at least a 90% correlation with the current 2-year progress:

Again it is clear we are still running above average (no doubt due to the FED’s stimulus – see “FED in the driving Seat“), but are still very much in tune with the directional cues imparted by the average as shown by the r-squared correlation of 0.97. Regardless if one looks to this chart or the chart depicting all past cycles, the message is clear that we are entering a seasonally weak period through to September 2014.

If we examine all prior stretches running from April through to September in the mid-term election cycle, we get the following distribution of returns:

Whilst it is not impossible for out-sized gains to occur during this period, the odds are clearly stacked against you with the historical record providing a lowly 35% chance of success and losing points outweighing winning points by 2.56 times to one. There are obviously many factors to take into account when deciding what do do during this period of weakness, most importantly the status of the economy, stock market health metrics, your investment horizon and so forth but if you are purely making decisions on statistical odds of past performance then this is the time to be sitting out the market since risks are more than double any likely rewards.

As we showed with our SuperCycle Seasonal Methodology, bear markets and recessions have a surprisingly large seasonal factor surrounding them. If ever this market is going to correct 10-15% off current heady highs it is very likely to occur between now and September. We certainly hope it does follow the playbook, since the 4-6 months pain is more than rewarded with the mother of all rallies that usually commences in the latter part of the mid-term election cycle.

Read more: http://recessionalert.com/seasonality-approaching-its-worst-point/

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Investors Aren't Displaying The Signs That Have Historically Marked Stock Market Peaks

Sentiment can be an important tool in measuring risk in the stock market. When investors get too bullish, it can be seen as a cautionary flag that the market may be due for a fall or a bubble is nearing its peak.

Fortunately, investors are not currently displaying signs of optimism that have historically marked a peak for stocks. When we look at sentiment, we focus most of our attention on the actions taken by market participants, rather than how they respond to surveys. A few key measures include: quiet mergers & acquisitions (M&A) activity, the lack of a surge in initial public offerings (IPOs), and only a very recent uptick in inflows into funds that invest in U.S. stocks.

M&A Activity Remains Quiet

A hot market for mergers and acquisitions has often been a sign of an overheated stock market as confident corporate executives seek to aggressively expand their businesses. The most recent example can be seen in the run-up in deals that took place in the mid-2000s that foreshadowed the 2007 peak in the stock market [Figure 1]. In addition, M&A deal premiums—the amount offered above the pre-deal price—remain around 25%, in line with the 10-year average.

LPL Financial

IPO Activity Is Not Surging

IPOs tend to soar leading up to market peaks when confident investors are eager to snatch up the shares in the newly public companies, as we saw in 1999 and the mid-2000s [Figure 2]. Currently, global IPO activity is not showing signs of heating up.

LPL Financial

Individual Investors Have Not Been Aggressive Buyers

While not always a sign of a market peak until it reaches extremes, a pickup in money coming into the stock market from individual investors is a sign of improving confidence.

Net inflows to funds that invest in U.S. stocks have been weak and only recently posted two months of back-to-back inflows—an occurrence not seen since early 2011. As presented in the Weekly Market Commentary from November 13, 2013 entitled Chasing Returns, investors tend to follow moves in the five-year rolling return for the stock market, which turned sharply positive with a double-digit margin over bonds about a month ago, helping to sustain the recent trend of inflows. We may be quite some time away from an extreme in the appetite of the individual investor for stocks.

LPL Financial

Currently these sentiment indicators, among others, are not waving any cautionary flags for investors despite the strong stock market performance in 2013 and since the low of nearly five years ago. However, we will continue to watch these indicators as a sign of rising risk in the market.

This post originally appeared at LPL Financial. Copyright 2013.

Read more: http://www.businessinsider.com/signs-this-is-not-a-market-peak-2013-12#ixzz2n6uEDB1W

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There's Almost No Relationship Between The Magnitude Of GDP Growth And Stock Market Performance

Stock market investors should be rooting for low single-digit economic growth next year—and the reason why has nothing to do with the Federal Reserve (Fed).

We forecast a low double-digit gain of 10–15% for U.S. stocks in 2014, as measured by the S&P 500 Index. This forecast for a slightly above- average annual return is rooted in our expectations for high single-digit earnings growth and a modest rise in the price-to-earnings (PE) ratio. An improvement in economic growth to an average 3% pace in 2014 should drive solid profit gains and boost confidence in the durability of growth.

Contrary to conventional wisdom, and what may be a surprise to those who see low single-digit rates of gross domestic product (GDP) growth as incompatible with solid double-digit stock market gains, GDP does not have to be booming to produce solid gains in the stock market — as 2013 can attest. In fact, there is little relationship between the magnitude of GDP growth and stock market performance.

There are perfectly logical explanations for this counter-intuitive fact. Strong GDP can be a sign of an overheating economy that may be due for a recession, and weak GDP may be discounted by the stock market ahead of an actual turnaround. As evidence, over the past 35 years, the S&P 500 posted gains in half of the 16 quarters that GDP was negative. Also, over the same time period, the S&P 500 posted gains in only about half of the quarters when annualized GDP was stronger than 6% and booming.

Historically, stocks have posted the most consistent gains when GDP has been around 3%. When GDP for a quarter was within plus or minus a half of a percentage point of 3%, the S&P 500 posted an average gain of 6.5% during that quarter—the highest of any 1% range in quarterly GDP and nearly triple the 2.4% gain when GDP was more than twice as strong. Even more impressively, when GDP was around 3%, the S&P 500 posted a gain in 22 of the 24 quarters [Figure 1]. That 93% batting average stands well above other GDP 1% ranges, even those with stronger growth, and is much higher than the 66% average for the whole 35 year period.

Looking back further to a full calendar year of GDP growth, rather than the usual annualized quarterly pace of GDP growth, we can see that 3% remains the sweet spot for economic growth as it pertains to the stock market. Since WWII, U.S. GDP of plus or minus 1% around the long-term average of 3% has produced an average gain of 16% in the S&P 500 and produced a positive return 83% of the time.

This is not just true of the United States; around the world GDP and stock market performance have not been closely related. For example, in 2013, the relatively sluggish pace of economic performance in the United States and Europe was not an impediment to much stronger stock market performance than in emerging markets that boast much faster economic growth rates. An example can be seen with Brazil and Spain. Brazilian GDP is expected to be 2.5% in 2013, while the stock market has declined 24.6%, measured by the Ibovespa Index in dollar terms year to date through last Friday. In Spain, GDP is expected to be negative while the stock market in Spain is up 24.3% this year, measured by the IBEX 35 Index also in dollar terms year to date through last Friday.

The risk to our forecast is from growth disappointing our expectations, not from policymakers derailing the recovery. Volatility in the months ahead is more likely to come from “growth scares,” when economic data may temporarily disappoint expectations on a path to better growth in 2014, rather than from the antics in Washington. A key lesson from 2013 is that the stock market and economy can overcome many challenges

by policymakers, including the fiscal cliff tax increases, the sequester spending cuts, the Fed tapering concerns, and the shutdown and debt ceiling brinkmanship. But a better pace of growth must materialize to find the growth sweet spot for clients; just more bond buying by the Fed is not enough to lift valuations from current levels to propel further gains.

This post originally appeared at LPL Financial. Copyright 2013.

Read more: http://www.businessinsider.com/little-relationship-between-stocks-gdp-2013-12#ixzz2mpXYzW89

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