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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Bad News For A Commodities Breakout

After more than two years and a half of downtrend, many analysts and pundits were calling the end to the cyclical commodities down wave this year. Since many of its components, in particular gold and agricultural, were already breaking out to the upside, I tended to agree with that analysis.

Though, this week FOMC meeting shifted my view on what to expect in the next few months for commodities and inflation. Why?

• Wednesday press conference shifted the narrative.
• Emphasis changed from near-zero interest rate to eventual hikes.
• The Federal Reserve revealed a post meeting hawkish bias.
• Bellwether price action deteriorated.
• US economic strength has been re-emphasized. 

From a macro perspective this change in tone is what George Soros refer to as "playing changes in the rules of the game" because that is the kind of event that changes market participants perception of the market place and creates orderflow that speculators can profit from.

In her press conference on Wednesday, Fed Chair Yellen accidentally caused the market to focus, laser-like, on the seemingly casual phrase “six months.” Prior to the presser, the narrative was focused on near-zero interest rates and their positive effects. “The US economy is recovering nicely,” the line of thinking seemed to go, “and we will have super-low rates for quite a while yet.” To hear SIX MONTHS was the needle scratching across the record.

This event is even more damaging for commodities as it happened right at the moment when the market seemed to wonder if it was more concern about inflation or deflation. See below chart of the ratio between bonds and gold, one of the best inflation/deflation indicator:

Just when the ratio was trying to break out to the upside, this week FOMC decision seemed to kill any hope for commodities bull as it created a bearish engulfing candlestick pattern right at the downtrend resistance line.

Some commentators inclined to shut their eyes tight and wish a dovish Fed back into existence, next-day comments from Fed members Fisher and Bullard are a blast of cold water. Consider these wire headlines (Zero Hedge):

*BULLARD SAYS YELLEN'S '6-MONTHS' COMMENT IN LINE WITH SURVEYS 

*BULLARD SAYS FED WATCHFUL FOR 'ANY KIND OF REPLAY' OF BUBBLES 

*FISHER SAYS FED HAS EXHAUSTED EFFICACY OF U.S. QE POLICY

*FISHER SAYS ASSET-BUYING TO END BY OCTOBER AT CURRENT PACE *FISHER SAYS SOME MORE VOLATILITY IN MARKET WOULD BE HEALTHY 

Here is another great comment from Joe Kalash, Chief Global Macro Strategist at NDR,  “Although Fed Chair Yellen cautioned against reading too much into the so called “dot plot,” we can’t get it out of our head that the median year-end values rose compared to three months ago.  The median year-end fed funds rate target of FOMC participants for 2015 is now 1.00%, up from 0.75%, while the year-end target for 2016 is 2.25%, up from 1.75%. This suggests the FOMC will begin hiking rates sooner and/or more aggressively than previously expected.”

Now the picture should be abundantly clear. Wednesday’s press conference, plus follow-on information, has revealed that the men and women of the US Federal Reserve are significantly less dovish than many anticipated (including me). Combine this cold-water dose of narrative sea-change with a slow growth global economy, and commodities are in danger. 

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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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Chinese Economy Sluggish But Hard Landing Risk Contained

Chinese monetary trends are stable and consistent with continued subdued economic expansion.

Real narrow money works best as a leading indicator for most economies followed here but in China’s case the broader M2 measure has performed equally well in recent years. Six-month real M2 expansion was stable in February and close to its average over the last two years – see first chart.

The six-month change in real narrow money M1 had turned negative in January but this was attributed here to Chinese New Year’s Day coinciding with the end-month reporting date. A rebound duly occurred in February, although real M1 expansion remains weak by historical standards.

Monetary trends, therefore, suggest continued sub-par growth but no increase recently in the risk of a “hard landing”.

On the credit side, six-month expansion of real bank loans has been stable over the past year but the broader “total social financing” measure has slowed as the authorities have clamped down on off-balance-sheet lending – second chart. The broader measure is still growing faster than bank loans, suggesting no early relaxation of credit restrictions despite low inflation.

Money market conditions, however, have eased since the New Year, with the one-month repo rate now close to its level at the same stage of the last three years* – third chart. This easing has been accompanied by some narrowing of spreads between interbank swap rates and government yields, although these remain elevated – fourth chart.

In other Chinese news, exports slumped in February but much of the weakness was probably due to New Year timing effects and a reduction in disguised capital inflows, the latter reflecting both an official crackdown on fake invoicing and (correct) expectations of a weaker exchange rate.

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A Warning On Junk Loans

Record margin debt is not the only dangerous sign of the overly leveraged and speculative atmosphere the Fed has encouraged.  Now the head of the world’s largest distressed debt fund, Howard Marks of Oaktree Capital, is warning of the dangers as retail investors gobble up distressed debt.

Oaktree’s Marks Urges Caution as Money Flows into Junk Loans

Here is a pretty scary line…

“You can’t go on strike and refuse to buy the securities you’re paid to invest in, because the market may not turn for months or years,” Marks said. “Never forget the old adage, being too far ahead of your time is indistinguishable from being wrong. So you have to buy but with caution.”

So in other words, the thing just keeps going until one day… it just ceases to go.  Yeh, that’s a great fundamental underpinning right there.

From Sentimentrader.com:

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RBA Hints Cash Rate May Not Fall Further From Here

The Reserve Bank of Australia provided one of the strongest hints that the cash rate may not go further down from here, saying it remains unclear if a shortfall in demand can be made up quickly through monetary policy action.

The hint was delivered by Governor Glenn Stevens in his opening statement to the House of Representative Standing Committee on Economics in Sydney and later while answering their questions.

Stevens said monetary policy is very accommodative and based on current indications, the RBA expects to keep the cash rate stable for a while.

He admitted "the outlook contains many uncertainties, not least the 'hand over' from mining investment spending to sources of demand outside mining," even as there are signs that handover is happening.

"The question then is: will the additional demand likely to be generated outside mining as a result of these trends be just the right amount to offset the large decline in mining investment spending, so keeping the economy near full employment?"

But even if there was a shortfall in demand, Stevens said, it "could not be assumed that a shortfall in demand could necessarily be made good in short order by monetary policy. Monetary policy can have a powerful effect on the general environment, but it cannot hope to fine-tune the quarterly or even annual path of aggregate demand,"

Later Stevens repeated he expects the cash rate to remain stable for some time but added the RBA hasn't specified "how long" the cash rate will remain stable because "I don't know."

The guidance to keep the cash rate stable for some time is a change from the previous signal there could be a scope for easing, Stevens said. But the change indicates that based on the current outlook, the RBA doesn't see scope for more easing, even as he emphasized that the guidance is based on "current indications" and could change if the outlook changes.

In short, Stevens seemed to suggest there was no scope to lower the cash rate further based on the current outlook but even if the outlook didn't come to pass as the RBA now forecasts, there isn't much scope for monetary policy to step in and make up for the shortfall in demand.

At the same time, Stevens provided no hint that the RBA was in any rush to raise the cash rate.

He said the unemployment rate is expected to drift higher in the quarters ahead. Asked specifically on how much the labor market lags the growth in the economy, Stevens said it may be "one or two quarters."

Assistant Governor Christopher Kent elaborated on the labor market, saying "roughly speaking, we see the unemployment rate drift up a little bit from here, but probably sometime early 2015 peak and stay there for a while."

An improvement in economic growth is not likely to make inroads to the labor market until late 2015, Kent said.

On the housing market, Stevens didn't show any discomfort with the rise in prices or the increase in buying interest from overseas investors.

Stevens said foreign investors have a role to play in the housing market. "In a way, we tend to feel we want to be open to foreign investment.. this is a form of that."

Stevens said foreign investors were buying new structures as it is easy for them to do this. "If there was a supply side constraint, the issue is worth addressing. Beyond that, the question is how welcoming we want to be... this is a matter for the Parliament to manage."

On the effect of restrictions in Canada on the housing market here, Stevens said there will be some effect but "I cant quantify the extent of spillover in our direction"

But if house prices continue to rise further, would the RBA consider macro-prudential tools, Stevens was asked.

Stevens said he has previously stated the RBA has had preliminary discussions with the prudential regulator about macro-prudential tools for housing. While he recognizes such tools are useful, he said, "we should use them with a bit of realism."

Deputy Governor Philip Lowe also said macro-prudential tools can be useful but can also create distortions, especially harming first-home buyers when tools like a cap on loan-to-value ratios are used.

A better tool would be tighter lending standards, where a home loan application is tested for scenarios of 300 basis points higher interest rate than around 200 basis points as is currently donr, Lowe said. This would be more useful than raising the cash rate as current mortgage borrowers and other sectors of the economy could continue to enjoy the benefit of lower rates.

On inflation, Stevens said the higher-than-expected fourth quarter inflation data may have contained both noise and signal for future inflation. But the RBA's overall assessment is "that inflation is not quite as low as it might have looked six to twelve months ago, but nor is it accelerating to the extent a literal reading of the latest data might suggest."

Still, the RBA's view remains that the "outlook for inflation, while a little higher than before, is still consistent with the medium-term target," Stevens said.

Stevens said monetary policy is very accommodative and is doing the sorts of things that is normally expected to result from low interest rates, including promoting a rise in asset prices, construction of dwellings and depreciation in the exchange rate.

However, he added, the exchange rate "is still high by historical standards."

Later, on a question on the meaning of "jawboning" that the RBA is said to be doing for the exchange rate, Stevens said they refer to the fact that "we made remarks about levels of exchange rate" and the assumption is "these remarks were made in an effort to move it."

But Stevens said jawboning has a limited effect in lowering the exchange rate and in theory a central bank could take other steps like intervening in the foreign-exchange market or lowering the cash rate in an effort to bring the exchange rate down.

On the current level of the exchange rate, Stevens said his view is unchanged from that expressed in an interview with the Australian Financial Review newspaper back in December.

He said, "($)0.90 or higher is rather higher than any plausible assessment" of the economy.

In the AFR interview, Stevens had said: "I don't think the extent of our knowledge about what's correct is that good, but I did think ($0.95) was rather too high. I thought ($0.85) would be closer to the mark than ($0.95) at the time we started to make some comments some months ago, but, really, I don't think we can be that precise."

"I just think that if things over the medium term evolve as we're presently assuming - and I think it's reasonable to make these assumptions - it's going to be surprising if a nine at the front is the right number."

A high school student asked Stevens a question on what policy step he would take if inflation rises above the target band and the unemployment rate also rises to, say 7%. Stevens said it depended on what caused that combination but if inflation was higher, he would focus on the outlook for inflation.

"I hope the combination remains hypothetical," Stevens said.

On a question on where future growth in the economy would come from, Stevens said the mining sector is likely to contribute positively to growth in to the long run, after the initial downturn in the near term. But based on history, it is likely the economy will evolve in the direction of services.

"That's where most opportunity lies, included trade in services," Stevens said.

Steven was asked his view on the U.S. Federal Reserve's tapering plans. He said he believes that a "fair bit" of weakness in the labor market may be needed there for Fed to change its path on tapering.

He reminded that even with tapering, the Fed's balance sheet is still expanding, so in effect it is "still easing monetary policy" but easing at a slower pace.

A question was asked about monetary policy comments made by RBA board members to which Stevens replied he's the only one authorized to speak on behalf of the board. He admitted the RBA can't stop board members talking about things they know about, including in their own field. 

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