Markets Are Getting ‘Crashier’

Authored by Lance Roberts via RealInvestmentAdvice.com,

Over the last three weeks, as interest rates surged above 3%, we explored the question of whether something had “just broken” in the market.

• Did Something Just Break? 10-05-18
• Yes, Something Just Broke 10-12-18
• Market Clings To Support – 10-19-18

As I stated last week:

“This past week has been a decidedly tough struggle for stocks to pick themselves up after last week’s drubbing. While we saw a sharp reflexive bounce earlier this week, that bounce quickly faded as stocks returned to retest support at critically important levels.”

While the market was oversold last week, there was no follow through on bounces which ultimately led to “crash”open on Friday morning.

Now, all this SOUNDS terrible. And, after having THE single longest uninterrupted bull run in the history of the market with record low volatility it FEELS even worse. 

So, before we get into the not so good news, let’s keep this all in perspective for a minute.

For the year:

• The S&P 500 index, not including dividends, is down 0.56%.
• The S&P 500 Total Return index is still positive by 0.98%
• A 60/40 model (60% Vanguard S&P 500 and 40% Vanguard Bond Fund) is down 1.72%

What has been different this year so far, is that bonds, while they have reduced the volatility of the recent decline in the S&P 500 index, have not contributed to portfolio returns this year so far. So, the only place to hide has been cash.

However, if we take a look at the market from 2009 to present, we can gain some better context.

The recent decline is very much like the previous corrections in the market. The red circles denote when both “sell signals” align (a correction of overbought conditions and a triggered sell signal). These corrections have specifically coincided with periods where the market was extremely deviated above the running bullish trend line (gold boxes.)  

Currently, the correction, while painful in the short-term has been nothing more than a correction back to the running bullish trend.

So why worry?

The “difference this time,” is significant:

• The Fed is hiking rates versus either lowering or keeping them at zero.

• The Fed is reducing rather than increasing their balance sheet.

• The current Administration is insisting on a “trade war” which slows global growth.

• The economic cycle is mature rather than recovering.

• Record levels of debt at risk of rising rates versus a re-leveraging cycle with ultra-low rates.

• A mature housing, auto, and consumption cycle versus a recovery.

• Global central bank interventions have begun to taper versus expansion

• Peak earnings growth versus expansion

• Peak valuations versus expanding valuations

I could go on, but since you want “short and to the point,” I will stop there.

Here are some simple observations from Doug Kass (click here for recent interview) which dovetails into the following market analysis.

• The S&P Index and most non U.S. equity markets are broken technically.

• The worldwide fundamental outlook (economies and profits) are worse than are generally expected by the consensus.

• Few still believe a large equity markdown is likely.

• The consequences of a pivot in monetary policy in the U.S. (and elsewhere) is understated and not understood by many.

• There are now legitimate alternatives to stocks available in risk-free Treasuries. Those yields only recently have exceeded the S&P dividend yield.

• Stocks don’t go down in a straight line – it usually looks like a jagged line.

• We are in a new regime of volatility.

• A changing market structure – in which passive money overwhelms active money – remains a significant market risk and disruptive influence.

Daily View

In early October, the market broke the bottom of the previous short-term bullish trend channel and tested initial support at the 61.8% retracement level of the push higher from the April lows. That move failed at the 38.2% retracement level and has now violated previous support this past week. This is not a good development and suggests that a failed rally back to that previous support will set the markets up for a retest of the April lows.

Action: Sell any rally next week.

Weekly View

On a weekly basis, the view doesn’t improve much. With the trendline from the 2016 lows now violated, the tenor of the market has changed from bullish to bearish. While the current selloff technically looks a lot like what we saw in late 2015 when the market fretted over Yellen’s decision to start hiking rates, this time is very different. As noted above, global Central Banks are not coming to the rescue, yet anyway, to inject liquidity into the markets, earnings have likely peaked, and global growth is contracting.

While technically there is a weekly confirmed sell-signal in place, the very oversold condition continues to suggest a short-term rally back to the top of the current trading range is likely.

Action: Sell any rally which gets near the top of the current trading range.

Monthly View

On a monthly basis, the backdrop has also worsened.  RSI has dropped into correction territory along with a confirmed monthly sell signal. As I noted back in both December and September, extensions of the market that move 3-standard deviations above the long-term mean are unsustainable. Currently, a reversion back to the longer-term monthly average would entail a drop currently to 2300. A break below the February lows will likely confirm such a move is in process.

Action: Reduce risk on rallies, as detailed above, and look to add hedges on any breaks of long-term support

Actions To Take Next Week

With the market exceeding 3-standard deviations below the 50-dma currently, the extreme oversold condition still sets the market up for a fairly strong bounce. That bounce SHOULD be sold into.

Portfolio management processes have now been switched from “buying dips” to “selling rallies” until the technical backdrop changes.

1. Re-evaluating overall portfolio exposures. It is highly likely that equity allocations have gotten out of tolerance from the original allocation models. We will reduce overall allocation models from 60/40 to 50/50 or less.

2. Look to add bond exposure to mitigate volatility risk. (Read:The Upcoming Bond Bull Market)

3. Use rallies to raise cash as needed. (Cash is a risk-free portfolio hedge)

4. Review all positions (Sell losers/trim winners)

5. Look for opportunities in other markets (Gold is showing signs of life.)

6. Add hedges to portfolios (Short term treasuries, cash, and short positions on breaks of support)

7. Trade opportunistically (There are always rotations that can be taken advantage of)

8. Drastically tighten up stop losses. (We  had previously given stop losses a bit of leeway as long as the bull market trend was intact. Such is no longer the case.)

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)

If I am wrong, and the bull market resumes, we simply remove hedges, and reallocate equity exposure.

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