An Open Letter About Today’s Market Environment 12-8-15
We have to trade and invest in the market that we have in front of us, not the one that we want. Therefore we have to be able to approach the market from a completely unbiased perspective. We don’t care if the market doubles in price or if it gets cut in half. We want to try to take advantage of moves in both directions. This is America after all.
I know it’s not sexy, but since October 23rd, we have wanted to approach the major U.S. stock market averages from a more neutral perspective. This is the day that both the S&P500 and the Dow Jones Industrial Average first got above what was then, and still is, a flat 200 day simple moving average. Securities in that sort of environment create headaches, for both the bulls and the bears. The reason is because there is no trend. Sure enough, prices this week are exactly where they were on October 23rd. This should not be a surprise and in fact, should be expected. But what does stand out is the dramatic underperformance in Emerging Markets during this period.
It is clear to us that October 23rd represents an important date in this current market environment. Yes, it’s when S&Ps and the Dow Industrials first got above their respective flat 200 day moving averages. But more importantly, it’s the day the MSCI Emerging Markets Index peaked. It is also the day that China’s stock market peaked and also the day that India’s stock market peaked. I am specifically referring to the U.S. Dollar denominated Exchange Traded Funds that represent each of these markets ($EEM, $FXI & $EPI respectively). What this tells us is that while the large-cap indexes in the U.S. have been trading in a sideways range wasting everyone’s time, there has been deterioration underneath the surface in other important markets around the globe.
There are a lot of ways to interpret what this means bigger picture. I personally like to look at it as a continuation of a dominant trend. The U.S. is still the best in the world from a relative strength standpoint. Considering the fact that the S&P500 is literally hitting an 11-year high vs the MSCI Emerging Markets Index this week, it should be no surprise that the weakness underneath the surface has continued over the past 2 months. I like shorting Turkey. When you look all over the world, this to me is the cleanest short. The MSCI Turkey Investable Market Index, which can be tracked using the ETF $TUR, is holding below both its 2012 and 2014 lows. This level, let’s call it $40, also represents the 61.8% retracement of the entire 2008-2010 rally. The line in the sand is very clear: We only want to be short Turkey if prices are below $40 and neutral if we’re above that. We want to be covering short positions in Turkey near $27 which represents the 161.8% extension of the most recent counter-trend rally in 2014.
Something else that I would pay attention to in Emerging Markets is how many of these countries have now broken below their uptrend lines from the August lows. Remember, a lot of these guys were crashing hard in August and then had wicked recoveries with plenty of higher highs and higher lows along the way. Go one by one and you’ll see how many are currently breaking this trendline support. I would chalk that up as a negative for the group as a whole. Then we look at Latin America, a very important area within Emerging Markets, and they look terrible. Brazil is still holding in there okay, which makes the Latin America 40 Index look stable, but underneath we see Peru, Chile, Colombia and now Mexico rolling over hard. Taking the weight-of-the-evidence here, this is not an area we want to be bottom fishing and fully expect lower lows coming in the near future.
Now in U.S. stocks, I don’t have many good things to say either. I’ve been very vocal about keeping a neutral stance in the S&P500, which we look at as a benchmark for U.S. equities. Although we’ve been in a sideways range for 7 weeks now, we haven’t seen back-to-back up days in over a month. The fact that we can’t string together more than a single day’s rally is further evidence that a neutral stance remains our best bet. It’s not sexy, I know, but we’re not here to be sexy. Remember we’re only here to try and make money, or keep it in this case.
We want to keep an eye on the Regional Bank Index. Financials are arguably the most important sector for the stock market. This sub-sector within that space has been a relative leader. But for this market to really get going, we need to see broadening participation and regional banks are a place where we want to look for strength. The problem is we’re seeing failed breakouts and bearish momentum divergences on multiple timeframes. Look at the Regional Bank Index ETF $KRE try to break above the Summer highs last month only to fail, then attempt again and then fail again. With each attempt to hold on to new highs, momentum diverged negatively each time. We’re also seeing the same exact bearish developments when you look at Regional Banks relative to the S&P500 as a group. So based on the weight-of-the-evidence, we want to short regional banks right here. From a risk management standpoint, we only want to be short $KRE if prices are below the late June highs. I like the risk vs reward as it is currently very much skewed in favor of the bears.
Technology is the other sector where we want to see leadership. The problem is that one of its sub-sectors and a prior market leader, Biotechnology, looks horrible. We want to be selling into any strength in the S&P Biotechnology index and staying short its ETF $XBI as long as prices are below $71.50. This level represents the 38.2% retracement of the July-August crash, which by the way had nothing to do with Hillary Clinton, as well as prior support in early September and resistance last month. I think the underperfrmance out of this group continues and drags down the technology index with it.
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What increases my conviction that tech is going to have a hard time keeping up this pace is that its leaders are running into a brick wall of sorts. Starting with the Dow Jones Internet Index, the leader of leaders, prices have been struggling to stay above our upside target that was first achieved back in July. Looking at the DJ Internet Index ETF, specifically $FDN, our target was $74 based on the 161.8% extension of the 2014 correction. These new highs last month came along with bearish momentum divergences on multiple timeframes. Going forward, an inability to stay above $74 (it is currently at $76), could be disastrous for this space, as well as the market as a group, as this is a lonely leader among U.S. stock sectors. We’re talking about the Googles, Amazons and Facebooks of the world. A sub-sector within that space is the Social Media Index. There is an ETF $SOCL which tracks the Solactive Social Media Total Return Index and it is currently running into a downtrend line connecting peaks in 2014 and April of this year. This combined with price just above a flat 200 day moving average doesn’t give me much of a reason to think this is going higher any time soon. This is also a problem for Tech.
This time of the year, you’ll often hear about how small-caps tend to outperform large-caps in December. Seasonally this is a big deal. But as you guys know, I want you to tell me when the market ignores seasonal trends and does the opposite of what it’s supposed to do. This is much more telling from a portfolio management standpoint. So far, we’re already a week into December and small-caps have dramatically underperformed large-caps. This is not good. Also notice how small-caps, specifically the Russell2000 Index, is exactly where it was on October 23rd, so is the Mid-cap 400 and so is the Russell Micro-cap Index. We are simply running in place in the U.S. stock market, at best. Going forward, I see nothing out there suggesting this will change for the better any time soon.
Moving on to more profitable markets, I think it’s important to point out what we’re seeing in Cocoa. This is a commodity that rallied 25% in just a few months off the lows in late March. What I like is that we continue to run up and bump our heads against that resistance. The way I see it: the more times that a level is tested, the higher the likelihood that it breaks. After 3-4 attempts to get through 3400 over the past few months, I think that we ultimately get through. This is a market that we only want to own once we have cleared all of this overhead supply. I believe this happens soon and we have a near-term target near 3700 based on the 2011 highs as well as the 161.8% extension of this consolidation since the Summer.
Also in the Agricultural space, Coffee continues to stand out. The 118 level is a big one. This is where prices originally broke out early last year and also the 161.8% extension of the rally last year from July to October. We only want to be long Coffee if prices are above the September lows. That is the line in the sand and represents a favorable risk vs reward for the bulls. The Commercial Hedgers, who we consider the “smart money” also like it and are net long down here.
Sentiment is something I wanted to bring up real quick because it’s a topic that gets thrown around loosely without much thinking. The problem with sentiment is that 95% of the time it’s just noise and doesn’t help us at all. We want to know when sentiment is at historic extremes. When it’s not at an extreme and just in the middle, it’s simply noise made by noisemakers and not anything we care about. So AAII changing by a few or NAAIM moving down a bit means nothing. Tell me when sentiment in the U.S. Dollar is at an all-time bullish level, and I’ll listen. This is what occurred in March and the Dollar has done nothing both go down or sideways ever since. This is a great example of the consequences of extreme sentiment.
Last week we wanted to be shorting U.S. Dollars and buying Euro against it and sentiment was a big reason why. Commercials Hedgers, or the “smart money” were buying Euro aggressively and dumping U.S. Dollars while public sentiment was the complete opposite. Sure enough last Thursday we saw one of the biggest moves in EUR/USD that we’ve ever seen. Some blamed the European central bank, some blamed the Federal Reserve, we saw Euro at support from the Spring with extreme sentiment unwind written all over it. Last week was one of those moments where we are thankful that we get to focus on the behavior of the markets rather than the noise coming from central banks and the noisemakers that have an unhealthy obsession with them.
I continue to think the Dollar weakens and Euro keeps rallying. An interesting component within this complex is the Swissy. Notice how Swiss Francs made new lows last week below the historic lows it made in January. If you recall, January was when the Swissy rallied 18% overnight crushing the hopes and dreams of anyone short that currency. Well USD/CHF briefly surpassed those January highs and then came crashing down. From failed moves come fast moves and I fully expect Swissy to continue to outperform the U.S. Dollar. Again, the line in the sand is drawn. We only want to be long Swissy if USD/CHF is below that January high prior to the collapse (rally in $6S_F). Sentiment is still way to bullish as a consensus for me to want to own U.S. Dollars. I’ll take the other side of the assumption that US Dollars are going higher.
In the Bond market, it’s the yield curve that we want to continue to focus on. We don’t care about rumors regarding what Janet Yellen said or thinks. Price pays. Rumors waste time. The crash in the 10-yr yield minus the 2-year yield keeps going. We are now down to the lows that held in June 2008, July 2012 and again in February of this year. We can argue that this is at least the 4th time that the curve is down to these levels. I have a very strong feeling that this cracks and the collapse leads to an inversion of the curve. We will watch for the break, call it around 1.20 to be safe, but I believe this would trigger the final leg of this yield curve narrowing that would take it sub-zero.
Getting more extreme, you can see this in the very short-end and very long-end of the curve as well. US 3-month yields hit the highest levels since 2008 this week and the US 1-year yields are at the highest levels not seen since…….wait for it……March 2009! The issue here is that the long-end still won’t budge. The 30-year yields are where they were a year ago and where they were a quarter ago. If you’re going to be buying bonds, it has to be on the long end. At this point I would only want to be long $TLT if prices are above last week’s highs. This represents key trending resistance from the August highs and a flat 200 day moving average. Once we’ve cleared that, then I would approach this long from an absolute basis. In the meantime, a narrowing curve is to be expected and a break in 1.20 in 10s minus 2s should be catastrophic.
That’s it for now. Please feel free to write with any questions or comments that you may have.
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