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Three Simple And Powerful Bullish Concepts

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Will Rates And The Dollar Doom Stocks?

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History Tells Us Polls And Anticipated Market Reactions Can Be Way, Way Off

This post contains the weekly CCM stock market video.

1980: Reagan vs. Carter

With Gallup being the lead industry dog, polling was a different animal in 1980. Gallup failed to project what turned out to be a wide margin of victory by Ronald Reagan. From NewRepublic.com:

The legend of Reagan’s epic comeback is largely the result of anomalous Gallup polling, which even showed a Carter advantage over the final month of the campaign. But if RealClearPolitics or Pollster.com had existed in 1980, the conventional wisdom would have been a little different. In fact, Reagan held a lead from mid-September onward and had a two or three point lead heading into the debates. Private polling conducted for the Reagan and Carter campaigns showed the same thing. Reagan’s 10 point victory is a precedent for sweeping undecided voters, but it isn’t a model for a come-from-behind victory.

The final 1980 returns from RealClearPolitics below show the outcome fell into landslide territory.

2012: Obama vs. Romney “Too Close To Call”

Scouring the internet for the latest poll numbers should be done with a gigantic grain of salt. The text below comes from a November 2, 2012 USAToday story “Presidential Race Too Close To Call”:

Only two days left — and, no, no one knows what’s going to happen. President Obama and Mitt Romney are scrambling for last-minute votes on Sunday and Monday in what could turn out to be a historically close presidential election — maybe not a rerun of the 2000 George-W.-Bush-Al Gore battle, but very close nonetheless. How close, you ask? The average of polls compiled by the RealClearPolitics website gives Obama a lead of 0.2% in the popular vote — 47.4% to 47.2%. That would leave 5.4% undecided. In terms of the Electoral College — which will decide the race — RealClearPolitics now lists 11 states as toss-ups, totaling 146 electoral votes.

The final 2012 tally from RealClearPolitics below shows us the actual outcome could not be accurately described using any term even remotely related to “close”.

Brexit: Were Forecasts Helpful?

Heading into the Brexit referendum, forecasts were heavily favoring a “stay in the European Union” outcome, while market forecasters were predicting catastrophic reactions in the financial markets if the final outcome put a W in the leave column. Both sets of forecasts were inaccurate; voters picked “leave” and after a short negative reaction, the financial markets rallied sharply.

What Are The Markets Telling Us A Few Days Before The Election?

Prior to the Brexit vote, the financial markets were not set up for long-term gloom and doom. What can we learn a few days before voters head to the polls in the United States? You can decide for yourself after watching this week’s stock market video.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

2016: A “Tight” Race

The headlines in the present day include, “New Battleground Polls Show Tight Race As Trump Makes Gains” and “National Polls: Tight race, Clinton Hanging On”. Time will tell in both the electoral college and financial markets.

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5 Facts Tell Us To Be Open To More Upside In Stocks

Charts Can Assist With Bullish And Bearish Probabilities

A reader of this post may come away with the impression the author has a bullish bias. However, the charts below, in the end, could also be helpful in identifying increasing bearish probabilities. We will look at hard evidence using price, retracements, trendlines, consolidation boxes, and moving averages.

Keep in mind, price, retracements, trendlines, consolidation boxes, and moving averages help us track the market’s current interpretation of all the fundamentals (earnings, valuations, Fed policy, the election, etc). Therefore, the facts and charts help us monitor all the inputs that impact the value of our investments.

The Charts Say What They Say

The charts say what they say and show what they show regardless of our personal views or biases. The only question is are we open-minded enough to see the charts as they are, rather than how our personal bias might want them to be?

What are the observable facts telling us right now?

The weekly chart of the NYSE Composite Index shows that 10,301 acted as resistance in October 2007. Since revisiting that level back in 2013, the market has made it clear, via price action, 10,301 remains important. The facts we have in hand lean bullish as long as price remains above 10,301. Conversely, bearish odds will pick up if the market fails to hold the key level. We learn something either way. The NYSE Composite Index was trading at 10,782 on August 31, 2016.

Fibonacci Inflection Points

When markets drop, we can pick up information about probabilities based on how price reacts at key Fibonacci retracement levels. Compare and contrast price action near the retracement levels in 2007-2008 and 2011-2012 (see red and green arrows below). Now, compare 2016 to the long-term outcomes following the red and green arrows. Right now, price relative to the retracements looks more like bullish 2011-12 than bearish 2007-08.

If the chart above deteriorates, we will learn something as well, but that falls into the “what may be” category. The chart above falls into the “what is” category.

Trendlines Dating Back To 2007

Markets tend to respect angles and parallel trendlines. The upper green trendline acted as resistance in 2008 (red arrow left), support in 2014 (green arrow), and resistance again in 2015 (red arrow right). Price has broken back above the same green trendline during the current post-Brexit rally. As long as price holds above the green trendline, it improves the probability of a push back toward the upper blue trendline.

Long-Term Consolidation Boxes

The charts below are monthly charts. All three charts closed above their respective orange box on July 31, 2016. All three markets are on pace to print a second consecutive monthly close above the multiple-year consolidation boxes. Larry Hite does an excellent job summing up the three charts that follow, via this excerpt from Market Wizards:

“The second item is something that Ed Seykota taught me. When a market makes a historic high, it is telling you something. No matter how many people tell you why the market shouldn’t be that high, or why nothing has changed, the mere fact that the price is at a new high tells you something has changed.”

Look at the charts above and consider the Dow first entered the sideways/indecisive/consolidation box back in calendar year 2013. Now, reread the quote above. The quote obviously remains more relevant if the breakouts hold; it they fail, it becomes much less relevant. We learn something either way (bullish or bearish).

Long-Term Moving Averages

An August 20 analysis covered a bullish signal that has only occurred ten other times in the last 35 years. The chart below is as of August 31, 2016; the improved look described on August 20 remains in place.

This is how the same moving averages looked as the stock market peaked in 2007 and rolled over in 2008. Compare and contrast 2016 above to 2008 below.

Long-term trend signals were helpful as the market regained its footing in 2009 in the wake of the financial crisis. Central banks played a large role in the turnaround.

Concerns about the Fed and economy left the market on shaky ground early in 2016. The chart below is as of February 12, 2016; notice how the market found support near the trendlines shown in chart 3 above.

After the Fed backed off the “four rate hikes in 2016” stance and other central banks around the globe announced even more aggressive stimulus campaigns, the long-term trends started to improve. The chart below is as of August 31, 2016. Compare and contrast the look of the present day chart below to the other turning points above (2007 and 2009).

What Is vs. What May Be

What is and what may be are radically different concepts. What is has a high degree of certainty; what may be has a high degree of uncertainty. Therefore, we prefer to make decisions based on what is rather than the nebulous what may be.

Predictions vs. Facts

Humans cannot predict the future. Markets cannot predict the future. Charts cannot predict the future. All three make probabilistic assessments of future outcomes based on the “knowns” of the day. When new information comes to light, the markets reassess; any reassessment will be reflected in the charts. Therefore, if the charts change, the probabilities will change. Thus far, both the charts and probabilities continue to favor good things happening relative to bad things happening. If you are looking for other examples of “evidence in hand”, the following posts may be of interest to you:

Messages From Emerging Markets And Cyclicals

How Does 2016 Compare To Stock Market Peaks In 2000 And 2007?

These 4 Charts Say A Lot About The Stock Market

Stock Rally Is Based On More Than Just Central Banks

2016 Investor Fund Flows Nothing Like Excessively-Optimistic 2007

Is This Long-Term Volume Signal A Warning Flare For Stocks?

Will The Jobs Report Induce Another Waterfall Plunge In Stocks?

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Small Caps - Wisdom or Wasted Opportunity in an Aging Bull Market?

There’s “conventional wisdom” out there that as a bull market matures, large cap stocks tend to become the out-performers. According to this thinking, investors tend to shift investments to companies with well-established revenue sources, market penetration, and huge stockpiles of cash as a bull market ages. In theory, and for the most part in practice, these are the companies better suited to weather an economic downturn.

This means that small caps tend to get slighted in the late stages of a bull, but I think there are some circumstances in the current environment that argue for the opposite. Indeed, I see some good reasons now to bulk-up on small caps in context of a diversified approach.

3 Reasons You Might Want to Bump-Up Your Small Cap Allocation

When we start working with new clients at Zacks, we tend to notice that folks are under-allocated with small cap stocks. Often, the response we hear is that small caps are “too risky and volatile.” While this is true, relative to large caps, it is far less true when you factor in the potential long-term growth benefit. In that sense, it is arguably riskier not to own small caps.

A look at the last 15 years provides a good example for what I mean here. From 2000 – 2014, small caps (using the Russell 2000 Index) as a category have annualized +7.4%, compared to the S&P 500 which annualized a much lesser +4.2% over the same period. Looking back further, a hypothetical $1,000 investment in Russell 2000 at the start of 1979 was worth $29,742 at the end of 2014, while the same investment in the S&P 500 would have been worth $21,468. That’s a +2,874% gain versus a +2,047% gain, a difference that isn’t exactly a rounding error!

I’ve just argued for the long-term, total return reason to own small caps in your portfolio, but I think there are circumstances now that could boost the performance of small caps over other categories over the next year.

1) The Dollar Is Strong and Likely Getting Stronger – small cap companies consist largely of U.S.-based companies that derive a large percentage of their revenues and profits from domestic consumers. That means they are largely insulated from the hindrance to exports caused by a strengthening dollar, which multi-nationals “feel” on their top lines.

2) Rising Interest Rates Shouldn’t Hurt – a rising rate environment generally hurts small caps since they are more leveraged than larger companies. High levels of debt in a rising rate environment hurts small companies because interest payment costs rise. But since interest rates are basically zero bound and the Fed has made it pretty clear rate rises will come very gradually, this should not be as negative a factor where it has been in the past.

3) Merger and Acquisition Opportunities – often, small caps are the targets of M&A activity since they’re the easiest targets. That usually means a nice boost for stock prices, since the ‘acquiring companies’ usually have to pay a premium for ownership. In the U.S., if M&A activity continues at its current pace, it could reach $4.58 trillion which would be the biggest year on record.

Bottom Line for Investors

Small cap stocks have proven over the long-term that they deserve or, perhaps, even require a place at the table when investors are making asset allocation decisions. I believe this to be true over the long-term – and, I think the narrative of small caps being ‘too risky and volatile’ is causing investors to slight them when they construct investment portfolios.

At Zacks, we try to educate our clients about the long-term benefits of owning small caps, if doing so is appropriate given their goals and objectives. And for investors with long investment horizons seeking growth, this is usually the case. I also believe small caps are worth considering for the short term. As you know, investment success is all about the future, immediate as well as in the years ahead.

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Disclosure: Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Zacks Investment Management, Inc. is not engaged in rendering legal, tax, accounting or other professional services. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel.

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Anomalies, Cycles, and Inevitable Periods of Underperformance

You’re new to investing and want to pursue a small cap value strategy. You’ve read that value stocks and small caps tend to outperform over time and you, of course, would like to outperform.

Looking at back at history, following such a strategy seems like an easy ride. An investment of $10,000 in 1979 would have grown to $829,578 in the Russell 2000 Value Index versus only $299,945 for the Russell 2000 Growth Index (annualized return: 12.9% vs. 9.8%).

In reality, though, sticking with small cap value was anything but easy. There were many periods in which value underperformed growth. In fact, in looking at rolling 3-year returns, value underperformed growth 33% of the time. That means value was deemed to be “not working” or “broken” in one third of all rolling 3-year periods.

This is where we are today. Value has underperformed growth by over 25% in the past three years. How many investors, given this backdrop, would choose value over growth? Not many.

And this is far from the worst period in history for value. At the end of February 2000, value had underperformed growth by 85% in the prior three years. Those selling value strategies at the time were literally laughed out of the room. We all know what happened next.

The moral of this story: all anomalies have cycles and periods of underperformance. It seems counterintuitive, but this is why they work in the first place. If there was a strategy that worked every month of every year, everyone would follow it and it would stop working.

In our 2014 paper on Beta Rotation, we illustrated a rotational strategy that outperformed the broad equity market in 80% of rolling three year periods. Notable outperformance, but this still meant the strategy was underperforming 20% of the time. And when you’re in one of those periods, it can feel like an eternity.

How should investors think about periods of relative underperformance?

If they maintain a diversified portfolio of asset classes and factors (as they should), they need to accept the fact that by definition, something in their portfolio will always be underperforming. I agree, this is not easy to accept, but it is a mathematical truism. The prudent investor will welcome such underperformance as an opportunity to rebalance and add to the factor or asset class that may now be undervalued.

Most will do the opposite, emotionally chasing asset classes or factors only after they have shown strong performance and selling whatever “isn’t working” in the short run. Unfortunately, chasing after the hottest fads is not a particularly successful investment strategy.

The best example of this today is in biotech stocks. Many new investors are just learning about the biotech boom in which we recently saw shares quintuple over the past five years. They see the chart below and instantly fall in love, projecting past returns into the future.

“Charlie, what do you think of biotech stocks?”

That is the most popular question I have been asked in recent weeks and tells you all you need to know about human psychology (certainly no questions on value stocks). Everyone loves a winner. I get that, which is why momentum exists and is one of the most powerful forces in markets.

But momentum, too, has cycles and few investors are willing to accept the drawdowns, volatility, and periods of underperformance that come along with such a strategy. Fewer still have a consistent process by which they try to take advantage of the momentum factor. Chasing performance years after a run is not the same as short-term momentum. There will many Johnny-come-lately biotech investors that learn this the hard way.

In the end, it all comes back to psychology. Can you accept the fact that something will always be underperforming in a diversified portfolio and use that to your advantage instead of giving in to your emotions? Can you ignore the noise of the short-term and understand that the path to successful investing is not paved by winning yesterday's war and engaging in "what ifs," but by realizing the future is not the past. If you can, you'll be investing often in things that "aren't working," but end up way ahead of those investors who believe that everything in their portfolio should be up at all times.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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Hunting for Growth

In the past few months, we learned that 4th quarter S&P 500 earnings declined 14%, their worst year-over-year decline of the expansion.

With growth harder to come by, investors have been actively bidding up growth names wherever they can find them.

The Russell 1000 Growth Index (IWF) has outperformed the Russell 1000 Value Index (IWD) by over 5% thus far in 2015. We have seen similar outperformance in small cap growth (IWO) over small cap value (IWN).

Looking at the difference in sector weighting between Russell 1000 value and growth indices, we can see that growth has benefited from the outperformance in Tech and Consumer Discretionary with an overweight in those sectors. Growth has also been aided from an underweight in Financials, Energy, and Utilities as those sectors have declined thus far in 2015.

Sector performance in the first quarter has largely followed revenue growth, with Tech, Consumer Discretionary, and Health Care posting above-average revenue growth while Financials, Utilities, and Energy have shown below-average growth.

With the release of 1st quarter earnings in a few weeks, it will be interesting to see if the outperformance of growth over value persists. If growth remains scarce, we could see a continued widening in this relationship. On the other hand, if growth comes in stronger than expected, particularly in the “value” overweight sectors such as Financials and Energy, we will likely see a convergence in performance.