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Wagging The Dog

Regular readers know I like to try to combine fundamentals with technicals and sentiment to form a holistic investment/trading thesis. Right now I believe that these three factors are lined up on the bears’ side in the case of small cap stocks, which have led the broader indices of late – the proverbial tail wagging dog.

First, to say valuations are stretched in the case of small cap stocks doesn’t quite tell the whole story. In fact, they may have never been more stretched than they are today. (I’d love to see a CAPE ratio for the Russell 2000 if anyone’s got that data.)

The trailing price-to-earnings ratio currently looks fairly absurd:

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Chart via WSJ.com

I would assume that the astronomical level of the p/e is due to the fact that a large number of companies have losses rather than earnings. But even if you look at price-to-revenues the stocks look extremely overvalued. WSJ reports:

As of Sept. 30, for example, stocks in the Russell 2000 traded at 1.5 times their revenue of the previous 12 months, a measure known as the price/sales ratio. That is just a hair below the highest valuation seen going back to 1994, the earliest year for which data is available. Such levels were last seen during the stock bubble of the late 1990s, according to Russell Indexes.

The index would have to fall another 15% just to return to the average price/sales ratio of the past 20 years.

A price/sales ratio of 1.5 times in the Russell 2000 doesn’t happen often, says Lori Calvasina, a U.S. equity strategist at Credit Suisse Group CSGN.VX +0.08% who specializes in small and midcap stocks. “But whenever we’ve been there, the Russell 2000 has literally never been up 12 months later, and the average decline is about 16%,” she says.

So it’s hard to make the case that small caps aren’t currently overpriced and technically, they look vulnerable on a couple of time frames.

Back when the ETF broke out above the 82.5 level at the end of 2012 I called this chart the most bullish chart I could find. I’ve been watching ever since, adding the 1.618 Fibonacci extension which has proved to be significant resistance since early spring:

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What’s most glaring about this chart is the recent selloff has seen the uptrend line that dates back to the 2009 low break. The ETF is now testing the underside of the trend line along with its 20-week moving average. So this correction is more than the typical brief pullbacks we’ve seen over the past two years.

Comparing it to the 2010 and 2011 corrections, then might give us a bit better idea of what to expect from this selloff. Notice both of those pullbacks saw the ETF make lower lows with divergences in RSI, volume and MACD histograms. Should the current selloff follow this pattern we should see a lower low made over the next few weeks.

The daily chart confirms this view. RSI (at the top of the chart) is showing another divergence/non-confirmation with the latest high made on Thursday. The index has failed to overcome its 61.8% retracement along with the other major indexes. Finally, volatility looks to have broken out and the pullback is just a test of the breakout level, suggesting we could see another surge in volatility soon. Unlike the other indexes, this relative high for the Russell comes in the context of a clear pattern of lower highs and lower lows, the definition of a downtrend:

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All of this makes a retest of last week’s lows very likely, in my opinion. It may be putting the cart before the horse, but I believe the big question after this next pullback will be whether this all amounts to a larger topping pattern for index.

Last month the index closed more than 1% below its 10-month moving average which amounts to a long-term sell signal for trend followers. Should it be unable to regain that level by at least 1% over the next few months, the most bullish time of year for the markets, I think it will be safe to assume the Russell will be faced with a new bear market lasting anywhere from roughly twelve to twenty-four months.

In fact, should the complex head and shoulders pattern in the chart above play out it would see the index decline to around the 950 area, a 21% decline which meets the definition of a bear market. But as I said, let’s see what happens over the next couple of weeks first.

Finally, sentiment toward the sector has surged. StockTwits traders are absolutely rip-snorting bullish on the Russell 2000 futures contract right now – even more bullish than they were a month ago when the major indexes were hitting all-time highs:

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Chart via StockTwits

The bottom line is these stocks are overvalued, overbought and over-owned right now. What’s more, they have led the broader indexes over the past couple of months and I believe they could very well represent a significant “canary in the coal mine” investors should pay close attention to.

See also: “The Dominant Risk For Wall Street” May Be Manifesting In Small Caps and What Does “Reduce Risk” Mean To You?

Disclosure: I currently own inverse Russell 2000 ETFs (what amount to short positions) for myself and for clients.

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Why?

I’ve been thinking about blogging and social media. Why do we do it?

There are all kinds of answers for all kinds of different folks and I’m sure they each apply to me in some degree.

Some are looking to be heard (in other words, to be listened to – aren’t we all?). Some are looking for their 15 minutes of fame. Some want to come down on one side or another of a specific issue and be right, damn it!

I’m guilty of all of these things, as I said, to some degree, but none of them are the main reasons I do this.

First and foremost, I blog and tweet and such because it helps me flesh out my own ideas. A lot of the time I’m just thinking out loud and typing it. There’s something about writing things down AND in a public way where you can get feedback that just helps expedite or make the thinking process more efficient. I can’t explain it but it works.

Second, it helps to put things out there where they can’t be retracted in order to hold myself more accountable. When something’s not put out there permanently it’s really easy to either totally forget about it or to change the way we remember it over time. A blog post or a tweet brings it right back into the present and makes it impossible to misremember or deny.

Finally, one of the best feelings I can get in my business is helping someone learn something that makes a dramatic impact in their lives – even if it comes from my own horrible mistake! It’s why I do this here and on social media and why I teach a class at the local community college. It’s just very rewarding.

But at the end of the day, this whole thing, the blog, social media and even my class is really just for me. It helps me be a better thinker and a better investor – so I’ll keep doing it.

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The Worst Trade Of My Life

“The only thing to do when a person is wrong is to be right, by ceasing to be wrong. Cut your losses quickly, without hesitation. Don’t waste time.” -Jesse Livermore

This morning I closed out the worst trade of my life. Corinthian Colleges stock price is up about 100% this week on news that its creditors aren’t going to immediately force them into bankruptcy. But that doesn’t even come close to making up for the losses I’ve suffered over the past three years.

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It began back in 2011 when I first started buying the stock. At the time, it looked cheap because the for-profit industry was facing two major challenges that hurt Corinthian even more than most of its competitors. First, the industry was heading into what appeared to me to be a cyclical downturn as the economy began to improve and those who were out of work became less interested in learning new skills or burnishing their resumes. Second, the federal government was unhappy with the industry’s business practices and started devising and implementing more regulatory restraints for the companies.

What I totally miscalculated was that it’s probably a secular decline, not a cyclical one, for the industry. AND the government was fully prepared to put a company like Corinthian out of business. To make things worse, the stock price tried to tell me this for three years and I just wouldn’t listen.

“The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade.” -Paul Tudor Jones

Guilty as charged, Paul. What I’ve learned – the hard way – from all of this: What the best traders and investors in the world perhaps do best is admit when they’re wrong and take a loss quickly.

Warren Buffett’s recent Tesco trade is a great example of this. A few weeks ago it was revealed that the company, the largest grocery store operator in the UK, is now being investigated for accounting fraud. Buffett began dumping his shares almost immediately, roughly a quarter-million of them, in fact, calling the investment a, “huge mistake.”

Buffett’s speed and decisiveness in cutting this loss should be an inspiration to investors. In fact, I believe that even if you don’t have the greatest possible investment or trading process to begin with (just a decent one), if you have a terrific plan for selling that involves cutting losses quickly and ruthlessly, you can generate alpha (outperformance) solely that way (by losing less when markets fall). That’s how critical it is.

Moreover, it doesn’t need to be based solely on fundamental developments as Buffett’s sale seems to be. The trend in Corinthian over the past three years was plain as day. In fact, while I owned it, it rarely spent any time at all above its 200-day moving average. Outside of late 2011, early 2012 it didn’t really ever make any higher highs and higher lows. The trend over the past two years was almost screaming, “this stock is a loser! Get out while you can!!”

The bottom line is this: We all will make mistakes in the markets. What separates the best from the rest is how they deal with them and then how they learn from them and adapt their methods going forward. This was the worst trade of my life. I’ll never forget it because, although it had to literally beat me over the head, this lesson has now been lodged firmly in my brain.

So if you learn anything at all from Jesse Livermore, Paul Tudor Jones, Warren Buffett or from my painful mistake, I hope it’s this: Recognize when you’ve made a mistake and sell immediately. And pay attention to the trend. If it doesn’t validate your thesis, move on to your next idea.

“There is no better test of a man’s integrity than his behavior when he is wrong.” ―Marvin Williams

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Be Adaptive

“One of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.” -Howard Marks

One huge trend I’ve noticed in financial social media lately is the use of statistics and market history to project future price movements. This is really cool stuff, actually, and it’s data that most investors haven’t had access to at all until now.

What I’m specifically referring to is all the traders out there, and there are plenty of them now, that see the market do x and then pull up all the times it’s done x in the past to see what it’s meant going forward.

This type of quantitative analysis is great in that it helps you become more objective and less emotional with your trading or investing.

But it looks to me like investors are beginning to rely on it a bit to heavily. It’s use is becoming a bit too “mechanistic,” as Howard Marks put it in his book, The Most Important Thing.

A great example of how traders can be overly reliant on this sort of thing was the Russell 2000 death cross a few weeks ago. Last month the index’s 50-day moving average was close to crossing below its 200-day moving average. This is known as the death cross because it sometimes signals that the overall trend is changing from bullish to bearish.

Traders ran all the previous times in history these moving averages crossed down and found that, historically, it has actually been a more bullish development than a bearish one. In fact, it got so popular to poo-poo the “death cross” that even CNBC and Jim Cramer ran with it calling it a “bull signal.”

The index has lost nearly 10% in the 3 weeks since then.

“To achieve superior investment results, you have to hold nonconsensus views… and they have to be accurate. That’s not easy.” -Howard Marks

Once the crowd takes up an idea it’s just probably not going work out. Once everyone viewed the Russell 2000 death cross as a buy signal – and probably positioned themselves that way, who was left to buy and provide the incremental demand to make the signal work out? Nobody.

Right now traders are looking at all kinds of bullish signals for stocks based on the “history” of the past two years. And as much as I appreciate the value of a quantitative approach, I worry that this type of analysis may have become too consensus and “mechanistic” for my liking.

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Obscene Risk Hidden In Plain Sight

Recently there have been numerous major economic agencies warning of the growing and severe risks in the debt markets. Investors have shrugged them off as they seem to think that their bond fund is immune as are equities. They’re not.

The Geneva Report, released last month, revealed that there has been no progress made in reducing debt levels around the world in the years since the financial crisis. In fact, debt levels have only grown over that time, even here in the US. This should be worrisome, they report, because, “there is considerable evidence that a high stock of debt increases vulnerability to the risk of a financial crisis.”

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Chart via Geneva Report

Clearly, the BIS is looking at the same research because back in July they warned these growing debt levels could kick off ‘another Lehman.’ BIS General Manager, Jaime Caruana, told the Telegraph, “We are watching this closely. If we were concerned by excessive leverage in 2007, we cannot be more relaxed today.”

This week, the IMF joined the chorus:

…Prolonged monetary ease has encouraged the buildup of excesses in financial risk-taking. This has resulted in elevated prices across a range of financial assets, credit spreads too narrow to compensate for default risks in some segments, and, until recently, record-low volatility, suggesting that investors are complacent. What is unprecedented is that these developments have occurred across a broad range of asset classes and across many countries at the same time.

For all of these bankers, economists and regulators, there’s just too much debt for their liking and much of it carries too much risk – and it’s spread beyond the debt markets to a broad variety of other asset classes. That’s funny because even the Fed has been warning about the very same thing lately! And they’ve pointed their finger directly at the leveraged loan market.

There’s not really one definition for these things but leveraged loans are typically floating-rate loans made to companies that carry an above-average amount of debt and, for this reason are labeled, “high-yield” or “high-risk.” The “high-yield” might actually be a misnomer because lately these things have been issued at a rate of around 5%. Many of these loans are used for leveraged buy-outs and the “high-risk” label is right on the money.

Back in 2012, the volume of these sort of loans rebounded to a new all-time record as investors, hungry for yield in a zero-interest rate environment, couldn’t get enough of them. Last year blew 2012 away and this year is on track to do even more than last.

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Chart via Dallas Fed

What’s more troublesome than just the sheer volume of these loans is the quality. Although the Fed has advised bankers not to loan an amount greater than 6 times EBITDA to any given borrower, in the third quarter of this year new LBO debt levels ran 6.26 times EBITDA. This amount of leverage would normally be very risky but it is especially troublesome today because current EBITDA for these companies is based on record-high profit margins. Should margins contract at all, it would make these borrowers less likely to be able to service their debt. In other words, a simple reversion in profit margins closer to their historical average level would probably mean rising defaults, maybe dramatically so.

With yields currently at 5%, investors in these loans currently don’t need to worry about defaults hovering around the 2% level (unless you think a net 3% return is silly for the amount risk you’re taking, as I do). But prior to the financial crisis, before the s*** even began to hit the fan, default rates were nearly twice that level. At the height of the crisis defaults soared to nearly 13%. Now consider that these companies are more highly leveraged than ever and a huge portion of their debt floats at rates that are now near record lows.

On top of that, the share of “covenant-lite” loans has soared. These are loans that place fewer restrictions on the borrowers and give lenders less recourse in the event of a default. So when (not if) defaults rise again lenders will feel more pain in these sorts of loans than they ever have before.

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Chart via Dallas Fed

Richard Fisher summed it up fairly well recently saying, “the big banks are lending money on terms and at prices that any banker with a memory cell knows from experience usually end in tears.” And this time it will be more than just bankers’ tears. Shadow bankers will be affected, too. And by “shadow banking,” I mean your bond fund (among other things).

From the IMF:

While banks grapple with these challenges, capital markets are now providing more significant sources of financing, which is a welcome development. Yet this is shifting the locus of risks to shadow banks. For example, credit-focused mutual funds have seen massive asset inflows, and have collectively become a very large owner of U.S. corporate and foreign bonds. The problem is that these fund inflows have created an illusion of liquidity in fixed income markets. The liquidity promised to investors in good times is likely to exceed the available liquidity provided by markets in times of stress, especially as banks have less capacity to make markets.

This may be why the Fed has been chastising the banks so much lately. Maybe they know how much more difficult a “shadow banking” crisis would be to deal with than just your run-of-the-mill “banking crisis.”

Anyhow, what is troublesome right now is that it looks like profit margins might have already begun to revert. This  puts pressure on all of these highly leveraged companies and makes the prospect of defaults more likely. This is probably why credit spreads have recently widened to their highest levels of the year, breaking the multi-year downtrend that inspired the boom in the first place. All in all, this could be the beginning of the end of the “reach for yield” in this cycle.

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Chart via St. Louis Fed

What I find most fascinating about the whole thing, however, is that the demand or appetite for leveraged loans is so closely correlated to the stock market. The black line in the chart below tracks the PowerShares Senior Loan Portfolio, a leveraged loan ETF with $6.5 billion in assets, relative to the 5-Year Treasury Note price (roughly the average weighted duration in the ETF portfolio). The S&P 500 Index is also overlaid. Clearly, the risk appetite for leveraged loans is nearly perfectly mirrored by the stock market.

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Chart via StockCharts.com

Now I don’t know if this correlation will hold up going forward but it sure looks like risk appetites across asset classes are currently dancing to the same beat. And if this credit cycle is going to end in tears then it may be hard for equity investors to avoid a similar fate.

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The Trend Is Now Your Frenemy

I titled my latest weekly newsletter (subscribe here for free), “The Trend Is Still Your Friend But Beware The Fat Tail.” After today’s action, however, you could make the case that the trend might be more of a frenemy at this point.

Stocks sold off across the board and all of the major indexes have now lost their weekly uptrend lines and 20-week moving averages.

The Russell 2000 Small Cap Index has been leading to the downside ever since it peaked back in June. It has now broken the uptrend line that dates back to the 2009 low. It’s also formed a series of lower highs and lower lows, the definition of a downtrend.

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The Nasdaq started testing its uptrend line last week but managed to close above it on Friday. Today, though, it broke it again along with its 20-week moving average. We’ll see if closes the week below or manages to pull another late-week rally.

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Finally, the S&P 500 looks fairly similar to the Nasdaq in that it’s broken below both the weekly uptrend line and the 20-week moving average. The wedge pattern/ending diagonal on this chart is also worth noting because when these pattern work they usually see all of the gains made inside of them given back. That would take this index all the way back to roughly 1,100 (45% decline from the highs). I’m not saying this is likely, just that’s it’s possible.

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So the weekly charts are suggesting the current trend, that dates back to at least late 2012, may be coming to an abrupt end. It all depends on the latter two indexes and whether they intend to follow the Russell 2000. As I’ve written recently, the Russell could be an important canary in the coal mine not only in a fundamental sense but in a technical one, as well.

For more information about “trend following” read this.

UPDATE (10/10/14): The Nasdaq and the S&P 500 both finished the week lower resulting in a weekly close below these trend lines and their 20-week moving averages.

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