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‘The Waiting Is The Hardest Part’

the-empty-stock-exchange-floor-justin-guariglia

I don’t have much to write about this weekend as we are basically waiting on the Fed’s “taper” decision next week and watching the Syria diplomatic debate as we creep closer and closer to the debt ceiling. I will direct your attention, however, to a few other posts I’ve written over the past couple of weeks that may have flown under your radar:

Have a great weekend.

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8 Reasons This Selloff Is More Than Your Average Correction

yogiNow that stocks have finally started to pull back from record highs investors are probably asking themselves, ‘is this a standard correction or something more than that?’ I believe we are in the process of forming a major top and here’s why:

  • Earnings in the retail sector have come in weak. Abercrombie & Fitch, Dick’s Sporting Goods, JC Penney, Macy’s, Nordstrom, Target and Wal-Mart have all reported weaker than expected sales recently. This kind of pervasive weakness in consumer spending suggests the economy may be decelerating at a faster pace than most investors or economists currently believe.
  • Long-term technical indicators are flashing warnings. Multiple Hindenburg Omens have been triggered over the past few months and on the monthly charts both the Nasdaq and the S&P 500 have triggered DeMark sell signals. Notice that the Nasdaq 13 triggered just as it ran into the 61.8% Fibonacci retracement of the bursting of the internet bubble. And we also have an interesting 13-year (and 6.5-year) cycle peaking right now that lines up with the 1987, 2000 and 2007 stock market peaks.
  • We look to be far closer to the greed side of the sentiment cycle than the fear side. It has been over 2 years since the VIX “fear index” has risen above 40. The demand for put option protection is nearly nonexistent as investors see no need to protect their portfolios when stocks just go straight up like they have for most of this year. Finally, margin debt has exploded this year, reaching levels not seen since the stock market’s prior peaks in 2007 and 2000 suggesting investors are just as euphoric today as they were then.
  • Stocks are currently valued at levels seen only at prior major market peaks. What’s more the historically high valuations are based on record high profit margins. Should profit margins simply revert to mean levels along with valuations stocks could easily lose half their value as they did after the 2000 and 2007 peaks.
  • The rise in interest rates could have major repercussions on economies and financial markets around the world. The 1987 crash came on the heels of an interest rate surge that is very similar to what we have seen over the past couple of months. As I wrote last week, these types of events typically have all kinds of unforeseen “butterfly effect” consequences in markets around the world.
  • Emerging markets are already showing cracks and this could be the canary in the coal mine for developed markets like ours. The last time we saw the sort of market action we are now seeing in Asia was during the 1997 and 1998 “financial contagion” events. Investors have typically been wise to heed these kinds of warnings in the past.
  • Another area that looks vulnerable to the interest rate rise is housing, which has been a major source of economic strength recently. Robert Shiller, Yale professor and author of “Irrational Exuberance,” recently said he sees excessive speculation in housing once again that will inevitably be reversed. Should this crucial sector begin to weaken due to the run up in interest rates it could once again become the economy’s “achilles heel.” This surely would not be a boon to financial markets.
  • Finally, investors appear to be losing confidence in the Fed’s ability to support asset markets of all kinds (stocks, bonds, real estate, etc.) via quantitative easing. This could result in investors abandoning risk assets, a shift that would surely mean a major bear market is underway.

My advice? In the words of Yogi Berra, “you can observe a lot just by watching.” Investors would do well to take some risk off and simply watch how this unfolds.

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Is The Fed’s Grand Confidence Game Coming To An End?

I was dead wrong when I recently wrote “how I stopped worrying about interest rates and learned to love the long bond.” Since that time long bonds have dropped almost 10% in response to the Fed disclosing it wishes to “taper” is $85 billion per month in bond purchases. In fact, my timing could hardly have been worse. I will say I’m glad I took my losses quickly and avoided the majority of the decline over the past couple of months.

Still, I’m watching the bond market like a hawk these days. Since Bernanke started the “taper” talk the surge in interest rates has been dramatic and it has all sorts of implications for other asset classes.

tnxLet’s put it into context. The rate on the 10-year Treasury bond has risen from 1.65% at the end of April to 2.9% today. This may not seem like much but when you consider that this rise amounts to a 75% increase in our government’s cost of capital over a period of three months you start to understand how significant it really is.

In addition to the government, it’s also been significant to investors. Income-based investment classes that have appealed to more conservative investors like REITs, preferred stocks and utility stocks have all been negatively affected by the surge in rates handing these investors losses they probably didn’t imagine were possible.

There are hints that Asian markets may be affected, as well. After surging through the first few months of the year Japan’s Nikkei now looks vulnerable to a significant decline and emerging Asian markets like Indonesia (fell nearly 10% this week) have already begun to show serious signs of distress. I can’t say for sure that these are related to the interest rate surge but it’s very possible that it’s more than coincidence. We are a world economy and you know what they say about a “butterfly flapping it’s wings in the Treasury bond market….”

What I find most fascinating is that beginning soon after the “taper” talk the Fed became much more dovish in its communications and rates STILL continued to climb. On Wednesday, for example, the Fed minutes included this statement: “Almost all committee members agreed that a change in the purchase programme was not yet appropriate” making it fairly clear the committee doesn’t intend to taper its bond purchases. STILL rates surged on the announcement.

This market action suggests to me that “Bernanke’s Grand Confidence Game” may be coming to an abrupt end. Over the past few years it’s very clear the Fed’s bond buying programs gave investors the confidence to push all sorts of risk assets to record highs. It’s very possible, however, that these same investors are now losing confidence in the Fed’s willingness, and perhaps its ability, to backstop them. In fact, it looks to me like they now have decided to front run the Fed’s unwinding of its bond buying programs and this is a very dangerous game.

I recently wrote, ‘should stocks and bonds begin to fall in tandem I’ll begin to worry that the marginal demand for risk assets that has been inspired by the Fed’s actions could evaporate very quickly.’ This is exactly what’s begun to happen over the past couple of weeks. Stocks have peaked as bonds have been slaughtered and I have indeed begun to worry that the end game is near.

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10 Charts I’m Watching Right Now

Stocks have recently run to new highs, surpassing the levels they first set back in 2007. However, we have a 9-13-9 DeMark sell signal on the S&P 500 monthly chart:

spx monthlyInvestors have also become very complacent recently. I’m not referring to sentiment surveys here; we’re talking what investors are really doing with their money. And they’re not buying any put protection right now. In the past, this sort of complacency has signaled a short-term top was near.

put-callThe Nasdaq has also recently triggered a DeMark 13 sell signal on the monthly chart just as it runs into the 61.8% Fibonacci retracement of the decline that began in the fall of 2000.

nasdaqI’m watching Nasdaq darling Tesla, which has gone completely parabolic so far this year, for signs of waning momentum here.

teslaI’m also keeping a very close eye on the bond market for clues to where we are headed. The stock market strength over the past month has seriously diverged from bond weakness. Either bonds should rally or stocks sell off for this disparity to be rectified.

stocks and bondsAnd taking a look at bonds, either this support will hold and we will see a new trading range form…

tlt weekly2…or bonds will continue to selloff back to their longer-term trend line which lies about 10% below current prices.

tlt weeklyMuch of this is left to the discretion of the Fed. Their views towards maintaining or reducing “quantitative easing” will drive the action over the near term. A lot can be learned from paying attention to a very similar experiment going on in Japan where they are much farther down an even more aggressive path of central bank easing.

I’m watching the Nikkei to see how investors are reacting to the Bank of Japan’s uber-aggressive policies. After starting the year on fire the Nikkei has struggled to keep its momentum and risks forming an awkward head and shoulders top.

nikkeiFurthermore, a longer term look shows the index running into very significant resistance.

nikkei monthly

As for the Nikkei, it’s been trading largely on what the Yen is doing. A strong Yen means investors don’t believe the Bank of Japan has the power to stimulate enough to make a real difference. Either that or they are not aggressive enough relative to the Fed. And the Yen looks to be forming a fairly rounded bottom here.

yen

Regular readers know I’m not bullish on the stock market’s current prospects. Obviously, I don’t know what the future holds but these charts will tell the story as it unfolds.

See all of my public charts at StockCharts.com

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Don’t Believe The Hype Of “Forward Earnings”

According to a variety of valuation metrics stocks have only been more expensive than they are today on two occasions: the 1929 stock market bubble and the 1999 stock market bubble. Relative to history then I think it’s safe to say that stocks are “very expensive” (aka, very risky) at current levels.

But this is not what Wall Street would have you believe. Wall Street only makes money when you, the retail investor, are a buyer so to keep you buying they play a shell game with both earnings and valuations to keep you hitting the buy button. One way they do this is to focus your attention on stock prices relative to “forward earnings” – a fancy term for analysts’ predictions for what companies will earn in the future.

Below is chart of the S&P 500 compared to “forward earnings” (via Crossing Wall Street). I’ve seen charts like this popping up everywhere lately.

image1345It looks great; doesn’t it? This chart makes it look like stocks should keep going up forever.

The problem is that this chart looked just like this at the 2000 and 2007 stock market tops just before stocks fell roughly 50%. So what gives?

Well, near market peaks investors tend to forget that everything, including the economy and the stock market, works in cycles and, in the words of the Federal Reserve, they, “extrapolate recent price action [or economic action] far into the future.” (This quote comes from a study the Fed did to determine how bubbles are formed.)

What analysts know and should prevent them from ‘extrapolating the recent earnings growth far into the future’ is that outside of financial companies, earnings growth actually turned negative last quarter. What’s more the strength in financial companies’ earnings is based on bogus accounting (reduced loan loss reserves are not real earnings and portfolio losses from rising interest rates are no longer reported). To my mind this makes these “forward earnings” numbers nothing more than hope… and you know what they say about hope as an investment strategy.

Professional investors understand this and I believe it’s the reason they’ve taken the opportunity over the past four weeks to dump a massive amount of equity exposure onto retail investors who are suddenly eager to buy both the Wall Street fairy tale of “forward earnings” and the stocks they are selling in the telling.

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