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Greatest Hits 2014

Here are the most popular TFR posts of 2014:

  1. Why Mr. Market Is Still Wrong About Apple
  2. This Is Probably The Second Worst Time In History To Own Stocks
  3. For Everyone Who Thinks Tom DeMark’s 1929 Analog Is A Joke…
  4. How To Time The Market Like Warren Buffett
  5. ATTN: DUMB MONEY – The Smart Money Is Selling To You (Yet Again)
  6. Don’t Believe The Hype Of Rising Interest Rates
  7. The New Wolves Of Wall Street
  8. Seeing The Forest For The Trees
  9. The Creative Destruction Of Wall Street
  10. The Problem With Index Funds

So we were bullish on Apple (up 70%) and bullish on bonds (up 20%) and bearish on stocks (up 15%). Well, two out of three ain’t bad.

Thanks for reading. I wish you a very profitable new year!

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It Pays To “Think Different” About Apple’s Stock Price

About 10 months ago I wrote that I thought Apple was worth $114 to $128 per share (split adjusted). That day the stock closed at $72. Today it closed at $116, 60% higher. So this morning I sold it. Here’s why:

Fundamentally, the company has gone from being very undervalued to fairly valued in a very short period of time. (Note: Carl Icahn, who is a lot smarter than I am, says the company is worth $200 per share. I just don’t know how much of this is salesmanship/optimism and how much is cautious analysis.)

I know, I know, Apple is firing on all cylinders and will probably continue to do so. iPhone 6 is selling like hotcakes even before we get into the holiday shopping season. New products are in the pipeline and Apple Pay will probably be huge for the company.

But how much of this optimism is already baked in to the current valuation? At 5 or 6x cash flow, almost none of this was priced in. At nearly twice that valuation today I’m not so sure. Ultimately, at the current price I no longer have a margin of safety. Should the company stumble, and I’m not saying they will, there’s no reason the stock couldn’t go back to the $80-95 level (where I’d probably buy it back).

Screen Shot 2014-11-21 at 12.18.53 PMAnd this is where fundamentals and sentiment get blurred. Clearly, investors don’t quite love the stock as much as they did during the summer of 2012 (will any stock be that loved ever again?) but they no longer think Samsung is going to eat the company’s lunch. So I wouldn’t say sentiment is super-frothy but a 60% run in 10 months tend to inspire at least a little euphoria and StockTwits sentiment has reflected that for some time. 90% of the messages on the site tagged with Apple’s ticker are bullish. That’s a pretty crowded trade.

As for the long-term trend, clearly it’s still bullish. But there are some signs that it may be getting exhausted. DeMark Sequential sell signals are now triggering on multiple time frames. A daily 13 sell signal registered at today’s open while another 9 sell setup triggered a couple of days ago. All this means is we are seeing a cluster of trend exhaustion signals currently:

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The weekly sell signal won’t trigger until the Monday after Thanksgiving but this time frame gives us a good look at the action over the past couple of years. The stock famously peaked in the summer of 2012 before losing roughly half its value into the spring of 2013. The stock has since rallied back and broken out above that prior high (taking the major indexes with it). A simple 1.618 Fibonacci extension projects a target of roughly $122.

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Interestingly, that 2012 peak was accompanied by a completed monthly DeMark 9 sell setup. Last month the stock triggered a monthly 13 sell signal off of that same setup. The risk level for this monthly signal sits at roughly $121. Coincidentally, that’s also the risk level for the daily signal. So according to DeMark Sequential analysis on multiple time frames, the stock could continue to run to $121-122 to test these risk levels and complete the 1.618 Fibonacci extension on the weekly chart.

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From where I sit, however, the stock has pretty much reached fair value, sentiment has shifted positively once more with investors nurturing great expectations for the holiday season and the parabolic move over the past few weeks has triggered a flurry of sell signals. So I’m not saying this is the top. I’m just saying I’ve had my fun and the risk/reward equation no longer appeals to me.

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Overcrowded Trade Du Jour: Short Volatility

Periods of low volatility are to investors what a sweet lullaby sung by whispering nanny is to an overtired baby. It relaxes them, gets them to put their worries aside and believe that everything is going to be okay. Great for babies. Not so great for investors.

Because Mr. Market is a sadistic nanny, usually lulling investors into a sense of calm and security right at the worst time.

The few years that led up to the financial crisis were the last great period of low volatility investors witnessed. Clearly, the overwhelming sense of calm in the market (lack of fear), even through the first half of 2007, was unrealistic. You may remember that all of the gains earned during those years were quickly given back and then some during the financial crisis.

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But investors were simply doing what they do best: projecting the results of the recent past way out into the future. They were lulled into believing that volatility was no longer cyclical and that the goldilocks economy meant that it was smooth sailing as far as the eye could see.

Alas, we learned shortly thereafter that volatility AND the economy AND the credit markets were, in fact, still subject to cycles.

“Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.” -Howard Marks

I bring this up today because volatility has once again witnessed a period of sustained depression and investors have once again been lulled into a sense of extreme complacency (if that’s even a thing).

ETFs that track the inverse performance of the VIX have become hugely popular this year. They have now attracted nearly $2 billion in assets, $800 million of that coming just in the month of September. In effect, these are bets that the current period of low volatility will last for the foreseeable future – that’s the only way they will make any money.

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Chart via FT.com

The problem is that the VIX currently stands at about 15. It’s lowest point in the past few decades is around 10. From the beginning of the year to early July when the VIX neared that 10-ish level these ETFs saw about a 35% gain (on about a 35% decline in the underlying index). Nice! Right?

Wrong. During the brief, not-even-10% correction we witnessed last month these ETFs declined nearly 50%!! Imagine what would happen if we actually saw a 20% decline… or more. These funds would be obliterated.

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I was recently listening to Tony Robbins on the Tim Ferris podcast and he shared an insight about one thing the world’s greatest investors have in common: they look for fantastic risk/reward setups. They look to risk a penny to make 25 cents. To me this looks just the opposite. It’s like risking 50 cents to make pennies. Good luck with that.

Further reading:

“Now that everyone’s a volatility seller…” – FT Alphaville

“Record short VIX notes sounding alarm to Deutsche Bank” – Bloomberg

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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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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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Desperately Seeking A Margin Of Safety

Back in 2000, I had one of my best years as an investor. You may remember that year marked the peak of the greatest stock market bubble in history. Anyhow, while everyone and their mom was buying internet stocks I was loading up on the exact opposite.

One of the unique things about that time was that the bubble was really concentrated in the technology sector. Outside of that there were some great values to be found in the old “bricks and mortar” types of companies.

I found a couple of those great values in Abercrombie & Fitch and Washington Mutual. I think ANF was trading around 8 times earnings despite the fact that it was still growing pretty fast and had incredible returns on new stores. And this was back when WaMu was still just a boring old thrift trading for 5 times earnings. When investors finally gave up on the high flyers they took refuge in names like these and both ANF and WaMu soared.

In 2007, things were very different. Although valuations didn’t get anywhere near those 2000 levels, there was even more pain felt as a result. There just wasn’t really anywhere to hide during the financial crisis as everything seemed to get hammered to the same degree.

Today’s market feels like a combination of these two and it honestly worries me. We currently have even higher valuations than we did in 2007 – in some cases, even higher than in 2000 (median price-to-sales ratios at all-time record highs). And the overvaluation feels just as pervasive as it did in 2007, maybe even more so (note record “median” valuations, not “mean”).

In other words, the diving board (valuation) is higher now and there’s even less water (pockets of value) in the pool than there was.

This is why I’ve spent so much time researching ways to avoid the next major bear market. Because I think it’s gonna be a doozy. So I think it’s probably wise for most investors in US stocks, at this point, to switch from buy-and-hold to a trend-following approach. Still, this assumes that the selling window, when it comes, will be wide enough and open long enough for everyone to casually exit through which is not always the case.

An alternative or complementary solution I’ve spent some time looking at is a “global value” approach. I got turned on to Meb Faber’s work a few months ago and I think this idea of his has so much merit, especially for investors in US stocks right now. There may not currently be those pockets of value within the US stock market that will help to weather the next storm but there are pockets around the world that may fit the bill.

Do yourself a favor and go read Meb’s book. It just might help you manage the next market meltdown.

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