Oversold Bounce, Relative Risk, More Downside Potential

Oversold Bounce

“Stocks have the best day since May 8th!”

That was the headline that was plastered all over CNBC yesterday as the S&P 500 finally was able to get a bounce after days of weak performance.

As I penned on Monday the bounce yesterday was expected:

“On a very short-term basis, the market has gotten very oversold over the last several weeks as noted below. That oversold condition will likely facilitate a bounce in the days ahead.”

I have updated the chart below to include that expected bounce.

Wednesday's SPX

Wednesday’s SPX

That very oversold condition on DAILY basis provided the setup for any piece of “news” to send shorts scurrying to cover positions. These short covering rallies have been the hallmark of the markets since the beginning of the year. Importantly, the market held its 150-day moving average which has been the bullish trend support back to the beginning of 2013 as QE3 was launched. However, the market needs to move to new highs to re-establish the bullish trend.

However, while it was certainly an impressive rally, unfortunately it did not cure the deteriorating condition below the surface. As shown in the chart below, every sector of the S&P 500 is seeing the percentage of advancing stocks on the decline.

Tuesday's SPX

Tuesday’s SPX

This is extremely important as a further advance of the “bull market” will be difficult until the trend of advancing versus declining issues reverses.

Since March, there has been little reward generally for investors. The good news is that, so far, stocks have held their ground exceptionally well given the weak economic reports and the overall earnings/profits picture.

Are Stocks Cheap Relative To Bonds?

Earlier this week I took a look at the “quality” of earnings and the question of whether valuations are actually “higher” than currently stated. To wit:

“It is worth noting that until financial engineering took hold in 1990, the economy grew faster than wages/profits. Since 2000, the wages/profits ratio has become detached from all reality.”

Wages, Profits And GDP

Wages, Profits And GDP

This detachment leads to another problem that is arising for investors – valuations.

There is some truth to the argument that “this time is different.” The accounting mechanizations that have been implemented over the last five years, particularly due to the repeal of FASB Rule 157 which eliminated “mark-to-market” accounting, have allowed an ever increasing number of firms to “game” earnings season for their own benefit. Such gimmickry has suppressed valuation measures far below levels they would be otherwise.”

The reason I reiterate this point is due to a note from John Hussman discussing the “cheapness of stocks relative to bonds.”

I’ll repeat what I’ve called the Iron Law of Valuation: every security is a claim on a very long-term stream of future cash flows that will be delivered into the hands of investors over time. Given that expected stream of future cash flows, the current price of the security moves opposite to the expected future return on that security. The value of a share of stock is determined by far more than current earnings, and one’s estimate of value will be ill-formed if current earnings aren’t a sufficient statistic for the long-term earnings trajectory.

Moreover, market valuations, prospective equity returns, and actual realized equity returns have historically been only weakly related to the level of interest rates (even long-term interest rates). The long-term rate of return priced into stocks is far less correlated and less sensitive to interest rates than investors seem to believe.

Read: “Fallacy Of The Fed Model” For Additional Information

“But aren’t stocks “cheap relative to bonds”? Unfortunately, the evidence suggests exactly the opposite. Indeed, despite a yield to maturity of hardly more than 2% annually, Treasury bonds are still likely to outperform the total return of the S&P 500 over the coming decade. The following chart presents the difference between the estimated 10-year total return of the S&P 500 and the yield-to-maturity on 10-year Treasury bonds, compared with the actual subsequent return of the S&P 500 in excess of 10-year bond yields. We estimate that from current valuations, the S&P 500 will underperform Treasury bonds by more than 2% annually over the coming decade. We’ve never observed a similar level of stock vs. bond valuations without stocks actually underperforming bonds over the subsequent 10-year period. Next, look at bear market lows such as 2009, 2002, 1990, 1987, 1982, 1978, and 1974, and recognize that the completion of every market cycle in history has provided better investment opportunities, both in absolute terms, and relative to bonds, than are presently available. Frankly, history suggests that a rather ordinary completion to the present market cycle would involve the S&P 500 losing more than half of its value.”

Stocks Vs. T-Bills

Stocks Vs. T-Bills

More Downside Likely

The recent push higher in interest rates is likely putting the Fed on the wrong side of hiking interest rates in the shorter term. With economic growth weak in the first half of this year, the surge in interest rates will likely have a rather significant short-term impact on consumer behaviors and sentiment.

As stated above, while the overall market has held up exceptionally well so far, the risks of a deeper corrective action this summer is on the rise. This is particularly the case given the ongoing deterioration in the technical underpinnings.

The following is a monthly chart of the market and several internal momentum/strength indicators. (Since it is monthly, only the end of month closes are important.)

Wednesday's SPX (Monthly)

Wednesday’s SPX (Monthly)

As of the end of May, all internal measures of the market are throwing off warning signals that have only been seen at previous major market peaks.

These “warning” signals suggest the risk of a market correction is on the rise. However, all price trends remain within the confines of a bullish advance. Therefore, portfolios should remain tilted toward equity exposure “currently.”

The mistake that most investors make is trying to “guess” at what the market will do next. Yes, the technicals above do suggest that investors should “theoretically” hold more cash. However, as we should all be quite aware of by now, the markets can “irrational” far longer than “logic” would suggest. Trying to “guess” at the next correction has left many far behind the curve over the last few years.

These “warning signs” are just that – “warnings.” It means that we should be prepared to take action WHEN the trend of the market changes for the worse. While I agree that you “can’t time the market,” I do suggest that you can effectively and consistently manage the risk in your portfolio.

Our job as investors is to navigate the financial markets in a manner that significantly reduces the destruction of capital over time. By spending less time making up previous losses, our investments advance more quickly towards our long-term objectives.

Currently, the markets are sending a very clear warning. When the “lights” are flashing, it has generally been a good idea to “slow down” a bit to avoid the danger that may be lurking ahead.


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