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Pay Attention To The Warning Signs

Tyler Durden's picture




 

Submitted by Lance Roberts via STA Wealth Management,

Over the last couple of days, I have been focusing on the longer-term risks of currently overvalued markets. The primary problem with valuation measures and fundamentals, is that markets can remain detached from reality for much longer than logic would dictate. As Sam Ro pointed out, valuations are a very poor measure of short-term performance. He is right, but as I stated:

"...while valuations do not matter at that moment, they will and when they do they will matter a lot."

But it is not just valuation levels that markets are currently ignoring, but also an ongoing deterioration in economic underpinnings. As I wrote yesterday, corporate profitability is currently running at a much weaker pace than originally estimated as the economy failed to gain traction.

Despite hopes of economic liftoff, the reality has been quite the opposite as the "restocking cycle" following a very weak Q4 of 2013 and Q1 of 2014 quickly faded. The economic composite index shown below shows this most clearly.

EOCI-SP500-032415

(The economic composite index is comprised of several Federal Reserve manufacturing regions, Chicago PMI and National Activity Index, NFIB Small Business Survey and the Conference Boards Leading Economic Indicators. It is a very broad measure of the economy and tracks very closely to the ebb and flow of GDP.)

The dashed black line shows the level that has signaled the onset of a recession. It is also worth noting that since the mid-90's, as financial engineering and technology began to change the economic landscape, the growth of economic output has deteriorated. This is the basis of the "structural shift" argument that currently plagues employment and wages.

However, for today's discussion, it is important to note that declining levels of the economic composite index has been mostly a coincident indicator of weaker stock market performance or outright contractions.

Since the beginning of this year, as the economic composite has declined, the financial markets have struggled to stay afloat. This struggle can also be seen in the deterioration of price momentum and internal strength measures.

SP500-Technical-Analysis-032415

As I discussed in detail recently:

"The effect of momentum is arguably one of the most pervasive forces in the financial markets. Throughout history, there are episodes where markets rise, or fall, further and faster than logic would dictate. However, this is the effect of the psychological, or behavioral, forces at work as 'greed' and 'fear' overtake logical analysis.

 

There have been many studies published that have shown that relative strength momentum strategies, in which as assets' performance relative to its peers predicts its future relative performance, work well on both an absolute or time series basis. Historically, past returns (over the previous 12 months) have been a good predictor of future results. This is the basic application of Newton's Law Of Inertia, that states 'an object in motion tends to remain in motion unless acted upon by an unbalanced force.'

 

In other words, when markets begin strongly trending in one direction, that direction will continue until an 'unbalanced' force stops it."

As shown in the chart above, the price of the market currently remains in a positive trend but the underlying momentum and strength measures are showing signs of a negative divergence. This suggests that while market prices are trending higher, the risks of a correction are currently rising as the "supports" weaken.

Chris Ciovacco recently penned another piece of relevant analysis:

"It is typical for markets to become a bit fussy when the Fed is on the verge of shifting policy. The stock market has been following the indecisive script. As shown in the chart below, the broad NYSE Composite Stock Index has been quite volatile and moving sideways for nine months."

NYSE-Chart-1-032515

"As the Fed postures, market participants have been jumping back and forth relative to their preference for more-conservative fixed income instruments (TLT) and growth-oriented stocks (SPY). If I invested in TLT in July 2013 and you invested in SPY, there would be no winner as of March 2015 (see below)."

Stock-Bond-Ratio-032515

"The wild swings between risk-on and risk-off are part of the interest rate cycle equation. Our approach is to implement a “less is more” strategy until the market calms down a bit. Less is more refers to making fewer adjustments to our allocations during binary periods of risk-on and risk-off. For now, we continue to hold an equity-heavy allocation with some offsetting exposure to bonds and currencies...the big picture does not align with 'a bear market is imminent' scenario, which allows for some patience with growth-oriented positions."

Chris is correct in his assessment that the technical bullish trend remains intact for now, and I agree that portfolios need to remain tilted towards equity risk for the time being. However, with valuations and fundamentals not currently supportive of asset prices at current levels, it is clear that investor overconfidence has risen markedly. Since investors repeatedly fall prey to the psychological factors of anchoring, herding and the disposition effect, it will be more important to pay attention to the price dynamics of the market for early warning signs of a change in the currently bullish trend. As I will discuss momentarily, it is the disposition effect that is most critical.

Despite much commentary recently about the needs of individuals to just index their portfolios and focus on the long-term, the reality is that never happens. The "herd effect" is quite apparent as investors cling to the hopes that the markets can turn in a seventh positive return year in a row despite the stastical odds against it. However, as long as markets rise, the "fear of missing out" overrides the logic of the risk management in portfolios.

When the market eventually cracks, the "disposition" effect will trump all the good intentions of "buying and holding" for the long-term. The eventual "panic to sell" will lead to a significant destruction in investment capital and a reversion in investor psychology to extreme negativity. While the basic premise of investing is to "buy low" and "sell high," repeated studies show that there are precious few who do.

Of course, this is the psychological cycle of the market. This time is not different, and the result will be same. It will only the be the timing and the catalyst that are different.

The negative divergence of the markets from economic strength and momentum are simply warning signs and do not currently suggest becoming grossly underweight equity exposure. However, warning signs exist for a reason, and much like Wyle E. Coyote chasing the Roadrunner, not paying attention to the signs has tended to have rather severe consequences.

Wyle-E-Coyote

 

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Wed, 03/25/2015 - 16:36 | 5926766 Thirst Mutilator
Thirst Mutilator's picture

'restocking cycle?' ~ YGFBKMe

 

The only 'restocking cycle' that exists nowadays is when Wall St. runs out of counterfeit chips to gamble with...

Wed, 03/25/2015 - 17:02 | 5926847 Stuck on Zero
Stuck on Zero's picture

Aye. And the only force at work on the market today is: Fed.

Wed, 03/25/2015 - 17:38 | 5926995 negative rates
negative rates's picture

Those Phoenixville gold bars rising out the frost can make or break a guy. So can a dam.

Wed, 03/25/2015 - 17:54 | 5927057 winchester
winchester's picture

that do not mean anything

you can manipulate any number to mean anything

we do not give a fuck

fuck it.

Wed, 03/25/2015 - 19:35 | 5927361 RU-GAY2
RU-GAY2's picture

fonestar is broadcasting live!

27.425 MHz LSB

CQ CQ DX DE "FONESTAR" 73's

Wed, 03/25/2015 - 16:34 | 5926771 Chippewa Partners
Chippewa Partners's picture

The best warning sign is Cramer smiling.

Wed, 03/25/2015 - 16:37 | 5926786 beavertails
beavertails's picture

Don't worry! Count on the FED STICK SAVE by Friday and a Smack down in Gold. And you can take that to the BANK for BAIL-IN

Wed, 03/25/2015 - 16:38 | 5926790 LawsofPhysics
LawsofPhysics's picture

Stabilitee!!!!!

Wed, 03/25/2015 - 16:40 | 5926792 The Count
The Count's picture

The thing with bubbles is that they can get a lot bigger than one expects. BUT the day of reckoning always comes. The only problem is that the ones causing the bubble (ie. the banksters and bone head politicians) always get awaywith causing distress for the average population. In the end the tax payer foots the bill. About time these criminals do some serious time...Take away all their ill gotten gains, all. 

Wed, 03/25/2015 - 16:48 | 5926816 LawsofPhysics
LawsofPhysics's picture

Yes, retribution must be paid, moral hazard is a real bitch like that...

Wed, 03/25/2015 - 17:41 | 5927003 negative rates
negative rates's picture

Hey lets go over and pop a wheelie in front of counts place.

Thu, 03/26/2015 - 20:55 | 5932007 LooseLee
LooseLee's picture

Better yet; execute them!

Wed, 03/25/2015 - 16:40 | 5926796 Chad_the_short_...
Chad_the_short_seller's picture

Buying SPY calls that expire this Friday. Ready for the usual rampup

Wed, 03/25/2015 - 16:50 | 5926819 Rainman
Rainman's picture

if you are betting the boyz would sooner chew off an arm before letting the quarter end red, you are probably right.

Wed, 03/25/2015 - 16:48 | 5926815 centerline
centerline's picture

Duh.

Wed, 03/25/2015 - 16:50 | 5926823 Fun Facts
Fun Facts's picture

One of the actual issues we face is that the FED has been defeating the warning signals via open market operations.

Particularly dangerous are the VIX/Gold manipulations because these are the primary warning signals of just about any kind of impending doom you can imagine.

The FED is defeating the feedback loops until there is nothing left to protect.

That means future large dislocations.

Wed, 03/25/2015 - 16:55 | 5926832 LawsofPhysics
LawsofPhysics's picture

so, there is no spoon...

 

my hypothesis is that everything will officially be reported as "awesome" right up and including that moment you go to the grocery store and the shelves are bare.  Plenty of historical precedence for this...

Wed, 03/25/2015 - 17:00 | 5926843 astoriajoe
astoriajoe's picture

And it will be even more awesome after the shelves are bare.

Wed, 03/25/2015 - 17:43 | 5927011 tarsubil
tarsubil's picture

Can't wait for the collective, "Hey, there's no food. Wait a minute... they lied! What?!"

Wed, 03/25/2015 - 17:43 | 5927012 negative rates
negative rates's picture

Yeah, and tiny tim just gave me his worlds smallest voilen too.

Wed, 03/25/2015 - 16:59 | 5926840 lawyer4anarchists
lawyer4anarchists's picture

If you don't "get the email" on what "they" plan to do, then all the analysis in the world won't help.    Because the system is scam, and the money is printed out of thin air.  End of story.

Wed, 03/25/2015 - 17:02 | 5926848 Dead Man Walking
Dead Man Walking's picture

when things get serious, people always refer to Wile E Coyote.

Wed, 03/25/2015 - 17:08 | 5926874 orangegeek
orangegeek's picture

Good night Sam.

 

Good night Ralph.

Wed, 03/25/2015 - 17:54 | 5927056 Consuelo
Consuelo's picture

One of my favorite skits...   Get the holy shit beat outta ya for skankin' the sheep, but at the end of the day, walk home friends...   Uh... we're gettin' our asses beat but there ain't no 6% on my CD at the end of the day.   WTF...?

Wed, 03/25/2015 - 17:17 | 5926918 MATA HAIRY
MATA HAIRY's picture

Janet B. Yellin' promised Wile E Coyote a "fat-tail distribution".

 

She lied...

Wed, 03/25/2015 - 17:21 | 5926928 Stained Class
Stained Class's picture

Uh-Oh, time to run a really scary article to stir up some Bears to fuel another face-ripping short-covering rally to new highs. 

Wed, 03/25/2015 - 17:23 | 5926932 Jstanley011
Jstanley011's picture

Anybody who goes long using a buy-and-hold strategy without knowing how to hedge during times of uncertainty -- such as when the Fed is about to change strategies after nearly a decade of ZIRP -- is begging for a haircut at the neck.

Wed, 03/25/2015 - 17:39 | 5926997 Stained Class
Stained Class's picture

Do you really think Janet Yellin has any authority to raise rates? She was sent in with strict instructions to keep her hands off the wheel. She really IS a garden gnome.

Wed, 03/25/2015 - 17:45 | 5927024 negative rates
negative rates's picture

I have one of her I see at every breakfast.

Wed, 03/25/2015 - 18:56 | 5927227 mt paul
mt paul's picture

momentum doesn't last long 

 

going uphill...

Wed, 03/25/2015 - 19:13 | 5927279 Financial Paparazzi
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