Now What?

Authored by Lance Roberts via,

Market Hits Correction Levels

It seems like it was just last week, that I discussed the risk of a bigger corrective action in the market.

Because it was.

“This past week, the market tripped ‘over its own feet’ after prices had created a massive extension above the 50-dma as shown below.  As I have previously warned, since that extension was so large, a correction just back to the moving average at this point will require nearly a -6% decline.”

“But more importantly, as I have repeatedly written over the last year:

‘The problem is that it has been so long since investors have even seen a 2-3% correction, a correction of 5%, or more, will ‘feel’ much worse than it actually is which will lead to ’emotionally driven’ mistakes.’

The question now, of course, is do you ‘buy the dip’ or ‘run for the hills?’

Don’t do either one, yet.”

I know, it “feels” like we should be doing something…anything.  Right?

Here is the issue.

The markets have not done anything WRONG…just yet.

Yes, corrections do not “feel” good. But they are part of a “healthy” market cycle. In more normal, healthy, correction to bullish trends should be used as buying opportunities to increase exposure to equity risk in portfolios. As shown in the chart below, that may be what is occurring now.

Currently, we do not know whether the current corrective action is JUST a normal, healthy correction, or the beginning of something bigger.

BUT – this is the expected correction we have been discussing over the last several weeks. It is also something we had planned for by reducing overweight positions and adding a short-hedge to portfolios. 

With the markets on a short-term sell signal (noted by black vertical dashed lines in the chart above,) the current correctional process is underway. But, with the market now oversold on a VERY short-term basis a counter-trend rally over the next week, or two, should be expected. 

Furthermore, as noted above, and below, the market held support at the 200-dma and the bullish trend line which goes back to the beginning of 2016.

In other words, the market has not violated any important trend lines that would suggest the current sell-off is anything more than just an ordinary “garden variety” correction. 

It is what happens NEXT that will be most important.

The larger concern currently, is the “sell signal” which has been triggered at abnormally high levels and remains in extremely overbought territory. Such suggests there remains “fuel” for either a “deeper correction” or a “consolidation” of the markets in the weeks ahead to “work off” that “overbought” condition. Historically, markets don’t resolve such conditions by trading “sideways.” 

That is the longer-term risk at the moment and something we will discuss more in a moment.

In the VERY short-term the market did attempt to rally mid-week and failed at the 50-dma where we added to our existing short-hedge. The breakdown on Friday led to a successful test of the 200-dma, where we reduced some of our short-hedge, as the market rebounded above the previous lows.

Technically speaking, this is not a good sign and suggests the market could be in for more selling to test the 200-dma as stated. 

As stated, with the market very oversold on a short-term basis, the most probable outcome following a test of the 200-dma is a fairly strong counter-trend rally.

But should you buy it?

It depends.

  • If you are a fairly adept trader, and can enter and exit trades easily, there is a decent setup here for a “trading opportunity.”
  • If you are longer-term investor, like us, just be patient and wait for a confirmation the market has regained its “bullish bias.” 

If you like us, then “YES” you will “miss” the bottom of the market, if this is indeed “THE” bottom. However, without waiting for a confirmation the bullish trend remains intact, you risk buying into the potential start of a deeper correction which puts more capital at “risk.”

The Rate “Bang” Point

The mystery has been solved.

We now know the point where interest rates implode the market – 2.9%

With interest rates now 4-standard deviations above the 1-year moving average there are several things which likely happen in relatively short order:

  1. The Fed will quickly back off from hiking rates
  2. The Fed will likely slow or curtail their balance sheet reduction program.
  3. Economic growth will slow.
  4. Earnings will come under pressure
  5. Treasuries are likely to become a “safe haven” of choice is the current “market correction” continues in the weeks ahead. 

This will be particularly the case as the recent spate of economic growth from 3-hurricanes, 2-massive wildfires, a surge in oil prices and an extremely cold winter which boosted economic activity temporarily begins to fade. In fact, over the next three-quarters we are likely going to see lower inflationary numbers, weaker economic growth and weaker than expected earnings.

If I am right, you are looking at substantially lower interest rates and higher Treasury bond prices.

As I stated last week, the next bull market will most likely be in bonds, not stocks.

We remain long-biased to bonds. 

Has The Oil Bust Began?

Back in September, I asked the question whether the run-up in oil prices was sustainable. Given that oil prices have been a huge contributor to both earnings and economic growth in recent quarters, and the expectation that inflation was surging back, this has been a crucial commodity to pay close attention to.

RIA analyst, Jesse Colombo, recently updated his analysis on this topic and the continued imbalance of non-commercial traders which suggests the correction in oil prices has now started.

As noted above, if our analysis proves correct, and oil prices do decline further, the negative impact to economic growth combined with fading support from natural disasters will push inflation and interest rates lower. 

What Next?

The most important words for any investor to learn is “I don’t know.” 

Currently, “I don’t know” what will happen next with any degree of certainty. 

Nor does anyone else.

The “odds” favor the “bulls” currently because:

  1. Bull markets last longer than bear markets
  2. Bull markets are hard to break
  3. Bull markets can defy logic longer than most anticipate

But bulls, like bears, are only right half the time.

Unfortunately, when the “bulls” are wrong – they are “really wrong,” and the long-term damage to capital is irreparable.

This is why we maintain a focus on the “trend” of the market for maintaining portfolio allocations. When markets begin to break down, or change trend, and the risk of loss outweighs the potential for reward, we become aggressively defensive.

Currently, such is NOT the case, as the bullish trend remains intact. 

The chart below shows the weekly view of the S&P 500 index going back to 2014.

Don’t get wrapped up in the technical specifics of the indicators, but instead focus on what they indicate.

(We will provide all our specific indicators to subscribers at RIA Pro, click here to get on our list for pre-subscription information)

The market has clearly remained in a bullish trend since the lows in 2009. The vertical black lines mark the points where the lower two indicators BOTH registered a sell signal.

  • The first of the two is simply an “ALERT” signal which suggests investors should “pay attention” to their risk related allocations and rebalance those risks accordingly. 
  • When both lower signals are triggered, a confirming signal, such has generally been a good indication to more proactively reduce allocations, raise SOME cash, and further reduce risk related exposure.

Notice – I did not say “sell everything” and bury your cash in the backyard. 

Currently, the market has not violated the accelerated bullish trend nor the bullish trend support levels from the pre-2016 correction advance.

It doesn’t mean it won’t happen. It just hasn’t happened yet.

We are not trying to “guess” at what the market “will do,” we are simply “reacting” to what it “does do. “

So, while we have taken profits in some positions and added short-market hedges, there is no reason at the moment to become extremely risk averse.

The trend is still bullish. For now. 

That could change, and, as indicated by the green boxes, if it does we will act accordingly reducing risk, raising cash and hedging further as we have done previously during those specific periods.

We are certainly on high alert as there are many reasons to be cautious from internal deterioration, to rising rates and liquidity concerns.

But up to this point, this has currently been nothing more than a correction within a very extended bullish trend.

Just be patient.

We will know in a few days rather we need to sell more, or start buying.