Investment Strategy by Jeffrey Saut

The Week That Was
By Andrew Adams, CMT
October 27, 2014

In the June 26th edition of the Morning Tack, Jeff Saut wrote, “I do believe the VIX bottomed last Friday (6/20/14) with an undercut low, much like the undercut low of October 4, 2011 that we identified as the ‘valuation low,’ and recommended should be bought with the SPX trading back then at 1075.” Well that proved to be fitting timing, since from that 6/20 low to the high on Wednesday 10/15, all the VIX did was shoot up about 200%! Now remember that the VIX (CBOE Volatility Index) is essentially the market’s expectation of volatility over the next 30 days, so when the index rises as much and as quickly as it has over the past few months, it conveys that investors believe that things are likely to really start picking up in the trading sessions ahead. Volatility shouldn’t be a dirty word, since, technically, markets can be volatile on the upside too, but these days the term is often synonymous with risk, and an expectation of volatility is generally understood to mean an expectation of lower prices or values.

As you can see in chart 1 on page 3, spikes in the VIX have historically been witnessed during intermediate-term corrections and pullbacks when equities are falling, and these spikes can also be used to help identify selling climaxes that may indicate that sentiment has reached an extreme. This is one of the reasons I was so convinced that the sharp moves experienced on Wednesday, October 15th represented a selling climax and believed that stocks could be ready to bounce back. The VIX had skyrocketed to its highest point since late 2012, more than doubling in just about three weeks, and sentiment definitely felt stretched too far to the negative side.

This past week we witnessed the snap-back rally meant to correct the extreme oversold measures we were seeing. The S&P 500 gained 4.12%, bringing its total appreciation to 7.9% since the Wednesday, 10/15 low. At the same time, the VIX collapsed by about half in only a week, recording the fourth largest five-day decline since 1990. This decline brings the Volatility Index to an interesting point on its chart, as it appears to be retesting a trendline that has proven to be very important over the past few years (chart 2). Even more curious, the S&P 500 is concurrently going through a significant retest of its own, hitting resistance after throwing back to the major trendline that had held all its declines since the 2009 bottom before it finally gave way on a closing basis two weeks ago (chart 3). Getting these two simultaneous challenges of respective support and resistance could mean that we have once again hit a point where probabilities favor some more downside, an outlook supported by a few short-term overbought indicators hitting extremes like the percentage of stocks above their 10-day moving average. This measure is at its highest point in the past three months according to Lowry’s, and at levels historically consistent with short-term tops. The result could be that we still get some sort of retest of the recent lows, but we will just have to see because this bounce-back has been much stronger than I initially anticipated.

Indeed, breadth readings this week show that we are seeing much of this market taking part in the rally, with about 78% of NYSE issues and 69% of NASDAQ stocks advancing over the last five days. We also had more than double the number of companies on the NYSE hit new 52-week highs than 52-week lows, a nice reversal from what we experienced a couple of weeks ago when we had more companies falling to new lows than at any point since the 2011 correction. Interestingly, the stocks hit hardest during the recent downturn have come roaring back the most, as can be seen from the wonderful study done by Bespoke Investment Group included at the end of this commentary (chart 4). Bespoke broke the market up into deciles by performance during the 9/18-10/15 sell-off and, sure enough, the deciles that fell the most have returned more during this recent rally. This pattern goes against what the textbooks will teach, as they typically recommend buying those companies that demonstrated great relative strength by holding up the best during a pullback. Over the last couple of years, however, the reverse has seemed true, perhaps because the companies that have been punished the most have more ground to recoup. This view does make some intuitive sense, too, since sectors that hold up during a downturn are often defensive and being bought mainly because of their supposed safety. When markets resume their uptrend, there isn’t as much reason to hold these defensive stocks so they are often sold and the money flows back into those perceived “riskier” companies.

A more qualitative piece of evidence that this market is stronger than most expected is the market’s lack of reaction to the news that came out Thursday about the New York City doctor contracting Ebola. Such headlines would have likely been enough to send equities into freefall just a week ago, but investors apparently shrugged off the concerns and showed enough demand to allow all the major indexes to finish in the black on Friday. When a market ignores negative headlines like this, it is usually a very good sign and indicative of underlying strength.

Investor attention has apparently shifted more to earnings season, and the results, thus far, have been healthier than expected, with 80% of S&P 500 companies beating profit estimates and 61% bettering revenue forecasts (source: Bloomberg). Furthermore, many participants likely remain convinced that the Fed will be there to support the market if the situation deteriorates, as the indexes have practically gone straight up since October 16th when St. Louis Federal Reserve Bank President James BULLard (a very fitting surname, by the way) advised policymakers to delay the end of quantitative easing until inflation nears the Fed’s target.

This coming week should give us another round of fresh economic news to digest, as the calendar is filled with a few important releases to note. The news flow actually started over the weekend, with the results of the European Central Bank’s stress test of banks in the Euro currency bloc. One in five banks reportedly failed the stress test at the end of last year, according to Reuters, but most have since repaired their finances, so we shall see today how investors view that news. The announcement of Pending Home Sales for September is due at 10 a.m. EDT today, and we get updated Durable Goods Orders and Consumer Confidence numbers on Tuesday. Wednesday brings the economic news most likely to move the markets, when we get the Federal Open Market Committee’s most recent policy statement. The advance estimate for U.S. GDP the third quarter is due Thursday. These latter two announcements will only add to the intrigue produced by the busiest week of earnings season, as almost a third of S&P 500 companies will report over the next five days. So there should be no shortage of newsworthy items to discuss and consider this week, and fresh news often brings volatility with it.

And that leaves the call for the week: In short, we are likely due for another round of selling, but we may not make it all the way back down to the recent lows if this current bout of strength is to be believed. Still, the S&P 500 has hit resistance while the VIX has hit support, a potential combination for lower prices, so I advise some caution here and it may make sense to wait for a better entry point for any new purchases.

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No More Black Mondays
October 20, 2014

In a true demonstration of impeccable and apropos timing given the recent volatility we have experienced, yesterday marked the 27th anniversary of one of the stock market’s most infamous and chronicled events. “Black” Monday, October 19, 1987 was one of those multiple standard deviation occurrences that statisticians will tell you are not supposed to ever really happen, but as is the case more frequently than most realize, it of course did happen, and its impact is still being felt today even as there are fewer and fewer investors around that actually had to suffer through it. The Dow Jones Industrial Average lost over 22% of its value that fateful day, a decline that takes on even greater significance when you consider the Dow hasn’t undergone a 20% or greater slide over any time period since the 2008-2009 bear market (we came close in 2011, but no cigar). Having that much wealth wiped out in a single session will understandably leave its mark in financial lore, and since then, it has been responsible for countless market gurus attempting to predict when the next such impossible Black Swan crash will occur. You may have even heard some rumblings lately that the current market pattern is similar to 1987, a belief that makes for a good headline but is most likely better at generating mouse clicks than it is at actually forecasting the direction and magnitude of the next move. Anything can happen, of course, but I would like to point out that in 1987 the DJIA had soared an incredible 44% year-to-date at its August high, while our current 2014 version did not even manage a 5% gain at its September 19 top. There are still some issues under the hood of this market, but unless we see some drastic deterioration, I remain hopefully optimistic that the “once-in-a-lifetime” 1987 crash will continue its path toward being just a distant memory and that history will not subject us to a 2014 variety.

With that being said, the equity markets still do not feel completely healthy, and it remains to be seen if last week’s wild rollercoaster action was enough to fully shake out the weak holders so the uptrend can resume. As we wrote in both Thursday’s and Friday’s Morning Tack, it certainly feels like we got a selling climax on Wednesday, but this week will be very crucial in determining whether or not we have truly begun the bottoming process. Strangely, I would have felt a little bit better if we had lost just a tad bit more last week in order to fully get the 10% correction in the S&P 500 that we have been expecting since the beginning of 2014. It’s now been almost 2 ½ years since the last 10% dip, and I’d like to go ahead and get it out of the way, if only so we can stop talking about it. By my math, the S&P 500 will need to touch 1817 in order to make it official, and so we almost seem destined for at least an undercut low to take it out once and for all. As I wrote Friday:

The action most consistent with a bottom would be that we get a decent oversold rally that takes us up near the major moving averages before another round of selling brings us back down to challenge Wednesday's low. Then, if the low can hold, we will have an opportunity to take a real shot at the next leg of the secular bull market that we still believe is in effect.

Even if we do get an undercut low that falls slightly below the one from last Wednesday, it does not negate the bottoming process, in my opinion, but ideally it would not stay under that low for long or stretch too far underneath. We do not want to see evidence of renewed broad-based selling, so hopefully any further weakness takes place on lower volume and is not as sharp as what we saw the past couple of weeks. The fact that we are having a pullback is not altogether surprising given the run we’ve had [the fifth longest streak of days above the 200-day moving average in the S&P 500’s history, according to Bespoke Investment Group (see Chart 1)], but we’re obviously near levels where we want to start to see some increasing demand from buyers who feel we’ve corrected enough.

Along those lines, it would be a boon to the market if the small caps can continue their recent spurt of outperformance. Perhaps lost in all the craziness of last week was that the Russell 2000 actually managed a gain of around 2.75%, particularly impressive considering the small caps have routinely underperformed large caps since the beginning of March. In Chart 2, you can see how the relative strength trend has been steadily in favor of the S&P 500 over the last few months (small caps are outperforming when the line is moving up and underperforming when it is moving down). One sign of a healthy market is when we have broad participation across the different classes of stocks, and most strong bull markets have historically featured the small caps as leaders, not laggards. So it would likely only help things to get some renewed interest in the smaller, more speculative stocks. At this point, we cannot tell if this recent pick-up in strength in the Russell 2000 is the beginning of a new trend or solely a result of small caps being relatively more oversold than the large caps, but I will be watching the line in the aforementioned chart very closely and would like to see it start rising again like it mostly has done since the 2009 bottom.

We are now in the heart of earnings season, too, which will continue to provide sort of a status report as to how much the perceived global growth slowdown is affecting actual company performance and future outlooks. Analysts on the Street have been ratcheting down earnings estimates recently, having lowered forecasts for 728 companies in the S&P 1500 over the last four weeks compared to raising estimates for only 372 (source: Bespoke Investment Group). The question now becomes whether or not analysts have lowered the market’s expectations enough to allow for some positive surprises, as a number of earnings and revenues beats could be an impetus to get things rolling again.

Europe may be playing its respective part, as well. Despite being the setting for many of the current issues the world markets face, the Continent actually finished last week with somewhat of a flourish and the iShares S&P Europe 350 Index Fund (IEV/42.22) looks to have made a hammer candlestick pattern, which is typically bullish in the short term (see Chart 3). If things can settle down across the pond and U.S. earnings turn out not to be the disaster many fear, it could set us up for another run at the highs to finish the year.

The call for this week: We are still in the early stages of what could be a bottoming pattern, but internal market indicators such as breadth readings still need to show improvement. Friday’s high in the S&P 500 was stopped practically right at the 200-day moving average and that appears to be the first resistance level in the way of higher prices. If we cannot overcome the 200-day soon, then we could fall right back toward the lows of last week, perhaps touching the 1817 point that would give us the true 10% correction. The April low sits right underneath at around 1815, which should provide fairly strong support.

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The Right Question
October 13, 2014

In this business it has been said, “Sometimes knowing the right question is more important than actually knowing the answer.” Over the years I have found that old Wall Street axiom to serve me well. One example would be reading the footnotes in a company’s annual report. My father taught me that trick years ago along with reading the auditor’s statement. Verily, the first thing I do when opening an annual report is to read the two aforementioned items first. That habit caused me to ask the question, “What are all of these transactions taking place between various partnerships inside the Enron Corporation?” Subsequently, I never purchased shares in Enron.

Currently, the question I have been fielding from investors the most has been, “Have we begun a bear market?” Why such questions are surfacing with the S&P 500 a mere 4.3% off its all-time closing high of September 18, 2014 (2011.36) is a mystery to me, but there you have it. Since July I have suggested the stock market just doesn’t feel right despite the recent Dow Theory “buy signal.” Make no mistake, on a strategic basis I firmly believe that we are in a secular bull market that has eight to ten years left to run. However, on a tactical basis there have been numerous negative divergences ever since the U.S. dollar began its upward moon shot in July. I have written about the Operating Company Only Advance/Decline Line’s upside non-confirmation, as well as the negative price divergence where the small/mid-capitalization stocks were falling while the large capitalization companies were hovering near their highs. That gave the illusion everything was okay because the major indices were near all-time highs, but clearly that was not the case.

Indeed, I recently sliced and diced Raymond James’ research universe of 1025 stocks and found that the average stock was down about 19% from its 52-week high with many stocks down a lot more than that. Such negative price divergences get resolved in one of two ways. First, the large cap complex hangs in there while the small/mid-caps correct, allowing the overall equity markets to rebuild their internal energy for another leg to the upside. Second, the weakness in the small/mid-cap complex eventually spills over into the large-caps as they follow the small/mid-caps into the netherworld. Until the past few weeks it appeared the first option was going to play. Over the last two weeks, however, the large-caps have joined on the downside. Currently, investors’ eyes are focused on the S&P 500’s (SPX/1906.13) intraday reaction low of 1904.78 that occurred on August 7, 2014, as well as the SPX’s 200-day moving average at 1905.22. If the SPX fails to hold those levels it would most surely cause a test of the often mentioned 1890 – 1900 support zone, which in my view would likely fail to hold. In fact, the D-J Industrial and the NASDAQ Composite have already closed below their respective 200-DMAs. If the SPX follows, the question then becomes, “Are we finally going to get the 10% to 12% pullback the historical odds have suggested should happen sometime this year?” While markets can do anything, and it doesn’t necessarily mean such a pullback has to happen, in this business you play the odds or they carry you out in a box. For the record, a 10% decline in the SPX would target 1810 on the SPX, while a 12% drawdown foots to 1770. Perhaps the Russell 2000 (RUT/1053.32) is already pointing the way lower, having fallen through its major support level of 1080 (see chart 1 on page 3).

Obviously volatility is back, as we opined last July when targeting the low in the Volatility Index (VIX/21.24) below 11 (see chart 2). The statement back then was that, “Periods of low volatility are typically followed by periods of higher volatility;” and, last week certainly proved that point. On Tuesday the SPX was down 1.5%+, Wednesday it rallied 1.5%+, again on Thursday the SPX fell 1.5%+. As the keen-sighted folks at Bespoke note, “This kind of three-day action has only occurred 54 prior times in the S&P 500’s history going back to 1928. ... Over the next week, the S&P has averaged a gain of 1.13% with gains 12 of the last 14 times going back to 1939. Over the next month, the S&P has averaged a gain of 2.71% with gains 24 of the last 28 times.” I certainly hope it plays that way this time, but I am going to continue to “sit on my hands and do nothing” until the stock market registers an all clear signal. Manifestly, I know old traders, and I know bold traders, but I don’t know ANY old and bold traders!

To be sure, the three most talked about charts over the past few months have been crude oil, the U.S. Dollar Index, and the 10-year Treasury note. Speaking to oil, more than a month ago I wrote about crude’s demise when some of my D.C. contacts telegraphed the U.S. and Saudi Arabia were going use oil as a weapon, and pressure the price lower, to penalize Russia and ISIS. It was also noted the downside level was probably $80 to $85 per barrel because below that would be detrimental to Saudi Arabia’s social agenda. And, here we are with the November crude oil futures dipping below $85 per barrel over the past two sessions (chart 3). As for the dollar, two weeks ago today I scribed, “I think the U.S. Dollar Index tops this week on a trading basis” (chart 3). So far, that looks like a pretty good call. On the 10-year Treasury note, however, I have been dead wrong. With a yield of 2.3%, many pundits are warning the 10-year is signaling recession and deflation. I am not one of those pundits. I think the yield yelp is more about what is going on in Europe and Draghi’s “QE-like” announcement, which I do think is finally going to kick-start Euroland because Europe has reached the “end game” where the consequences would be terrible.

One thing for certain, the market mauling has left eight of the ten S&P macro sectors very oversold. The two most oversold are Energy and Materials, while the two most overbought sectors are Consumer Staples and Utilities. In screening the S&P 500’s largest energy stocks, the ones from Raymond James’ research universe that are the most oversold, and are positively rated by our fundamental analysts, include: Halliburton (HAL/$54.29/Strong Buy); Baker Hughes (BHI/$56.68/Strong Buy); Cabot Oil & Gas (COG/$29.34/Outperform); and Devon Energy (DVN/$59.42/Outperform). And yes, I know the chart patterns look terrible.

This week the markets will face a much more active economic calendar with the most important releases being Producer Price Index, Retail Sales, Fed Beige Book, Industrial Production, Building Permits, and Housing Starts. You can see Raymond James Chief Economist Scott Brown’s estimates for said releases in chart 4. This week will also feature a torrent of earnings reports. Analysts’ earnings estimates have been ratcheted down significantly over the last few months for various reasons. My sense remains, as it has for the last three years, that earnings will still look good, providing a downside cushion for stocks at lower prices.

As for all the questions about Ebola, at this stage the impact is unknowable. My belief is that the estimated death of 1.2 million people is unreasonable in today’s medical world. While it is true the Spanish flu pandemic from 1918 to 1920 killed 50 million people, there were many exceptional factors that contributed to the deadliness of that pandemic. The most recent precedent would be the SARS crisis of 2009. A mild pandemic, such as the Hong Kong flu (1968 – 1969), could reduce global GDP growth by 2%. Of course if it turns out to be a major pandemic, the world’s GDP could be more severely impacted. It is obvious that the travel/resort industries would be hurt by such a pandemic, but the networking/handset industries could benefit as people stay home and work. In any event, I am not yet all that concerned about the impact of Ebola on our country’s economy. I do wish I had acted on one portfolio manager’s advice to buy cocoa futures since the Ivory Coast, the world’s largest producer of cocoa, has closed its borders to African workers to pick its cocoa beans with a concurrent rise in the price of cocoa.

The call for this week: Given the oversold nature of the equity markets it would not be a surprise to see a rally attempt, but I do not think it is sustainable. As stated last week, I think rally attempts here are a “bull trap” that will eventually lead to lower prices. Indeed, the Russell 2000 is down 13.2% from its July high as stocks have suffered their worst decline since the European crisis of 2011. This is an option expiration week so volatility should remain high. This morning we have better economic news out of China, there are scuffles in Hong Kong as protesters knock down barricades, Kurds hold off ISIS in Kobani, and Turkey says the U.S. can stage air attacks from its bases if we agree to topple Assad. The result has the preopening SPX futures up 6 points, but while there may be a rally attempt, I would not trust it.

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