Employment Numbers, Economy and Market

Economy continues to perform below expectations. Latest job numbers were OK but not GREAT. I don't think they are even good enough to justify future rate hikes. But unfortunately Federal Reserves is locked into this situation where they have already committed several rate hikes for 2016. Although they won't do four hikes in 2016, any hikes will result in a flattening yield curve and possibly lead to negative yield curve.

Yield curve inversion typically leads to a recession. Although the numbers are not showing eminent recession right now, the stock market is now surely discounting a significant slowdown in economic activity. If the economy is to enter a recession, we could see further losses in the market.

From a socioeconomic perspective, a recession/bear market in the final year of election, could pave the path for a socialist president in the form of Bernie Sanders because people will be angry towards capitalists.

Getting back to economy, industrial activity has slowed considerably, which is an indication that the manufacturing sector is already in a recession. Number of job cuts being announced reminds us of the days of the great recession, when the news was always about reduction in workforce. When you have job-cuts coupled with tightening Fed policy, restricting the money flow, it just exacerbates the economic situations.

In fact, it leads the economy into a death spiral where one negative news feeds the other negative thing and so the cycle continues. For example, reduction in jobs will result in lower spending, which will in turn reduce profits, resulting in lower stock prices and cost-cutting measures, which will result in more job-cuts.

Under these circumstances, stock market is tracing out a series of mini-head and shoulders patterns. As you know head and shoulders pattern are topping formation. These patterns also appear in a downtrend as continuation patterns. Following chart shows H&S pattern in SP500.

If market declines in the next few days, this pattern will be broken and January lows will be tested. This will allow the market to complete the right shoulder of a longer-term head and shoulders pattern (discussed here)

Under these circumstances, the best option is to stay out of the market and wait for a trend change before going long again. Bonds remain in a bull market, so they can be a good place to park cash and ride-out this rough patch in the stocks, which could last for the next few quarters (at least).

Portfolio Performance & Market Overview

Market remains in a bear market. Sharp rally of last weak as the feel of a bear market rally. Today's decline might be the start of next leg down. However, this leg might not be as long as what we saw in early January. In fact, once this phase is over, we could see a sharper rally, lasting for 2-3 weeks.

Although the above analysis is based on Elliott Wave theory, overall trend remains down. And till the time this trend turns up, we should remain cautious. Our portfolio allocation model exited long positions in August. And shorted the market at the start of 2016.

So far the portfolio is up ~5% (YTD) in comparison with ~8% (YTD) decline in the SP500. Another interesting aspect of this portfolio is that its "Beta - measure of risk when compared to SP500" is -0.56. 

Therefore, it is not correlated to the market. In a bear market, this portfolio mix not only allows us to gain from the market decline, but also enables us to protect ourselves in case of a sharp rally (like the one we saw last week).

This portfolio is an auto-allocation portfolio with diversity considerations to ensure protection against systematic risks. Asset class risk is managed by employing proprietary Bull/Bear identification mechanisms. We will keep tracking this portfolio on an on-going basis to see how it performs over the long-term. This portfolio can also be considered as the next step in our effort since March 2015 to automate portfolio management through advanced analytical and statistical tools.

As for the overall market, their is no change in the outlook. Stocks remain in a bear, while bonds remain in Bull market. There are some asset classes which have just entered a Bull market or are trying to carve not a base before entering the next phase (Oil is not one of them).

Stock Market Trend and Russell 2000

We have been discussing market and its down trend for quite some time at Understand, Survive and Thrive. It seems like this relentless downtrend doesn't want to end any time soon. Oil keeps on falling and keeps dragging the stock market with it. At some point market will rally but in a downtrend one cannot trust the rallies. In fact, hoping for a rally in a bear market is akin to hoping for a correction in a bull market.

Rallies will come but will be short and sweet. By the time people embrace them, they will be over and the primary trend will resume. One of the biggest red flag in current market is the significant under performance of Russell 2000. Russell 2000 is a small caps index and small caps are most impacted by changes in economic conditions because they are most sensitive to credit availability.

These business depend on economic growth and easy credit for their survival. Therefore, whenever you see small caps declining, its a major red flag.

In December, we highlighted that Russell 2000 ($IWM) was forming a head and shoulders topping pattern (link). The pattern looked like:

Now a completed pattern looks like following. This pattern still has another 7% decline left before it reaches its measured target level.

Small caps are already in official bear market, another 7% decline will bring the Russell 2K index in low 900s.

This analysis shows the importance of objectivity in investing and why trend following is critical. An up-trending market will find excuses to go up and a down-trending market will find fundamental and technical excuses to go down.

At this time, long-term trend in stocks is down. So every rally attempt should be treated with caution. Downtrends implication are very severe on the economy. We might be headed for a recession. Junk bonds and oil related bonds are doing poorly. This could be another area of serious concern. We will continue to evaluate the situation. But the bottom line is the best portfolio right now will be a portfolio who beta is lower than the SP500. Lower beta would reduce your risk in a down market and will allow you to preserve capital.

In the next few blog posts, I will share our portfolio which is a -0.56 beta and is beating the market since the start of the year.

Bonds Bull is Roaring

We have been discussing stock market's #Bear and Bond market's #Bull for a while. Now it seems like Bond market is really taking-off. This is evident from a sharp rally in the bonds over the last 2 weeks. Some might attribute it to the declining stock market but a bull market keeps on rising and people find reasons for the rise.

As a confirmation of the trend, bond prices have just completed an inverted Head and Shoulders pattern (shown below):

We have been discussing this pattern since December, as following charts was published here on December 21.

As bonds rally and stocks decline, we are short stocks and long bonds. Being long bonds gives us cash flow in form of dividends and being short stocks allows us to take advantage of the downside.

Like any market, this bond rally will come across obstacles but the constant cash flow and the diversification provided by this investment is invaluable, along with the potential for capital gains. At the same time, it will provide a very good opportunity and probably the last opportunity for people to buy homes at very low interest rates.

As market gets more volatile, it will even make more sense to invest in bonds. But the good time to invest in any asset class or stock is before the major move happens and the news becomes public. Let's see when the stock market bounce happens, which might provide added insight into the long-term (6 months to 1 year) market trajectory.

After all is said and done, there will be a very good opportunity to buy stocks down the road.

Nasdaq Head and Shoulders Completed

Market is declining and Head and Shoulders have played out exactly in Nasdaq. We are in a #bear and we have been discussing this scenario since August 2015. 

 

Following chart was presented on January 4, 2016 (link).



 

 

Market so far has played out Head and Shoulders pattern to the target, as shown below.

Head and Shoulders patterns are forming in many other asset classes. We will review these in the next few blog posts.