Bonds Rally Analysis and Stocks

Market's decline on Friday was very sharp and was on top of Thursday 250+ point decline in $DJIA. This decline has brought the market to a critical support level in Nasdaq and $DJIA, while in other indices like Russell 2000 and $SPY this critical level has already been broken to the downside.

Downside break means that the near term trend has turned down. Although some technical analysts might take this decline as a trend change signal, at UST we have been suggesting that a sea change has already taken place in the stock markets in August.

Unfortunately, many market participants are still not seeing the bigger picture because they don't follow objective trend analysis. Instead, they follow the market events and try to gauge the markets response to these events. At Understand, Survive and Thrive, we have always used objective market analysis and statistical models to identify market trends and turn points.

In the last post (link), we analyze the significance of recent Federal Reserves action and suggested that although the Federal Reserves thinks that the economy is strong and they can raise rates, this rate increase could not only have negative consequences on the market but also could result in lower rates. Longer term rates are governed by the perception of the economy of market participants and if investors don't believe in the same story of strong fundamentals, they might keep on buying the bonds, resulting in lower bond yields and higher prices.

Although this concept does not make intuitive sense, it was evident in the last few days where the market went down and interest rates also went down even after Fed's rate hike.

We have already discussed the potential fundamental issues with the economy and how its depends on the perception. There are also several technical reasons behind rally in bond prices:

1. Inverted Head and Shoulders Pattern
2. Capital outflow from bond funds
3. Proprietary trend indicator

Current pattern in the bonds suggests that the longer term bonds, as depicted by $TLT below, are carving out an inverted head and shoulders pattern. As you know, inverted head and shoulders pattern is a bullish pattern and shows trend reversal from lower to higher. So it will be interesting to see how the market reacts over the next few weeks when this pattern matures and is about to break-out.

From socio-economic and sentiment perspectives, in anticipation of Fed's announcement many people jumped ship from the bonds and exited in great numbers. This could be interpreted as a potential contrarian buy signal for longer-term bonds.

Finally, as we have been saying for quite some time, bonds are in bull market for some time and will remain till model says otherwise. Therefore, we will find reasons for the bull market to continue which can be either due to economic weakness, technical rally or delay from Fed in raising rates further.

Please note that this analysis is only pertaining to high quality long-term bonds and not related to Junk bonds, which are linked to the economic activity. Weakness in economy would result in a decline in Junk bonds, as we have been witnessing over the past few months.

Fed Decision and its Impacts

After 6 years, Federal Reserves raised the Fed benchmark rate. While on one hand it signifies the fact that the underlying economy is doing well because of which Fed increased the rates, it also suggests that the market should embrace the new normal i.e. upcoming higher interest rates. Higher rates can impact many different walks of life ranging from savers to home owners.

Higher rates mean lower bond prices and could impact:

1. Home buyers
2. Credit Borrowers
3. Real estate investors
4. Savers
5. Equity investors
6. Bond investors

Although one can write separate blog posts for every individual class, the major theme will revolve around increased cost of credit. With increased borrowing cost, it will get difficult to buy homes, borrow for credit card purchases, borrow for investments in real estate or other venture, thus reducing the flow of money in the economy.

It will also encourage corporations and individuals to save and at some point make equities less appealing, as they will be able to get higher rates without added risk. Please don't get me wrong - savings are the engine of long-term economic development, while spending helps in the short-term.

Since the rates and prices move in opposite direction, rate increase by Feds means that bond prices will decline. However, contrary to this simplistic idea, UST's proprietary bond market analysis suggests that longer term bonds are still in a bull market. It is one of the 3 primary asset classes that is in a bull market.

Therefore, bond investors should not be scared by this Fed hike. Bonds will continue to do better for some time. This also flows well with our discussion on objective trend following, in the last blog post. Objective investing requires one to analyze asset classes holistically rather than event based analysis. And at this point, holistic picture based on proprietary indicators is suggesting that the bond market will do better. This could mean:

1. Stocks are going to perform poorly to push interest rates down even with fed hikes
2. Fed fund rate hikes will be in contrast to economic reality, and could result in yield curve inversion

Both of the above scenarios are bad for economy and investors. In the next few posts, we will discuss:

Detailed discussion on potential causes of bond yield decline even with Fed's increased rates

Alternative investments, according to their state - Part 2

Elliott Wave analysis of current stock market

Asset allocation options

Tax implications 

Revisiting Objectivity and market trend

Let me know if you think the best time to buy homes is about to come or has already passed?



 

Importance of objectivity in trend following

Market managed to put in a nice turn-around and must have made many market commentators happy. However, the market remains in a downtrend and in a bear market, according to our proprietary models. In a bear market, we expect to see nice rallies - rallies that can shake the shorts and lure in more longs.

Although we are still near the highs, as measured by $DJIA and $SPY, small caps, junk bonds and Global Dow are significantly lower. In facts, some of the major indices are completing Head and Shoulders patterns, shared in the last post.

From a socio-economic perspective, euphoria is the primary driver near the top. And last week's milestone climate agreement is a sign of remnants of euphoria of the bull market. We have talked about market psychology is greater detail in prior posts on the blog, so we won't get into that discussion over here. But we need to make sure that all the market analysis tools are good, but one can only make money in the market by being aligned with the broader trend.

No matter whether its a Bull Market or  a Bear Market, trend is your friend. I have seen people getting wiped out in both Bull and Bear markets because they fought the trend. Therefore, if the current market is trending down or we are in a bear market, one should not get excited about the rallies. In fact, in bear markets following are the keys actions an investors should take, depending on his/her risk profile and personal situations:

1. Exit longs except for very solid dividend paying stocks (if cannot exit longs due to tax reasons)
2. Enter positions in asset classes already in bull markets
3. Short with a fraction of portfolio because shorting is very dangerous and is for professionals (link to sad story)

If someone wants to short, shorting an ETF is much safer than shorting an individual stock because of diversification. After all, risk management should be the top priority of every investor. Never the less, the most important part of any trade is to consistently be on the right side of the trade and hold on to positions for the longer-term to avoid short-term capital gains rates, which can sting at the end of the year, especially if your in the top 39% tax bracket.

Now the key to being on the right side is being OBJECTIVE in your assessment of the market.


Although there are many ways by which one can bring objectivity into investments, UST team has done significant analysis on identifying Bull/Bear markets using objective statistical analysis techniques. At some point we will go into the details, but right now these models are saying that:

• Stocks - Bear
• Bonds - Bull
• Bit Coins - Bull
• Gold - Bear

In the next few posts we will discuss:

• Elliott Wave analysis of current market
• Alternative investments, according to their state
• Asset allocation options
• Tax implications 
• Revisiting Objectivity and market trend

 

Technical Overview of the Market

Market is in sideways range and in doing so it has traced out a triangle pattern. Pure technical analysis says that longer term triangle patterns suggest that a trend reversal is approaching. Triangle pattern in DJIA is shown below:

While triangle pattern is almost complete, one could also construe market's current pattern as a head and shoulders pattern. However, the problem with this assumption is that the current pattern can be regarded as a either a upright Head and Shoulders or inverted Head and Shoulders.

Upright head and shoulders pattern suggest a market topping pattern. If market is playing out this pattern, we are in the right shoulder. In order to complete the right shoulder, market should decline from current level to the neck line. This potential pattern is shown below:

On the other hand, if we consider that currently market is undergoing consolidation and will soon breakout, an inverted head and shoulders pattern will support that call. In fact, current market structure also supports a potential inverted head and shoulders pattern, as shown below:

However, the fundamental flaw with this pattern is that its target, if pattern is completed, would mean that SP500 would rally to 2350. This means that economy has to do very well and easy monetary policy should continue. However, both of these are unlikely scenarios because after ~6 years of economic expansion, we are due for a recession.

Furthermore, proprietary indicators suggest that the stocks have entered a bear market in August and internals have continued to deteriorate since then, even with the sharp rally that we have seen over the past month or so. Therefore, one should be weary of the market and its prospects. Market should now prove itself before one can fully commit to the long side.

On the other hand, there are other investment vehicles like BitCoin, which has just entered a new bull market according to proprietary Bull/Bear model and could yield substantial gains for investors. But please keep in mind that BitCoins are very volatile and portfolio size should be adjusted accordingly.

In the upcoming blogs we will talk about:

Importance of objectivity and trend following

Elliott Wave analysis of current market

Alternative investments

Asset allocation

Tax implications

 

Current Market - Bear Case Evaluation

Over the past few weeks we have seen a stagnant market. In fact, entire 2015 was a sideways market with SP500 starting the year around 2080 and is now at 2060. Although sideways action is good to digest gains, this kind of action can also be attributed to distribution. Distribution means shares are being sold by strong hands to weak hands. Distribution typically takes place near the top and results in market declines.

From a psychological perspective it makes sense because when the people how bought at lower levels sell and people who buy at higher levels are left in the market it has two consequences:

1. Weaker buyers are the first to sell, which exaggerates selling
2. When all the buyers have bought, sellers are left in the market. Since weak hands join the rally towards the end, the concentration of sellers is very high near the top

At the same time, the weaker buying hands are being sold-to by strong shorts. That's why this process is known as distribution. Now there can be this argument, as stated above, that we are tracing out a longer-term consolidation pattern before a very nice rally. Although this is possible, it is unlikely due to the following facts:

1. Average gap between recessions in the US, over the past century, is ~5 years. Since last recession ended 6 years ago, we are due for another recession
2. Markets rally in easy monetary policy environment. Under current circumstances, Federal Reserves is planning to raise the interest rates, which will reduce the monetary supply that fuels bull markets
3. Stocks PE valuation is also at a very high level, which is another reason not to be very aggressive with the stocks

Above reasons suggest that from a fundamental perspective stocks are not the most attractive investment opportunity at this time.

Our proprietary model suggests that the stocks entered a bear market in August and recent rally hasn't been able to change that status. Market will remain in the bear market mode till we see a broader rally. However, so far we haven't seen the kind of broader rally that is a hall-mark of a new bull phase.

Therefore, we will continue to evaluate the market conditions and also review other alternative investments at a time when the stocks don't seem to be the best option. In the next few posts we will  cover:

• Technical overview of the stock market
• Importance of objectivity and trend following
• Alternative investments
• Asset allocation
• Tax implications