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Category: Chart of the Week

This Indicator is Flashing Warning Bells for the Market

By John Del Vecchio

The New York Stock Exchange (NYSE) Bullish Percent index is creating a potential bearish divergence with the S&P 500. This could be suggesting a lot of weakness under the hood of the market.

The bullish percent is the percentage of stocks in bullish patterns using point and figure charting. Point and figure charting has been around since before 1900 and is a simple chart showing price movement (X’s for up and O’s for down). It makes it easy to see trends in the prices of stocks. In addition, stocks are either on a “buy” or a “sell” so the analysis could not be clearer.

The beauty of the NYSE Bullish Percent is that is shows stocks moving up and down in the aggregate. Importantly, each stock gets a single vote. This differs from the S&P 500 because the S&P is market capitalization weighted. So, a stock like Apple gets significantly more weight than Waste Management. The top 5 stocks in the S&P 500 are 12-15% of the total index. In the NYSE Bullish Percent, they are all the same.

Most people use the S&P 500 when they talk about “the market”. But, what’s going on in the market could be quite a bit different than what is going on with the typical stock. We can see this in the chart below.

The green line is the S&P 500. The blue line is the NYSE Bullish Percent. Prior to the butt kicking the S&P took in February, both of these lines mostly moved in tandem. The S&P made new highs as did the bullish percent.

But, recently that relationship has weakened. The S&P 500 has rebounded and is close again to new highs. Small cap indexes hit new highs recently as well. However, the bullish percent figures are lagging. The one stock, one vote nature of the index is letting you know that not as many issues are participating in the rise of “the market.”
You might see this in your own portfolio. The market may be making new highs but your holdings are lagging. In healthy markets, we expect to see lots of stocks making new highs. At the very least, we would like to see them back into uptrends.

That’s not happening.

The danger here is that by the time the S&P 500 rolls over, the average stock could be down 10-20%. This is useful gauge to monitor the health of the market in aggregate.

Right now, it is sending off some warning bells that things are not as strong as they appear to be.

Watch this Trend for Changing Stock Market Fortunes

By John Del Vecchio

I like to look for extremes in the markets. Extremes often pinpoint areas where returns can be higher and risk lower than in other time periods. Take the relationship between commodities and stocks. The chart below shows that commodities haven not been cheaper than stocks in a generation.

Could the relationship between commodities and stocks have changed forever? Possibly. We often hear “this time it is different” to justify what’s going on in the world. But, one thing that never changes is human nature.

People push markets to extremes. Then they revert.

You see this in the real world. Have you ever noticed in a basketball game that a team gets really hot in the first half of the game? Blazing hot. The players are nailing three pointers and outside jumpers and guys coming off the bench score more in the first half than they typically do in a game.

Then in the second half the team falls apart. They can’t buy a layup. Meanwhile, the opponent plays a bit better and catches up. The hot team has reverted to their mean.

It happens all the time.

When markets revert, there can be big returns with much less risk.

So, what to do with commodities and stocks? Well, the stock market has had one of the longest bull runs in history. We are way overdue for a meaningful pullback. Commodities are cheap relative to stocks. But, that doesn’t automatically make them a screaming buy. They have been below the median level for six years and headed lower! Additionally, we could have a deflationary bust that wipes out wealth beyond comparison.

What it means to me is to raise cash, not allocate fresh capital to stocks and be on the lookout for changes in trends in the stock market. These generational lows won’t hold. So, it will pay to watch this trend going forward to look for the beginnings of the reversion to the mean. It could make you a lot of money. But, more importantly, shield you from big losses in stocks.

Alarm Bells are Ringing! Could we be Entering Recession Territory?

By Brad Lamensdorf and John Del Vecchio
The yield curve is inverting, which means that long-term interest rates might start to trade below short-term interest rates. If the past is any indicator of the future, it could mean that we are staring a recession in the face. If investors are concerned about the economy, they may prefer to hold longer-term treasuries that yield less than short-term treasuries. Obviously, this makes no sense in a perfect world. But, in the real, world if investors think a recession is coming they don’t want to own short-term treasuries that ultimately will see their yield fall. They’d rather get locked into a lower rate now that may end up being higher when short-term rates tank as the result of a recession.

A look at the chart below shows that the recent trend between the 10-year treasury and the 2-year treasury (blue line) is nosediving toward the zero line. The grey shaded areas in the chart show past recessions. Typically, when the yield curve implodes, a recession has been close by.

It’s not always immediate. Look back at the 1990’s, when it took a while for a recession to rear its ugly head. The wealth effect from the boom in technology may have shielded some of the impact of the negative yield curve, but eventually the economy got bit. Bit hard.

Now you can see that we are trending down to multi-year lows. The difference today is that there’s a boatload of leverage in the system. Leverage is great while it’s working…until it isn’t. Then some bad things can happen.

For example, many financial institutions set up trades, called derivatives, that depend on a positive interest rate carry (blue line above trending up) to be profitable. These trades may have been set up a couple of years ago, and the bank may have misjudged the future of the yield curve. As these trades go against them, it does huge damage to their balance sheet. Not only are they no longer profitable, but the addition to leverage adds fuel to the fire. There’s a reason why Warren Buffett has called these type of trades “financial weapons of mass destruction”. We could see another wave of massive write-downs or bank failures just like we saw 10 short years ago, for many of the same reasons. People have short memories!

Another scenario is that short-term loans on long-term assets could lead to the consistency of payments to a bank to fluctuate wildly. Let’s say someone owns a building that is financed with short-term loans that are often refinanced because rates have trended lower, and the building generates $100,000 in rent. If the economy gets hit by a recession, the building owner might see his cash flow evaporate as tenants go under and close up shop. Now the bank might get stuck with a default. Meanwhile, the bank can’t borrow money at short-term rates and loan it out longer-term for higher rates. Loan growth slows and margins take a hit. The result is bad all around.

The concern is that “this time it’s different” and there won’t be problems. It’s never different this time. Human nature never changes. What’s more is that we cannot believe the economic growth or job statistics reported by the government. There’s all sorts of voodoo math in those figures. We should all position our investments accordingly.

Chart of the Week 05-07-2018

Should You Sell in May and Go Away?

 

By John Del Vecchio

There’s an old market saying to “sell in May and go away”. Over time, a heavy seasonal pattern of stronger stock price performance from the late fall to early spring has developed. But, just blindly following a Wall Street maxim can also be a good way to have money picked from your pocket.
It turns out that this old Wall Street maxim is right on the button. The chart below illustrates the performance between stock price performance from November – April (blue line) and May – October (red line).
The difference is stark.
$1,000 invested from November – April returns $79,100 while $1,000 invested from May – October yielded just $2,201.
Obviously, we have just entered May so this seasonal pattern of lower stock prices is just under way. There’s no guarantee that this pattern will hold this year. However, it’s worth noting that we are living amongst one of the longest bull markets in history. Increasingly, market performance is being driven by just a handful of stocks such as Amazon.com, Netflix, Facebook, and Alphabet (Google). Meanwhile, below the surface of the indexes there’s plenty of weakness in individual stocks.
Given that the market is long in the tooth and divergences among stocks are forming, it may pay well to heed the advice to sell in May and go away. For a while at least.

The One Metric That Could Trigger a Bear Market

By John Del Vecchio

Chances are, if you watch the talking heads on TV, they are drooling all over themselves about the Federal Reserve and what actions members plan to take on interest rates. It’s the Fed this and the Fed that.

But, the interest rate that really matters is LIBOR. LIBOR stands for the London Interbank Offered Rate. It’s a really, really important rate.

Here’s why…

When investors borrow money and use their portfolio as collateral, the loan is often priced at LIBOR plus some base interest rate. For example, the loan might be priced at LIBOR plus 1%. Importantly, these loans are not priced on the federal funds rate.

Look at the chart below. The blue line is 3-month LIBOR. Over the past 30 years, LIBOR has trended down. However, recent history tells a much different story.

It’s been rising steadily from the ashes to multi-year highs. Nearly every day it is getting more and more expensive to maintain these lines of credit that wealthy investors have been using.

How much credit is out there borrowed against stock portfolios? Trillions of dollars.

You see, people with portfolios of liquid assets get access to these credit lines. That means people who own stocks. Often you must have more than $1 million in stocks and bonds to get access to LIBOR-plus loans. These are the one percenters.

They can buy a new house or finance a large purchase of an illiquid asset by using their portfolio as collateral. These assets might be boats, planes, fine wine, or investable art.

You name it.

The rub is that the banks don’t ask you what you’re going to use the money for. You just can’t use it to buy more stocks. Anything else is fair game. Want to have a great time in Montreal this weekend? No problem! Just tap into the line of credit. Need to charter private plane for a round of golf at Pebble Beach? The bank will be more than happy to let you tap the line of credit.

The problem is, as interest rates creep up and more portfolios have been used to finance asset purchases, it could create a huge storm if stocks and bonds take even a minor dip. Montreal is fun, but that money has been spent. Hopefully that round of golf wasn’t full of three putts. There’s an old saying that you can always buy a boat but you can’t sell one. And, that’s the problem. Shedding assets when everyone else is feeling pain leads to terrible deals for the seller.

If stock prices slide, the borrower could get margins calls. They have to sell stock. But, they also have to reduce their leverage because they can only borrow so much against the portfolio. Everything unravels at once. This accelerates the selling pressure. What should be down 10% in normal markets might be down 30% in a highly levered market.

Each day, we get closer to the tipping point…

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