The Right Question

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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