A Buying Opportunity Will Present Itself

On August 21 we decided to fade the rally (see Seven Reasons To Fade This Rally and The “Low Energy” Rally) . While we were not going short the market, we decided to start taking profits on many of our positions and raising cash.

We did not get the pullback that we had hoped for in September and are still awaiting a decent entry point to redeploy capital. That said, our relative performance against the major indices in September was satisfactory. Our portfolio was up 1.5% for the month against a 0.6% increase for the S&P 500. Both the Nasdaq and the Russell 2000 posted negative returns for the month with -0.7% and -2.4%, respectively.

We continue to wait for a better opportunity to redeploy and will continue to take profits on our existing positions as warranted.

Interestingly enough the Dow Jones Industrial Average was up 2% for the month of September. This is important as it relates to perceptions on main street. I have a wonderful uncle; his name is Tony. He is a staunch Trump supporter and is 100% behind his protectionist policies and isolationist agenda. He and I speak often about politics and we agree on many things as it relates to the current path of fiscal policy but disagree on the Administrations current trade policy actions (see Thoughts on Trade Policy).

When President Trump initiated further an additional 10% tariffs on $200 billion of Chinese imports (rising to 25% rate in January) after the close on September 18th, the markets reacted in an unusual way. On September 19th, the S&P 500 finished the day +0.1%, the Nasdaq finished the day -0.1% and the Russell 2000 small caps finished the day -0.5%. The Dow Jones Industrial Average went on to rally 251 points or roughly +1.0% on the day.

Of course, my Uncle Tony went on to point out, based on the performance of the DJIA, that the markets have approved of the moves and that the naysayers of a pending trade war have it wrong. We went on to talk about the difference between price-weighted and market-cap weighted and 500 vs. 30 stocks in an index – but ultimately is didn’t sway either of our opinions.

It did get me thinking about the perceptions on main street though. I read a tweet by Liz Ann Sonders (@LizAnnSonders) that highlighted a recent Gallup Poll.

She notes, “Percentage of Americans who see economic issues as the most important problem is at the lowest level in decades”.

That is fair enough, the economy is very strong and it would be foolish to argue otherwise.

Consumer Confidence is very high as well. As Bloomberg points out, “Sentiment improved a third month, reaching one of the best levels in a half century of data, as a strong job market and tax cuts keep Americans optimistic about the state of the economy and their finances even amid an escalating trade war with China.”

What I find with these two data points is that one can truly consider them contrarian indicators. If you look closely at the Gallup poll, the percentage of Americans that considered economic issues as the most important problem was at the lows right before the last two bear markets (1999 – 2000) and (2007-2008).

Charlie Bilello from Pension Partners went on to point out that, “If we separate the Consumer Confidence data into deciles and compare the highest and lowest 10% of readings, we find the following:

Above-average returns and a higher probability of positive returns following extremely low confidence readings (Decile 1 in the table below).

Below-average returns and a lower probability of a positive return following extremely high confidence readings (Decile 10 in the table below).”

The extreme levels of consumer confidence has not gone unnoticed by many market professionals (see Americans haven't felt this good about the economy in 18 years, but that could be foreshadowing a coming recession – Business Insider).

Skittish Markets

Volatility readings from the VIX point to nervous traders. Dana Lyons in See It Market points out, “while the stock market, e.g., S&P 500, was hitting a new 52-week high, the volatility market, e.g., the VIX, was well off of its lows — and trending higher.

As we noted in the piece, this type of “divergence” from the two markets’ normal inverse relationship had only been seen a handful of times over the prior 2 decades — with all observances occurring near cyclical or significant market peaks. We bring it up again now because of the occurrence of another similar divergence at yesterday’s new high in the S&P 500.

Specifically, the S&P 500 rose by more than 0.75% to a new 52-week high. Yet, at the same time, the VIX closed nearly 30% off of its 52-week low — and up on the day. As in the case of the divergence in our previous post, precedents were few and far between in the past 18 years. In fact, the only days meeting similar criteria since 1999 were the following:

3/23/2000

4/25/2007

1/17/2018

8/27/2018

9/20/2018

Now, in case you don’t recognize the significance of this particular list of dates, the following chart should provide ample color.”

We too track the difference between the S&P 500 and the VIX. We look at the three-month beta between the two. There is an inverse relationship of course so the beta is always a negative number. What counts though is the degree of sensitivity the two data points have on each other. Typically, the higher the number, say -5 to -10, the better the buying opportunity in the market. When the figure is lower, -12 to -15 and starts heading higher, we find market weakness during that time period. We are currently coming out of the range that would signify market weakness.

The skewness of the VIX is rising as well.

In a recent Business Insider report they write, “Things are quiet in markets right now. Perhaps too quiet.

That's the thought process being employed by traders who are paying the most in at least 28 years to protect against a significant market event.

Their trepidation can be seen in the Cboe SKEW Index, which is sitting near its highest level on record, according to data going back to 1990…

The simplest explanation is that traders see the conditions building for a sudden negative market event — especially since US indexes are sitting close to all-time highs, meaning they'll have further to fall if conditions go south quickly.”

Housing – What Gives?

As I sit here and collect my thoughts, Lennar Corporation (LEN) has announced their earnings and have guided lower citing hurricane disruptions and a slowing housing market. They say that higher home prices are impacting their business as well as rising mortgage rates. They also claim to be seeing a less than anticipated benefit from the recent tax reform.

The following chart is the iShares US Home Construction ETF (ITB). The sector experienced a parabolic breakout in mid-September of 2017, rocketing up roughly 33% to the end of that year, but has now given-up all those gains. The same could be seen in SPDR S&P Homebuilders ETF (XHB) that has recently broken a key support level.

In April of this year we wrote in our blog entitled First Quarter 2018 Commentary that we thought the housing market and home builder stocks were a good buy. Indeed, we took a position in D.R. Horton, Inc. (DHI) and Lowe's Companies, Inc. (LOW) as a way to take advantage of this perceived value. We moved out of DHI when the stock failed to break above the $47 resistance in August and also took profits on the LOW position with the gap higher on the announcement of the new CEO.

The sector metrics continue to be favorable. The S&P 500 Home Builders sector is trading 7.6x forward earnings of $109.31. Using an average multiple of 12.1x one could expect significant upside from current levels. The five-year projected EPS growth rate from consensus forecasts sit near 21% compounded annually. While this may be a stretch given the late stages of our economic cycle, even if one were to cut that by half to 10%, it still gives us a five-year IRR of approximately 18.5%.

Sector earnings quality as measured by Net Income less Cash Flows from Operating and Investing Activities expressed as a z-score are a bit elevated (meaning deteriorating earnings quality) but still below the peaks leading into the 2000-01 economic recession and bear market and certainly below the housing crisis of 2007-08.

This begs to question the foundations of our economic growth. I read this interesting tweet from @MikaelSarwe.

Getting back to sector rotation

When speaking with my wonderful Uncle whom sources the DJIA as vindication for political gambits out of Washington, it is clear why those on main street would believe this to be true. The following chart shows the performance of the DJIA (black line) relative to the typical indices one would track on Wall Street.

Clearly the Dow has been the stellar outperformer over the past 30 days.

What’s worse is that global markets are badly underperforming the U.S. markets. From Business Insider, “The firm {Morgan Stanley} finds that the percentage of global stock markets that are outperforming the benchmark MSCI All Country World Index is close to the lowest in 30 years. In fact, the measure has only been lower on one occasion over that period: in September 2008, right around the global financial crisis.

Based on this, Morgan Stanley says the stock market is at a crucial crossroads that could determine whether a recession is coming. And it largely depends on whether a rebound in the indicator — as seen in this chart — is driven by worsening conditions in the US, or an improvement internationally.”

Lance Roberts from Real Investment Advice brought to light the current dichotomy between the U.S. markets and other markets globally. He notes, “One of the biggest concerns I have addressed previously is the divergence of global markets from the U.S. This suggests two things:

Economic strength in the U.S. has been a function of short-term stimulus (ie. Natural disasters, tax cuts, and massive increases in Federal spending) rather than more sustainable long-term factors.

Rising interest rates and “trade wars” are having an impact that will cycle back to the U.S.

Around the globe, sell signals abound.

In the United Kingdom, the 50-day moving average has crossed below the 200-day moving average which is viewed as an important warning. Furthermore, despite the S&P 500 being up almost 9% year-to-date, the U.K. is down -5%.”

“Likewise, Japan has also registered a similar warning despite the Government regularly buying equities directly in the market through their “QE” program.”

“Not surprisingly, with Trump’s “trade war” being levied directly at them, China has slumped markedly year-to-date pushing a near 10% decline since June.”

“South Korea, where exports are a strong leading economic indicator for the U.S., has also slumped -6% since June as trade woes continue.”

“Germany, a leading exporter of luxury automobiles, also suggests something has turned for the worse since the beginning of the year.”

“But it is not just these selected countries which have all signaled a change in their current trend, but as we noted previously, it is in the combined emerging market and industrialized international countries globally.”

“Since the turn of the century these global signals have been important warnings for the domestic markets. In fact, going back to 1998, when momentum and moving average crossovers have combined with more extreme overbought conditions (relative strength index above 70), the domestic markets have been negatively impacted.”

“The same analysis holds true for industrialized international markets as well. Again, we see that when these quarterly signals are combined with overbought conditions, the domestic markets have eventually been negatively impacted.”

“While the U.S. can certainly remain detached from the world in the short-term due to fiscal stimulus, the “demand pull” from stimulus fades rather quickly and leaves a consumption “void” in the future.”

Sector rotation within the U.S. markets has been telling. We highlighted the rotation into defensive names in our blog post Seven Reasons To Fade This Rally as one of our recent concerns behind the recent rally.

In Business Insider, “A strange anomaly has been brewing in the stock market over the past few months.

Defensive stocks — or those in the healthcare, telecom, utilities, and consumer staples sectors — have been keeping pace with the broader market.

It's a relatively new phenomenon, as the chart below shows. Defensives have only been market performers since about early July.”

“Jim Paulsen, the chief investment strategist at Leuthold Group, has taken notice — and he's not too encouraged by what he sees. In fact, he argues that this aberrant outperformance could be signaling rough times ahead for both the market and the supposedly bustling economy at large.

"For a stock market supposedly driven by some of the best economic performance of the entire recovery, its leadership seems out of whack," said Paulsen. "It might be worth paying attention to this oddity."

That's because the rare combination of defensive outperformance and economic strength has historically been a warning sign that a recession is near. And since recessions are accompanied by market crashes, anyone who owns stocks should be on high alert.

Paulsen notes that in the modern era from 1988 to 2018, every single US recession was preceded by the strong relative performance of defensive stocks. This can be seen in the chart below.”

“Paulsen's historical study actually goes all the way back to 1948 and reaches a similar conclusion. While he's found it difficult to identify a specific unemployment threshold to serve as a surefire recession indicator, the area between 4% and 6% has usually been the sweet spot for imminent economic pressure and the market declines that accompany it.”

From Zero Hedge, “In fact, as the 'global synchronous recovery' evaporates, US and European economic data has not been so completely decoupled in years... but don't forget, this is the greatest economy in the world.”

From Top Down Charts, “USA vs Global Ex-US Manufacturing PMI: This one shows how stark the divergence or decoupling has been between America and the rest of the world. “

Near-term Tactical Strategy

On July 23 we wrote on in our blog, “We’ve concluded, purely based on technical analysis, that a FOMO summer rally could start in the coming days or weeks. If we look at the daily chart for the S&P 500, we see two bullish patterns that have emerged. The first one is a bullish cup-and-handle formation with the SPX breaking the rim to the upside. We believe a confirmation rally on stronger volume should propel the SPX to new annual highs.” We have used the latest market strength as a means to take profits and decrease our overall market exposure. We have expressed several times in the recent past our concerns within market internals (Seven Reasons To Fade This Rally and The “Low Energy” Rally).

While there are several support levels to watch for in the SPX, we would be buyers aggressively should the index fall to around $2780. This represents a 38% Fibonacci retracement from the February lows this year. It was also resistance for the S&P 500 in late February, mid-March and mid-June. It finally broke this level in early July.

We believe a better buying opportunity will present itself later this year.

Joseph S. Kalinowski, CFA