The Less Traveled Road to the 200-day Moving Average

Since November 2012, the S&P 500 has remained above its 200-day moving average for 421 consecutive trading days, the longest streak in history. I have compared this streak in the S&P 500 to the Joe DiMaggio hitting streak in 1941 for its incredible consistency and resiliency.

200-day 7-28-2

The so-called “path of least resistance” has been up and if you are a long-term trend-follower focused on large cap U.S. equities, this has been the best period in history for your strategy. But no trend lasts forever and strategies come into and out of favor over time as the market environment changes.

I know it has become blasphemy to question this historic advance, but I am wondering aloud here if we are about to take the road less traveled, that is the one back to the 200-day moving average as the market environment is slowly changing. Last week, as the S&P 500 hit yet another all-time high, there were a growing number of red flags that indicate that the probability the streak may soon be in jeopardy is at its highest point since it began in November 2012.

Let’s have a look:

Credit

The credit markets are showing signs of weakness for the first time in months. High Yield credit spreads have been consistently widening since late June and are close to a 3-month high. This has been a minor move higher in spreads thus far, but as credit typically leads, one that should not be ignored.

200-day 2

European credit spreads have also been widening, notable in my view as we are seeing this credit weakness in the face of what was supposed to be a highly positive event: a move to negative interest-rate policy. As I questioned recently, what is it telling us when negative rates are not enough?

200-day 3

Small Caps

Small Cap weakness has been a nagging red flag this year and it continued last week as the Russell 2000 closed out the week at its 200-day moving average. In a stark divergence from the all-time highs in the large cap indices, the Russell 2000 is actually down year-to-date. The weak behavior in the average U.S. stock is being masked by the strength in the largest stocks.

200-day 4

Similarly, breadth did not confirm last week’s new highs with the NYSE Advance/Decline peaking back in early July.

200-day 5

Housing

We are also seeing persistent weakness in housing, with homebuilders down over 7% on the year and hitting new relative lows last week. It is notable that this weakness has persisted in spite of a decline in yields this year and in spite of the market not expecting the Fed to raise rates for at least another year.

200-day 6

 Late-Cycle Sector Behavior

As I have noted in writings showing the many parallels to 2007, we continue to see late cycle sector behavior with Energy/Utilities leading the market higher while the most cyclical sector, Consumer Discretionary, is lagging. You rarely want to see this type of defensive backdrop this late in the economic cycle. The persistent strength in Utilities is particularly notable because it tends to precede more difficult market environments, as we outlined in a research paper earlier this year.

200-day 7

In the past two weeks, I have also noted the divergent behavior in the cyclical Industrials sector, which hit new relative lows and failed to hit a new high with the S&P 500 last week. The last two corrections, in 2011 and 2012, were both preceded with Industrial  sector weakness.

200-day 8

Yields Falling

Long duration (30-Year) bond yields have been falling for the entire year, and hit a new YTD low last week at 3.2%. This behavior indicates that investors are seeking out the safety of Treasuries, likely anticipating more difficult times ahead.

200-day 9

It is not simply that yields are falling that is a problem, but the behavior within the Treasury market as well. The Yield Curve hit new YTD lows last week as the demand on the long end is outpacing demand on the short and intermediate end of the curve. This defensive behavior tends to precede more difficult market environments, which we wrote about in another research paper this year.

200-day 11

The Less Traveled Road to the 200-day

Collectively, the market is sending signals of caution while the large cap indices are hitting new highs. In markets, we deal with probabilities, never certainties, and the probability of the S&P 500 finally taking the less traveled road to the 200-day is rising. That probability is not anywhere near 100% but it is high enough to warrant our attention, particularly as we approach the end of QE in October (see Fed Prisoner’s Dilemma) and as long-term stock/bond returns are unattractive at current valuations/yields (see Has the Fed Doomed Buy and Hold?).

Does this mean that the bull market that began in March 2009 has to come to an end? No, and as I have written many times in the past, picking an exact top is impossible and not particularly helpful to long-term investors. What it will mean is that we are returning to a more normal market environment where corrections exist and risk management matters. Such an environment should favor more active, tactical management.

For our part, we rotated to a more defensive posture last week in our mutual funds and separate accounts. It remains to be seen if the red flags outlined above will persist, but as long as they do the long-term probabilities favor defense over offense.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New YorkCharlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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ATAC Week in Review: The Source of Complacency and Coming Fear

“Never be afraid to sit a while and think.” – Lorraine Hansberry

Over the last several days, I’ve had the pleasure of presenting for the CFA Institute, Market Technicians Association, and several investment advisory offices our award winning papers on predicting stock market volatility and corrections. I have interacted with those in the business, and debated about the current state of markets. Universally, there does appear to be an underlying tone of negativity and skepticism about US stocks continuing their manic rise in the face of clear negative signaling Treasuries are expressing. Yet, as concerned as these fiduciaries seem to be, few are acting to fix the roof before it rains.

Several advisors noted that their clients in recent weeks have been asking “when should I sell my stock?” This in turn has made those advisors worried about being blamed for taking a potential dip lower in portfolio values. I had a particularly interesting discussion with one advisor who noted that from a contrarian standpoint, one could argue this is bullish. After all, markets have a habit of climbing a wall of worry, and markets tend to trend higher when individuals are afraid of stock declines.

My response to this point was that he was right in his thinking. Yet, how many of his clients are asking “when do I sell my junk debt, my high yielding investments?” The answer? None. The source of all complacency and coming fear in the stock market is not the stock market. The greatest source of risk now is in junk debt, with yields so low that it suggests investors have forgotten what default premiums are. To be contrarian does not mean to only look at equity market sentiment, but rather sentiment up the capital structure. The reach for yield is the source of all fragility now, precisely encouraged by the Fed, and now at extreme and dangerous levels.

As to our mutual funds and separate accounts, we did a risk rotation last week. Something is legitimately disturbing with the way long duration Treasuries are behaving. They are in some ways acting as if a negative event is about to unfold. Now clearly Treasuries can be wrong about the future, but they tend to probabilistically be more right than wrong. With rolling 6 month correlations between stocks and Treasuries at extreme positive levels relative to history, we are truly on the verge of something breaking. Either stocks will break down, or Treasuries will. Both cannot be right for an extended period of time in their completely opposite views of future economic growth and inflation.

From April to May 2012, long duration Treasuries outperformed the S&P 500 by a whopping 3000 basis points (30%) in two months. Its time they start staging such a move once again.

Sincerely,
Michael A. Gayed, CFA
Chief Investment Strategist
Pension Partners, LLC
Twitter: @pensionpartners
YouTube: www.youtube.com/pensionpartners

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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Has the Fed Doomed Buy and Hold?

In December 2008, the Federal Reserve embarked upon the most expansionary monetary policy in U.S. history.  In an unprecedented action, the Fed moved its Federal Funds Target Rate to a range of 0% to 0.25% and began its first ever “Asset Purchase Program,” better known as Quantitative Easing (QE). At the time, these extraordinary measures were deemed “necessary” by most to save the world from financial “Armageddon” and prevent a second Great Depression.

Nearly two years later, in November 2010, the Economy was back in expansion mode (the official end of the recession was in June 2009) and financial conditions had stabilized. This would normally be around the time when the Federal Reserve would start talking about or initiating a tightening of monetary policy. However, this time the Fed had other intentions, as Ben Bernanke outlined in an op-ed that shocked the world.

In his November 2010 op-ed, Bernanke made the case for additional QE and an extended period of low interest rates. His justification was that such a policy would lead to:

(1)    “Easier financial conditions”

(2)    “Lower mortgage rates”

(3)    “Lower corporate bond rates,” and

(4)    “Higher stock prices”

Fast forward to today and what do we observe?

Easier Financial Conditions

Financial conditions are near their loosest levels in history.

Doom1

Lower Mortgage Rates

Mortgage rates hit historic lows and remain near their lowest levels in history.

Doom2

Lower Corporate Bond Rates

Junk bond yields are at their lowest level in history.

Doom3

Higher Stock Prices

U.S. stock prices are at all-time highs.

Doom4

Mission Accomplished?

Whether you believe it was a result of their policies or not, it is difficult to argue with the notion that the Fed has largely achieved the objectives outlined in Mr. Bernanke’s November 2010 op-ed.

While this has undeniably been a boon for investors over the past five years, the question today is what achieving those objectives means for investors going forward. Judging by the record levels if bullish sentiment of late, investors seem to be assuming that the future will look very much like the recent past, but is this a valid assumption?

By forcing bond yields to all-time lows and increasing stock prices to all-time highs, has the Fed repealed the laws of valuation and mean reversion or simply pulled forward returns? Let’s take a look.

Pulling Forward Returns – Bonds

The 10-Year U.S. Treasury yield is currently at 2.4%. Historically, there has been a very close relationship between the beginning yield on the 10-Year Treasury and the forward returns from bonds funds. This is simple bond math; on average, the higher the beginning yield, the higher the return and vice versa. You can see this clearly in the chart below. While we don’t have enough history yet for yields below 3%, investors should expect returns to be well below anything they have seen in the past.

Doom5

That is the critical issue investors are facing here. By maintaining interest rates at artificially low levels for over five and a half years, the Fed has effectively driven yields on nearly all fixed income products to historical lows. The reach for yield has entered the desperation phase in recent months as investors have grown tired of waiting for the Fed to raise interest rates.

From Treasuries to mortgage-backed securities to investment grade bonds to high yield bonds, yields on average have never been lower. The current yield on the iShares Core U.S. Aggregate Bond ETF (AGG), which is designed to approximate the total U.S. bond market, is 2.0%.

With this low starting level of yield, can investors really expect to achieve a nominal return from bonds of above 3-4% annualized over the next seven years? It is difficult to argue that they can. And this is assuming that interest rates could remain low going forward. As we saw in 2013, if interest rates rise from here, the actual returns are likely to be lower.

Pulling Forward Returns – Stocks

Moving on to stocks, we unfortunately observe a similar picture where forward returns have been pulled forward by Federal Reserve Policy. At a current cyclically adjusted P/E (CAPE) of 26 for the S&P 500, we are approaching the 90th percentile of historical valuations. There are few times in history where we have seen a higher valuation and none of these periods were favorable for equities going forward.

Doom6

While not a short-term predictor, forward returns from CAPE levels above 26 have been significantly below average in the past. In the chart below, you’ll notice the strong relationship between beginning CAPE valuation and future returns. If we approximate the 90th percentile by taking a simple average of the 7-year annualized returns from the two top deciles of CAPE levels (4.8% and 2.5%), we come to a forward expected return of roughly 3.7% for U.S equities.

Doom7

Has the Fed Doomed Buy and Hold?

After five and a half years of unprecedented action, the Federal Reserve has largely achieved what they set out to do: namely inflate asset prices. We can debate whether this has actually led to a real economy “wealth effect” as they implied it would, but the historic rise in asset prices here is unquestionable.

That has certainly been great news for investors in their retirement years that are cashing out of investments at their highs. But for anyone not cashing out, it remains to be seen if this was indeed the best outcome. Mathematically, it would seem suboptimal to buy at elevated prices if you are adding additional funds to your retirement savings each year, as Warren Buffett has said in the past:

“If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.” – Warren Buffett

Buffett focuses on stocks, but a similar argument could be made for bonds, whereby forcing net savers to buy into bond funds at artificially low yields is likely to diminish long-term returns.

Much like the Fed-induced housing bubble that peaked in 2006, only those few homeowners who cashed out during the latter stages of the bubble actually benefitted from the bubble. Anyone else was hurt by it, either existing homeowner through rising property taxes (as taxes in most areas are based market values) or new homeowners who were forced to buy in at overvalued prices if they wanted to participate in the “American Dream.” We’ll leave the speculators buying five condos in Miami out of this but they of course suffered as well.

Doom8

Thus, the problem facing most investors today is that the short-term gains that they have readily enjoyed in recent years have not been realized, and they also do not come without a price. There is no “free lunch” in the markets and the price to be paid from higher returns in the recent past is lower returns in the future.

The Federal Reserve, through five and half years of zero-interest rate policy and various rounds of quantitative easing, has effectively doomed the buy and hold investor to a period of low returns. With bond yields near historical lows and stock valuations near historical highs, it is difficult to argue otherwise for a typical buy and hold stock/bond portfolio in the coming years. In fact, a low single digit return would not be unprecedented given current yields and valuations.

Buy and hold is often touted as the best strategy for most investors. It hard disagree with this notion, as investors are notoriously poor market timers, with the behavioral tendency to buy high and sell low. That said, like any strategy, there are times when the market environment is more and less favorable to buy and hold. When prospective returns were high as they were in 2009, it was a great time to be a buy and hold investor. You want constant beta exposure when valuations are cheap.

But fast forward to today and we have an entirely different backdrop, where constant beta exposure is almost guaranteed to deliver below average long-term returns. In my view, such an environment is more favorable to active or tactical management, as was the case back in 2007. I am well aware of the derision that such strategies are facing today, as this has been one of the best periods for buy and hold in history. But this is precisely why they are more favorable going forward. No one wanted buy and hold in March 2009 and everyone wanted to be “tactical.” The opposite is true today.

The Pushback:

1) The market can remain irrational longer than you can remain solvent.

This is one of the most overused and misused phrases in investment history. Solvency is not an issue in this analysis as I’m not writing about making an LTCM or Corzine type of bet. I’m also not suggesting that it is a good idea to short the market simply because it’s overvalued. There is a big difference between being cautious/defensive and being bearish/short. I’ve written extensively this year about how being defensive in 2014 has cost you nothing, with the two most defensive areas of the market, Utilities and long duration Treasuries, widely outpacing the average U.S. stock.

What I’m discussing here is asset allocation and for the majority of investors, who are not using short-term levered instruments, solvency is not a concern. What should be a concern for these investors is how the short-term irrationality going on today is going to lead to lower returns going forward.

2) But Jeremy Grantham says that the S&P 500 is going to 2250. Doesn’t that disprove your thesis?

While a long-term value investor, Grantham is one of the best promoters in history. There is a reason why his firm is managing over $100 billion. He knows that investors love forecasts and precise numbers and he is giving them exactly what they want. While 2250 target is making headlines, if you read the rest of the piece his projections are not far from my own, and may even be more cautious as he is arguing for negative real returns from a U.S. stock/bond portfolio over the next seven years. He is also suggesting that U.S. small caps may be at their most overvalued levels in history, with projected real returns of -5% per year over the next seven years. This is ingenious marketing as Grantham has put himself in a position where he cannot be wrong. If there is a bubble, his 2250 target will be easily hit and if there’s a bear market before that, well, he warned you that small caps were at extremely dangerous levels. Heads or tails and he wins.

But I digress. The 2250 forecast is a short-term forecast and the analysis here is focusing on longer-term returns. It is certainly possible for the market to continue to march higher in the coming months and I would note that Grantham’s forecast is only 13% above current market values. However, should it do so, that would only lower expected returns even more. Again, if you are not going to cash out on that rise but will be adding money to your 401k/IRA, shouldn’t you prefer a short-term decline back to more reasonable valuations over another late 1990’s bubble?

3) But the Federal Reserve is projected to keep interest rates low for at least another year. Won’t this cause even more of a reach for yield and higher bond prices?

It is certainly possible and I can only conclude that this must be the Federal Reserve’s objective by continuing with ZIRP after five years into a recovery and record low Junk bond yields. But again, is this the preferable outcome for a long-term investor that is continuing to add money to bond funds each month? Wouldn’t more normalized, market interest rates be more beneficial to most investors?

I would also note that investors are unlikely to wait to the very end of QE and ZIRP to begin making adjustments as I wrote about recently in “The Fed Prisoner’s Dilemma.”

4) This only talks about U.S. investments. Can investors boost long-term returns by moving abroad?

Yes. I have been making the case for much of this year that Emerging Market stocks and bonds are significantly cheaper and offer better prospective returns than the U.S. when looking out over the next seven years. The problem, though, is that most U.S. investors are unlikely to have enough exposure to these areas to make a difference to their portfolios due to home bias and recency bias. The other issue is that the interest rate suppression is a global phenomenon and while bonds in Emerging Markets are more attractive on a relative basis, yields are still historically low.

5) Can’t valuations remain high and yields low for the next seven years?

They could, but I would ask what probability you are assigning to that outcome and what your expected return from stocks and bonds would be in that scenario. If average bond yields are still 2.0% seven years from now, can you make the case that bond returns will be much higher than 2% in that scenario? Similarly, if the CAPE is at 26 seven years from now, can you make the case for strong equity returns based on earnings growth alone when nominal GDP is currently running at between 3-4%? The “permanently high plateau” theory has rarely been a good strategy for long-term investors.

5) What would change your outlook?

Buy and hold is not doomed forever. Markets are cyclical. Though it seems unlikely because we are conditioned by the recent past, there will be better valuations and higher yields in the future. If you are a long-term investor that is adding to your savings and investments each month, you should not fear this inevitability but should welcome it.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New YorkCharlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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