for the upcoming week beginning May 9, 2016
With Market Questions and Answers
Who is leading whom?
Having a leader is the natural order of things. All species seek order through the presence of one who leads. This serves to create a form of social process that provides comfort and assurance to the larger group that there is a unified direction on which we can move as one and not as a divergent group that moves randomly with a meandering sense of chaos. However, in order to realize success, leadership must be accompanied by alignment.
Markets also need leadership, and as we engage in market making activities we search for where the leadership exists at any point in time. Identifying the leader and the leader’s potential to remain in that role through real or perceived strength is very often the way in which we successfully position our participation that maximizes returns. In today’s financial markets we have seen a struggle for leadership amidst conflicting information and a swirling rip tide that often emerges suddenly with movement that was not anticipated. In this week’s report I will offer my perspective on the leadership that I see in the murky waters of the investing sphere but more importantly, it is the emerging alignment that strongly indicates to me that the market leaders are now deciding which way to move in unison.
For quite some time market leadership has been found in interactive digital media (think Facebook, Amazon, Netflix, and Google (“FANG”)), Biotech and Pharma (think Valeant, Celgene, Gilead, Mylan, Allergan, Biogen, etc), and Commodity/Energy plays. One by one they have fallen, with upward leadership now becoming more and more narrow, while downward leadership has been expanding in numbers. This troubles me from an overall market perspective and with recent concerns about Apple, Microsoft, Google, Netflix the semi-conductor chip companies, coupling with a possible retracement by energy and continued softness in Life Sciences, the continued expansion of downward pressure has more than a mere correction feel to it. It has alignment.
To give you an idea of how this downward leadership and alignment shows up in one underlying metric, consider these two facts: (1) Between April 22nd and April 29th the Dow Jones Industrial Average fell by 230 points. The number of declining issues for that week totaled 1,528 companies. Between April 29th and May 6th the DJIA fell comparatively by only 33 points, yet the number of declining issues totaled 1,759 yielding an additional 231 companies with declining prices for the week; and (2) for the same periods noted above and looking at the more tech heavy NASDAQ exchange we see an April 22nd to April 29th point decline of 131 points with 1,853 declining issues, and the April 29th to May 6th point decline of only 39 points with 2,001 declining issues. Again, more companies went down in price on the NASDAQ during a week when the index was less negative. This is a warning as the breadth is expanding to the downside at a faster pace then the indexes are declining, confirming a narrowing of upside leadership and the expanding of downside leadership. A fragile market is the current state, so be very careful in how you position yourself. Additionally, the NASDAQ is falling faster than the other indexes and is taking the lead as it seeks a new lower foundation. The other equity exchanges will likely follow the leader as more and more of the broader market internals align with the NASDAQ index path lower.
The market questions and answers that will be discussed below confirm this trend but, more importantly, the mixed signals of the prior weeks have now been replaced with greater alignment of direction for the majority of indicators. That alignment coupled with the former upward leaders now leading to the downside is a dangerous combination.
During the past week I reshuffled parts of the portfolio, buying some beaten down names and moving my short hedges around the markets movements. The Gold Miner equities sold off during the week but did bounce up on Friday, but not enough to make up for the earlier declines. I still hold the miners as a hedge and believe they are destined to move higher in a turbulent market. My portfolio’s performance for the YTD period and the resulting period-end portfolio asset allocation is set forth below.
The Connolly portfolio and the market performance for the Year-to-Date period ending on May 6, 2016 is as follows:
YTD Connolly portfolio gain as of May 6, 2016 equals +5.90%
S&P 500 Index YTD gain as of May 6, 2016 equals +0.65%
NASDAQ Index YTD loss as of May 6, 2016 equals -5.42%
Portfolio composition as of May 6, 2016 is as follows:
• Cash 50.5%
• Equities 33.0%
• Gold 15.0%
• Fixed Income 1.5%
Forecast for the week: Given the recent weekly declines in the indexes a technical bounce higher would not surprise me. I expect the market to begin the week with upside action that fades. Having said this, simply due to the structure of the charts, the change in market internals and the fundamental expensive nature of the present market causes me to focus on preparing for a great level of risk that the market will decline to levels that are meaningfully below where we currently reside. So if we get the upside bias this week, I will use it to prepare for the anticipated deeper pull-back I foresee within the next eight or so weeks.
What are DJIA, DJT, DJU, S&P and NASDAQ metrics indicating?
All of the indexes are showing weakness to the downside. The NASDAQ is the most pronounced in pointing to continued declines. The consistency, whether in Relative Strength readings north of 70, earnings multiples north of 24X for the S&P and 19X for the DJIA, and chart patterns that reveal resistance to further moves to new highs, indicates meaningful risk exists to any investor who puts additional capital to work in equities.
The DJT has reversed to the downside and is now joining the NASDAQ in leading the market trend down. It is at a resistance point and if it can break higher it would be a positive sign for the overall market, however if it breaks lower through this resistance it could quickly drop by approximately 1,000 points.
The DJU had a meaningful correction down of approx. 5% in late April but has now reversed and is back close to new highs. It continues to reflect the safety of yield in a nervous world of Central Bank easing and Negative interest rates on foreign government debt.
What is the current score on the Market tells metric?
The Market Tell indicator, which is a comparison of the market’s current cash flow and valuation metrics to its historic medians, closed the week at negative 13. When we have a high positive reading this is a strong buy signal and when we have a high negative reading it is a strong sell signal. The -13 reading indicates an only mildly expensive market and reflects the pullback of the past two weeks as its prior reading was -41.
The Portfolio’s Cash flow multiple based on expected 2016 full year results is 17.93X as compared to last week’s 17.74X. These are relatively high readings of price to cash flow when compared to the historic median of 16.8X.
Comparing current equity prices as the week closed on the 187 portfolio companies to their Discounted Cash Flow values indicates 65 companies were priced above their DCF value which exceeds the historic average of 60 for the portfolio. This supports an expected fall in the market as more companies have become overvalued.
The dollar spread between the Current Price and the DCF price utilizing 2017 cash flow projections on the 187 Portfolio has narrowed and is now at $19.69, pulling back from the February high of $25.14. A higher spread indicates greater value to invest in whereas a lower spread indicates subpar returns will be realized from investing at current prices. The difference today is below the historic median of $22.52. In this environment it should be apparent that future performance has been pulled into the current pricing in a manner that reduces potential gains.
What is the position of the net up down Vol/Issues?
The week’s volume and issues were aligned with the index point decline. There was higher volume on down days and greater volume into declining equities then rising equities.
What are the daily point vs issues and point vs volume measures indicating up or down?
The daily metrics of (1) index point moves vs the daily volume in rising and falling issues, and (2) the index point moves vs the daily rising and falling number of issues traded, were consistently declining and supportive of a market that should move lower.
Where are the New Highs and Lows moving toward?
There is divergence in terms of degree between the New York Stock Exchange and the NASDAQ. The companies traded on the NYSE have a relatively static number of New Highs over New Lows whereas the companies on the NASDAQ delivered a greater number of New Lows over New Highs. The NASDAQ results are troublesome because companies hitting new 52 week lows should be small in number given where the index is now (down 5.42% YTD) vs where it was in February (down 13.4% YTD).
How well are Market Tells correlating with Market trading internals?
Technically, the 5-day activity in volume and issues is supporting falling prices. The fundamentals of the Market are indicating an expensive story and so these two are re-enforcing one another in terms of calling for a market decline.
What is the composite reading of the Calendar, Environment, Duration, Action, Trend, Emotion and Valuation Index (“CEDATEV”)?
The reading is -4. Range is from +7 to -7. Contributors are:
Negative in the following areas:
Positive in the following areas:
Neutral in the following areas:
Bitcoin is at $459 per coin and is showing stable growth development. The per unit value based in the low $400 area over the past two months but this week it advanced again. Over the past year, the price has increased by roughly 100% from the $230 area. I hold a position in Bitcoin as we move ever closer to digital currencies vs paper money and coinage. Please note I also own stock in the company PayPal (symbol “PYPL”) given the success and reach of its online payment platform and, in the mobile space, its penetration of the Millennial generation with the Venmo App platform on mobile devices.
Gold closed the week at the $1,289.70 per ounce. Continued currency weakness and Central Bank actions to keep interest rates at low or negative levels is supporting the price of Gold. Additionally, China continues to purchase meaningful quantities of Gold and just launched a Gold trading vehicle priced in their local currency vs US dollars. The price action and the demand for equities of Gold and Silver mining companies has been very strong. Many of these companies have more than doubled in price since the beginning of the year.
The Ten-year bond yield closed at 1.78% and has shown a great deal of volatility day-to-day. The trend does appear to be leaning toward lower rates. We are near the weekly closing low for the calendar year that occurred on April 8 at 1.72%, and is well below the 2015 year-end rate of 2.27%. Our Central Bank is weighing when to institute another increase in the Fed Funds rate. At some point this will likely weigh on the equity markets if the cost of US dollar financing rises.
Commodities: On April 29th the CRB index of commodities rose to its highest weekly closing level since July 2015. The past week saw a slight pull-back. This rise in prices helps the Emerging Markets navigate the economic challenges of being resource providers to the world markets. With higher raw material prices in the world markets they can sell their natural resources at better prices and thereby support the social and economic needs of their countries at a more comfortable level. As a precautionary note, I should point out that any strength in the dollar and associated rise in US interest rates will likely cap any future price increases here.
The High Yield vs Investment Grade spread has found a near-term bottom it appears. We touched 4.255% on May 2nd and since then each day has seen a turn upwards. We closed this week at 4.512%. If this spread continues to move upward this will be problematic for the equity markets as it will reflect greater market risk is being priced into the overall financial markets.
That about covers it for this week. I believe we are in a period of transition to lower prices in the equity market.
Watch carefully, and as always, have a great week! Happy Mother’s Day to all.