Sideways Shuffle

In The Highstreet Group by John Bartoletta

Sideways Shuffle

MARKET REACTION: We want to update our prior Blog, dated July 26. The broad markets pulled back a modest 2% during the month of August but little has changed in our call for a broader market pullback required to maintain a healthy long-term bull market, we have been trying to sleep a lot with the chair pillow in order to get new ideas for the blog. The market indexes appear to be in some neutral consolidation periods, by trading in relatively tight ranges for the past month after their previous burst of strength. These sideways periods are common to see within a longer-term trend, and are a normal part of the process. What we like about consolidation periods is that they give us some short-term numbers to watch for support below and resistance above that can then be used as signal levels for the next move, once either side is breached. Sometimes, these sideways periods turn out to be tops, but you really can’t call it that unless the support level below is broken, which is around 21,600 for the Dow Industrials and 2420 on the S&P. Otherwise, the daily volatility counts as “business as usual,” in our opinion.

CURRENTLY: The pullback in the markets during the first half of August is being commonly attributed to the large amount of uncertainty investors need to worry about domestically and internationally. These concerns have been with us for a much longer time than just recently, and we cannot recall too many times when there were so many unknowns for the world to deal with, and yet despite all the fear, the indexes are still within a few percent of their all-time highs. Uncertainty may be difficult to deal with emotionally, but apparently it’s good for business. The uncertainty has also caused an increase in the bearish sentiment as measured by many indicators. We would expect more of a volatile trading range period that could last a month or two, and eventually lead to a resumption of the longer-term bullish trend, but at this time we think the low end of that range is still uncertain.

ECONOMIC SURPRISE INDEX: Little has changed with the Economic Surprise Index. The index (above) shows the degree the economic analysts under- or over-estimate the trends in the business cycle. The surprise elements of regularly reported weekly and monthly economic data releases are smoothed over a six-month period with more weight given to recent releases. While the value of the index is important, the overall trend of the indicator is significant. The declining trend of the index that has now extended to over 5 months indicate a continued underperformance of the economy relative to economist’s expectations. At best, a weakening trend — especially into negative territory – has led to a consolidation period in the markets.

COMPLACENCY (S&P P/E to VIX SPOT Ratio): The market and stocks do tend to cycle between periods of higher and lower volatility, enough so that when a more volatile period does arrive, it comes as a shock to investors who get settled in and used to the quieter periods.

The recent increase in volatility has caused the Complacency Index to come off of its historic highs. In order to be significant though, we would need to see the index break its trend of higher-highs and higher-lows. This continued complacency of rising valuations (P/E ratios) and falling volatility suggests that a market pullback is likely or at least a pause. It is a modest move relative to the overall market performance recently, however the markets need to continue to rein in this complacency in order to maintain healthy market balance.

VOLATILITY (VIX): Volatility, as measured by the VIX, is a statistical measure of the dispersion of returns for the S&P 500 index. This index is the standardized barometer for volatility used by most institutional and private investors worldwide. Despite the recent bump in volatility, we would like to see sustained volatility as represented in the 200-day moving average (Green Line on chart). As investors begin hedging their portfolios, a rise in the VIX is the most common broad market indicator.

The chart above represents an overlay of the S&P 500 Index and the spread of the VIX spot (current) price minus the VIX 3 month futures price (as represented by the green and red shaded areas on the chart). Previously, it showed the VIX term structure known as “contango” (in green). The term structure when combined with the other volatility indicators can represent a near-term reversal (correction) in the equity markets. Conversely, when these series of indicators show a discount (shown in red) at increasingly larger spread, a short-term reflex sell-off ensued. The status-quo is currently at play and we need to see a spike in the VIX spread to indicate a near-term correction. We will be watching this closely.

SHORT-TERM (Days to Weeks): Toppy. After the short and shallow pullback in August, we would need to see the markets to push to a new high in order to change our short-term view. That would reinforce the higher-highs and higher-lows trend that has held recently. The market indexes have been scoring some token new highs over the past few weeks but have not been able to follow through with a meaningful advance. The main obstacle to a larger rally appears to be the lack of participation by a majority of key market groups. Every day we are seeing groups switching places by bouncing or pulling back thus keeping the averages from making any real headway. We think this could be a sign of a developing correction, as a stronger market trend generally has good upside participation from most groups, and that is missing.

INTERMEDIATE-TERM (Weeks to Months): Neutral. The S&P 500 and the Dow Jones Industrials have recorded a long string of new highs, along with most of the other stock indexes, to form a bull market that is confirmed by most definitions. The intermediate-term trend has been in this bull market for the past eight years, and the several 10%–15% pullbacks that the market has experienced during this time have been buying opportunities, in our opinion. We suspect there will be more of those corrections ahead, which is a normal part of a long-term trend. The current market position may be close to the start of another one of these pullbacks, in our opinion, and we would want to have some cash on hand to take advantage of such an opportunity if it happens.

LONG-TERM (Months to Years): Bullish. The Dow Industrials and the S&P have been in bull markets since 2009, and they continue to trade in rising channels that we think imply further gains over possibly many more years. We continue to believe that the U.S. stock market is still in a longer-term secular bull market that we expect to rise until the sentiment of investors and the public becomes much more optimistic about the future than the mood of today, which could still take quite some time to develop. The overall theme of the long-term bullish trend has been that of changing group rotation where different market sectors and groups do better, or worse, at various times, and we expect those kinds of changing cycles to continue. It is usually not until much later in the long-term cycle that the market gets to the point where most groups and stocks are in bullish trends, so a long-term holder of a diversified portfolio can expect to see varied performance between different stock groups for possibly several more years, in our opinion.

TRADING UPDATE: We remain committed to holding some cash on the sidelines as both a hedge to the markets and as “dry powder” to put to work should opportunities arise. We have continued to put a limited amount of cash to work into equities as pullbacks in specific sectors and individual stocks occur and have been rebalancing portions of the portfolios where necessary. The excess cash can be put to work quickly should we see further opportunities present themselves with emphasis on a bottom-up investment approach given the constantly changing market sector leaders. Until then we remain diligent in our research and will continually monitor the markets.