Monday, April 30, 2012
Whether this current bull market lasts another two months or another six months, the erosion process appears to be underway, and investors must be alerted to it. The level of selective demand (fewer stock leaders pushing the major indices higher) is consistent with an aging primary uptrend; this expression of limited longer-term buying interest calls into question the durability of the market’s primary uptrend.
The opportunity-risk for investors positioned conservatively is that new highs for the market may yet be reached before a final market top is made.
The greatest challenges to investors are recognizing major tops to the market, as well as major bottoms (minor tops and bottoms cannot be recognized reliably and consistently so our focus is on larger moves). After nearly 38-months of a bull market rally (starting March 6, 2009), the current challenge is identifying a major market top while it is still in the making (it’s not of much value to recognize it in hindsight). A primary reason for the difficulty in identifying the slow erosion of market strength that precedes major market tops is that it usually takes place in more obscure stocks that few investors are watching. Whether this current bull market lasts another two months or another six months, the erosion process appears to be underway, and investors must be alerted to it. The opportunity-risk for investors positioned conservatively is that new highs for the market may yet be reached before a final market top is made.
In an effort to better explain this process, allow us to share an analogy we read that may be of help in illustrating what it is Berkshire Money Management is looking for. The final months of a bull market are similar to the autumn months in an orchard, in that history tells us both will be followed by a period of stark loss (caused by either a bear market, or by winter) for the unprepared. Thus, the autumn of the stock market and the autumn of the year are times when the prudent prepare for the coming winter, by harvesting at the proper time, by deferring new plantings, by protecting the crop, and waiting patiently for the new planting season to arrive.
In the orchard, the fruit of the trees is not harvested just because of calendar dates, but because specific signs (such as color and taste) show that some pieces of fruit reach full maturity before others. And if fruit is not harvested at the peak of maturity, it can quickly go to ruin. Immature fruit can be allowed to remain on the tree, but in all cases the harvest must be completed before winter destroys everything that is left.
In the last months of a bull market, small-caps typically reach maturity first, in that they stop participating in the uptrend and begin to roll over into their own bear markets. Eventually, this process extends into the mid-caps and beyond, while some elements of the big-caps remain strong right up to the peak day of the market’s top. As the market participation gradually thins, the market becomes more fragile.
This process has traditionally been monitored by comparing each new rally high in the major indices to the height of various Advance-Decline Lines (for the unfamiliar, Investopedia.com’s definition of an Advance-Decline Line is: This indicator is used by many traders to confirm the strength of a current trend and its likelihood of reversing. If the markets are up but the A/D line is sloping downwards, it’s usually a sign that the markets are losing their breadth and may be setting up to head in the other direction. If the slope of the A/D line is up and the market is trending upward then the market is said to be healthy.) If the Advance-Decline Line fails to make new highs along with the major price indices, it is called a negative divergence and warns that fewer stocks are participating.
For example, the Dow Jones Industrial Average and the S&P 500 rose to new bull market highs on April 2nd, but the Advance-Decline Line failed to make new highs (the same was true for Adv-Dec lines for small-caps and mid-caps, as measured by the S&P 600 and S&P 400, respectively). At this late stage of the bull market, negative divergences prompt us to more frequently review portfolios, looking for asset classes, sectors, and regions that show negative divergences to cull them from portfolios (and / or perhaps include stronger asset classes, sectors, or regions).
A declining Advance-Decline Line is a pre-requisite for a major market top, but it has shortcomings as a perfect indicator (don’t they all?). The Advance-Decline Line only measures the number of stocks going up or down in price; it does not reflect the intensity of those gains or losses. And it works in both directions. A market exhibiting negative divergences can continue to go higher until major indices turn down. Also, as a result of this era of high volatility, Advance-Decline Lines may not fully reveal the extent of losses that can occur in individual stocks during the late stages of a bull market. This can be exampled by witness an Advance-Decline Line of a broad list of domestic operating companies. For example, in April 2010 (the top) only about nine percent of these stocks were down by 20% or more. At the next major high in April 2011, that number had increased to about fifteen percent. But at the April 2nd, 2012 bull market high, twenty-nine percent of these stocks had already declined by 20% or more. To be clear, at the recent top of the market nearly three out of every ten stocks listed on the New York Stock Exchange were down by 20% or more.
It is very possible that the NYSE and the S&P 500 Index could continue to make new market highs for a number of months. But individual stocks are breaking down one by one, like the leaves in autumn. The fruit is getting mature; it feels like winter is coming.
Again, it is worth reemphasizing that the major stock market indices could very well make a new high (think S&P 500 at about 1,450 points, or about 3.5% higher than current levels) without affecting our concern for a second quarter and/or Summer-months consolidation. The level of selective demand (fewer stock leaders pushing the major indices higher) is consistent with an aging primary uptrend ; this expression of limited longer-term buying interest calls into question the durability of the market’s primary uptrend.
The good news is that, thus far, indicators point to what could be called a disruption of the primary trend (an up market) as opposed to the resumption of the bear market. Increasing Supply (i.e. selling) and not just a lack of Demand (i.e. buying) is required to signal a significant market top that could result in significant market damage (“significant” might be considered something like a drop of 25-33%, the magnitude of decline typically realized during U.S. recessions). Thus we are currently more interested in hedging portfolios by holding some cash and/or holding more conservative investments( for example, large-cap as opposed to small-caps, or preferred-stocks as opposed to technology-stocks, or domestic stocks as opposed to emerging market stocks).
The popular media buzz-phrases have been “Risk-On” and “Risk-Off”, and the phrases have been applied to particular trading days, as well as longer-trends (even if the “trend” has only been weeks). On “Risk-On” days more aggressive stocks do well; on “Risk-Off” days more conservative instruments do well. Should the “Risk-Off” trade come back into vogue after a new market top (achievable over the course of the next few weeks), a lingering period of “Risk-Off would not necessarily mean that disaster lies ahead. In fact, a period of Risk-Off could set up the return of Risk-On.
Lower-priced oil and commodity indices (both Risk-On components) would ease fears of a taxation effect from higher energy prices and limit inflation concerns in China. Given China’s decline in money supply growth and economic momentum, the latter could increase the chances of a Chinese interest rate cut, the potential trigger for a Risk-On rebound.
Rising Treasury bond prices (a Risk-Off component) would ease interest rate pressures and limit stresses on the banking sector, in Europe in particular.
More selling would produce more deeply oversold conditions and a move toward greater investor pessimism, ingredients needed for a market bottom and thus the resumption of the Risk-On trade.
In the developed world’s secular bear market environment of chronic debt burdens, deleveraging, and sub-par economic growth, it doesn’t take much slowing to revive recession worries and send investors into a Risk-Off mode. But given our view that global economic growth will maintain its steady pace of improvement this year, the fears of U.S. recession will most likely be unfounded, at least in 2012. As such, any second quarter weakness in the markets will lead to a buying opportunity for a bull market recovery lasting into the fourth quarter.
Bottom Line:
The major stock market indices could very well make a new high (think S&P 500 at about 1,450 points, or about 3.5% higher than current levels) without affecting our concern for a second quarter and/or Summer months consolidation. The level of selective demand (fewer stock leaders pushing the major indices higher) is consistent with an aging primary uptrend ; this expression of limited longer-term buying interest calls into question the durability of the market’s primary uptrend.
The data most certainly do not speak with one voice; they never do. The concerns we have cited are necessary prerequisites for a market top, but they are absolutely not perfect indicators. The risk of maintaining a conservative posture at this point is that of opportunity lost. That is acknowledged, as is the philosophy of Berkshire Money Management to foremost be concerned about protecting your wealth. Thus with the evidence of possible market weakness creeping into our view, our preference is to position portfolios to protect assets. Should data change, whether over the course of weeks or even days, we will remain flexible enough to move from a position of preservation to that of performance.