Research & Advice

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Stage 2 Update

Monday, June 2, 2014

 

On April 11, 2014 we issued a report titled “Shifting Stages: Stage 2 in Sight”. A review is below:

• Still overweight stocks, but leadership shift since late February suggests a topping process remains likely.
• Buying of equity should be deferred as the market approaches a weaker stage.

In our Economic Outlook for 2014, we noted that the calendar year could be divided into stages, with Stage 2 possibly experiencing the biggest correction since at least 2011, but we would wait for technical indicators to confirm the uptrend had been broken before taking any (if any at all) defensive action.

As discussed in previous reports, “the risk and the reward for the stock market will not be beginning to end, but rather during the year.” The price action of the stock market for 2014 is expected to be far less linear than 2013 and, instead, be defined by stages.

•Stage 1 (January to April?) – Leading into a cyclical bull-market peak, this stage has been characterized by momentum, and a Growth bias over Value.

•Stage 2 (April to September?) – A significant stock market decline characterized by relative out-performance of low-beta selections and dividend payers with reasonable valuations.

•Stage 3 (September to December?) – Following a bear market bottom, the magnitude of the decline will be important in determining sector and asset class leadership, but high-beta selections and a mean-reversion theme are likely.

 

An update on Stage 2

In May, the Dow Jones Industrial Average (DJIA) and the S&P 500 were up 2.1% and 0.8%, respectively. Given that there was an expectation of market stalling around this time, ultimately leading to market weakness, it is appropriate to review and update our indicators.

There has been, deservedly so, much media attention placed on the recent highs of the popular large-cap stock market indices. Though, in this case, the price of the popular indices does not necessarily tell the tale of what is going on under the surface. The continued coverage of new highs being made in the market is a distraction as to how the stock market is rising. Rather than displaying signs of a strong expansion in demand for stocks, the price gains have been based largely on a drop in selling. The price of stocks, like the price of anything, is based on Demand and Supply. While Supply (selling) has been virtually nonexistent, the amount of Demand (buying) has only managed to incrementally outpace selling. Higher prices have not drifted in that direction due to robust demand, rather they have done so because there have been no sellers. This is not exactly the ideal situation to support a significant move higher. As importantly, the lack of demand leaves the market vulnerable to an increase in selling

For example, at recent highs in the S&P 500, 21.7% of stocks were at or within 2% of their 52-week highs. But, at the early April high, the percent was at 31.7%. There are fewer stocks participating in pushing up index prices, a common sign of market deterioration. At the same time, a rising progression is apparent in the percentage of stocks down 20% or more from their 52-week highs: from 15.5% to 18.6% to 20.6% at the April 2nd, May 13th and recent market highs, respectively. More and more stocks are slipping into their own bear markets while fewer and fewer stocks are supporting the index level. All this suggests a rally based on increasingly selective strength. Thus, investors should be concerned about a stock market correction over coming months.

Bottom Line: We reiterate that we are not calling a new long-term bear market. But because you have tasked us with protecting your principal, raising cash and/or deferring new stock market investments appears to be prudent. We suspect that this bull-market has years to run, which allows us to be protective now – in the short-term – and more comfortably raise equity exposure later, whether it be after a correction by price, or after a correction of time (i.e a sideways movement for the markets over a period of months).