Weekly Update

January 15, 2016 Update

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Can we realistically expect to find the next great stock?

The list below comes from @ivanhoff a professional stock trader and frequent investment writer, blogger, tweeter, et al. The list outlines the stages of a market correction. Given that stocks are mired in a significant correction right now, it seems worthwhile to revisit this list. Herewith is Mr. Ivanhoff’s outline. The typical correction has distinct stages that vary in duration:

  1. Quick and wide-spread leg lower that ends with a momentum low, that sharp whoosh lower that generates notable fear. This leg lower is like the wake-up call for the market that something has changed.
    Disbelieving bulls then try to take the opportunity to buy what is now “on sale”, leading to the:
  2. Oversold bounce that usually fizzles out rather quickly.
  3. Choppy period that whipsaws both bulls and bears. Almost no one makes money trying to trade these short back-and-forth moves.
  4. A Retest of the momentum lows with breadth divergence. Breadth divergence means that despite the fact that the market price is revisiting the lows, there is some breath of fresh air somewhere, such as fewer stocks falling at the retest.
  5. A Recovery that lasts and drives stocks ultimately higher.

The history of U.S. stock markets has been a perpetual long-term uptrend interrupted occasionally, but very consistently by shocks. Most of those shocks take the form of short-term drawdowns that come and go. Some corrections turn into bear markets that last more than a year. They say that almost everyone loses money in bear markets – both bulls and bears. Bulls lose because they stubbornly hold on to positions in favorite companies and some stocks never recover from deep drawdowns. Bears lose because they get squeezed during the violent rallies that happen under declining 200-day moving averages. Bear markets should be respected, but they should not be feared. They just require a different approach than what is used in bull markets.

For more information on the topic, see @ivanhoff’s website and/or book on the subject found here: Crash Course on Market Corrections

What is the difference between an ETF and an ETN?

Exchange-traded funds (ETFs, for short) are very similar to mutual funds in structure. They are just collections of securities, often focused on a particular purpose – for example, U.S. large-cap stocks, or oil and gas stocks, etc. When you buy the ETF, you are buying a small piece of the entire portfolio of securities, just as when you purchase shares in a mutual fund. The difference from a mutual fund being mainly that you can trade ETFs throughout the day, just like individual stocks, whereas almost all mutual funds trade only at the end of the day. Because of this ability of ETFs to trade throughout the day, investors have more control over when they enter and exit the trade, which also gives them control over some of the tax implications of holding the security. Mutual funds distribute capital gains whenever they choose, not when you choose.

Exchange-traded notes (ETNs, for short) are structured more like bonds in that they have a maturity date, but do not necessarily pay interest like a bond. Because bonds and notes are contracts dependent on the underlying issuer to “make good” on their obligation, there is a chance that the issuer could default on the note (the ETN). This is a very remote scenario, because even if the underlying issuer were to go bankrupt, there would likely be other firms interested in stepping in to take over the ETN obligation and receive the management fees derived from providing the security.

Of more interest to some investors, there has arisen a tax difference between ETFs and ETNs which has made ETNs attractive when buying commodity-based securities, MLP-based securities, and anything that is structured as a partnership (which many commodity-based ETFs are). Rather than dive into the nuances of the tax difference, we’ll just point out that ETNs are taxed like a bond – interest is taxed as regular income; gains are taxed when taken. Commodity-based ETFs can be taxed as partnerships, which can lead to filing of K-1 statements, changes in cost basis from “return of capital” rather than simple capital gains, and various other nuances. And, of course, one should consult their tax professional for help with their particular situation.

The tax treatment differences are usually confined to commodity-based ETFs and ETNs. Otherwise, most investors will notice little difference between ETFs and ETNs on a day-to-day basis.

Market Update

Investors entered the second week of the year shell-shocked from a brutal selloff to begin 2016. They would have to wait another day for any bounce, however, as Monday offered little help. Another -5% dive in oil prices and weakness in China continued to rattle markets. Investors were able to hold the stock indexes flat in the face of the bad news as some buyers emerged to keep things neutral. A modest bounce came Tuesday despite oil’s relentless march downward toward $30. Buyers bought the dip in the prior market leaders like technology and consumer discretionary to leave the Nasdaq Composite up +1% on the day. The positive vibe was quickly squashed in a market bloodbath Wednesday.
After opening positive stocks slid all day with those same leaders that had shown well Tuesday suffering 3-5% losses Wednesday. Weak words from the railroad sector stoked recession fears to propel stocks to a -2.5% slump. All was forgotten the next day, however, as buyers once again swooped in to buy up the bargains. Energy stocks led the way with Exxon (XOM) and Chevron (CVX) adding +5%. JP Morgan (JPM) reported decent earnings while investors bid up Intel (INTC) in advance of their announcement after the close. Of note, the stock market managed a +1.7% advance, less than the downfall experienced the prior day. Thus, a net negative return over the back-and-forth of the two days. Intel guided revenue lower to keep global recession fears at the forefront Thursday night and pave the way for another market drubbing Friday. Friday morning’s market open was another slippery affair. Weakness in China overnight and oil prices breaching the $30 level combined with the Intel news to set investors on their heels. Attempts by buyers to halt Friday’s -2.5% slide were held in check as fear levels rose throughout the day ahead of a three-day weekend for U.S. markets.

Warm wishes and until next week.