Weekly Update

February 19, 2016 Update

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Some find reason for optimism

We thought that our friends here in Austin at Per Sterling did a good job with this month’s blog post. So we’re sharing portions of their monthly comments below. The words are theirs, not ours and thus reflect an investment approach that is more “traditional” than ours. Nevertheless, we think they do good analysis and bring it together in a clear fashion.


“It seems like, all of a sudden, television and print media are full of stories about how the “stock market” may be entering into a “bear market,” and each respective reporter references one of the two most popular benchmark indexes (the Standard and Poor’s 500 Index and the NASDAQ Composite), neither of which has yet declined by at least 20% (the standard definition for a bear market).

However, these indexes can significantly obscure the true condition of the domestic equity markets because they are capitalization-weighted. As such, large companies have a much bigger influence on the value of the index than do smaller companies which, in turn, allows the out-sized price movements of a few large-capitalization leaders (or laggards) to make an overall index or market look deceptively strong or deceptively weak.

Last year provided a great example of this phenomenon, when the 10 best-performing stocks on the Standard and Poor’s 500 Index averaged impressive gains of 19% on the year, while the other 490 stocks in the index actually lost an average of 4%. Despite this divergence, the index itself was remarkably unchanged on the year. However, even this perception of a flat market obfuscates the severity of this decline, during which the majority of U.S. stocks have already fallen by over 25% from their 52-week highs.

Chart 1: Markets since the Fed’s first rate hike

Markets since the Fed's first rate hike

That general downtrend has both continued and accelerated through the first six weeks of 2016, which has thus far produced the worst start to a year for equities in the history of the domestic stock market. Equally telling is the fact that it has also been the best start to a year in the history of the gold and U.S. Government bond markets. The aforementioned media reports ignore the obvious, which is that most equity securities around the globe, including in the U.S., have been in a bear market since early last summer.

The question should thus not be whether we are/will be in a bear market. That answer is self-evident. Instead, the more useful and much more provocative questions should be “when will the bear market end?” and “what are the signs that you should look for to help to identify and confirm a likely bear market bottom?” We will use the opportunity of this writing to attempt to shed some light on these two questions, and why we believe that some of the answers are more immediately bullish than many people might think.

Chart 2: Stock markets worldwide struggling

Stock markets worldwide struggling

There are certain signposts that analysts look for to help identify market lows, and there are certain requisite things that must take place before virtually any bear market can end. One of those things is “capitulation,” which is the point at which things appear so incredibly bleak that the last potential sellers finally give up hope and sell their shares. At that point of maximum despair, the market runs out of potential sellers and begins a bottoming process.

Please note the use of the word process, as market bottoms tend to be processes rather than events. We believe that it is very likely that this bottoming process began with the vicious sell-off and then upside reversal on January 20th of this year, when trading volume was twice normal levels and twenty-nine stocks declined on the day for every one stock that went up. Carrying forward the theme from the January edition of this report, this is the sort of market action that you often see at market lows. For additional confirmation of this low, you want to see it successfully re-tested and, for the time being, that appears to have taken place last week, with a bounce off of the January 20th lows (a level that it will be critically important for the markets to remain above).

Chart 3: Stocks find some interim support?

Stocks find some interim support?

It is also encouraging that investors finally “knocked down the last man standing,” as the old saying goes. In other words, bear markets very rarely end until investors aggressively sell so-called “Teflon stocks” that seem almost immune to the sell-off until late in the decline. We believe that this purging took place in the first half of February. In other words, the technical picture for the equity markets generally, and the U.S. markets, in particular, suggest the near-term potential for a sustainable low in this nine-month-old bear market. Indeed, we find a variety of reasons to be encouraged.

Stocks at critical support for this bull market

As a companion piece to the above chart, we offer a much longer-term chart looking at the importance of the market’s current price in the scope of the now almost seven-year-long uptrend. Thanks to Chris Kimble for the chart.

Chart 4: S&P 500 hits a critical price juncture

S&P 500 hits a critical price juncture

Market Update

Stock investors looked to see if an oversold market could build on a positive end to the prior week. Coming back from Monday’s President’s Day holiday, stocks advanced with vigor after a rumored oil production freeze agreement combined with happy talk from European Central Bank (ECB) head Mario Draghi to put plenty of wind in the sails of the bulls. Stocks roared higher to a +1.7%. Wednesday’s effort duplicated that gain on a strong industrial production report and a continued optimism about an oil production freeze. Minutes from the Federal Reserve did nothing to dampen enthusiasm with the report noting that economic risk have risen thus giving investors reason to feel that further interest rate hikes are unlikely anytime soon.
The three-day rally came to an end Thursday with stocks pulling back -0.5% after having risen to notable resistance. Friday kicked off with additional although modest downside pressure. Stocks were able to bounce back to a flat finish however despite weak earnings reports from industrial and consumer stocks.

Warm wishes and until next week.