“As shown in the chart below, the market has been remained trapped in a tightening pattern of higher lows and lower highers. This type of action is like the compression of spring. In the next few days, the markets will make an important decision. A breakout to the upside of this consolidation will confirm the current bullish trend, and portfolio actions should remain allocated and tilted more heavily towards equity related risk. However, a break to the downside will likely suggest a more significant correction in the near term. It is worth noting that this consolidation in the market is happening during a decline of relative strength. This is a warning sign that generally bodes poorly for the bulls.”

(Note: The chart has been updated to Friday’s close to show the breakout of that consolidation.)

“Since portfolios are currently fully allocated to the market, if the market breaks out to the upside of the current consolidation this will simply confirm that the “bulls” are still currently in charge of the market. No action will be required.”

As shown, that breakout did occur this past Friday,which suggests that the bullish trend is still intact and that portfolios should remain currently tilted towards equity exposure. 

However, this does NOT mean that all market risk is now resolved, or that investors should return to their complacent slumber.

As discussed in this past weekend’s missive the market is currently more overbought now that at any other point in history going back to 1940.

The vertical dashed white lines show that when the extreme overbought condition begins to decline it is coincident with past historical peaks in the market.  Furthermore, the long term MACD (moving average convergence divergence) has also turned down which has also historically aligned with more significant market peaks and corrections.

Importantly, this overbought indication is “longer-term” in nature and is slow to move. This means that in the short-term, stocks can, and most likely will, continue to try and advance further due to underlying price momentum. As I have discussed previously:

“The effect of momentum is arguably one of the most pervasive forces in the financial markets. Throughout history, there are episodes where markets rise, or fall, further and faster than logic would dictate. However, this is the effect of the psychological, or behavioral, forces at work as ‘greed’ and ‘fear’ overtake logical analysis.

This is the basic application of Newton’s Law Of Inertia, that states ‘an object in motion tends to remain in motion unless acted upon by an unbalanced force.’ In other words, when markets begin strongly trending in one direction, that direction will continue until an ‘unbalanced’ force stops it.”

Currently, with Central Banks fully engaged in monetary interventions on an unprecedented global scale, there is seemingly nothing that can stop the current advance. Of course, it is that very “thought process” that has been a hallmark of exuberant markets in the past.

Margin Debt Strikes New High

Along with the markets currently being more overbought now than at any other point in history, they are also more leveraged as well.

Late last week the NYSE released its latest margin debt figures for March. Despite a rather sluggish market, investors piled on margin debt pushing levels to all-time highs as shown below.

It is worth noting that when net credit balances have plunged very negative levels it has been coincident with major mean reverting events in the market. 

While “this time could certainly be different,” the reality is that leverage of this magnitude is “gasoline waiting on a match.” When an event eventually occurs, that creates a rush to sell in the markets, the decline in prices will reach a point that triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying “collateral,” the forced sale of assets will reduce the value of the collateral further triggering further margin calls. Those margin calls will trigger more selling forcing more margin calls, so forth and so on.

Notice in the chart above that margin debt reductions begins innocently enough before accelerating sharply to the downside.

Tending The Garden

The combined overbought, overleveraged condition of the financial markets is of extreme risk to investors currently. While the bullish trend remains intact currently, it is extremely prudent to perform some risk management in portfolios. As discussed this past weekend:

“…it is worth remembering that portfolios, like a garden, must be carefully tended to otherwise the bounty will be reclaimed by nature itself.  If fruits are not harvested (profit taking) they ‘rot on the vine.’ If weeds are not pulled (sell losers), they will choke out the garden. If the soil is not fertilized (savings), then the garden will fail to produce as successfully as it could.

So, as a reminder, and considering where the markets are currently, here are the rules for managing your garden:

1) HARVEST: Reduce “winners” back to original portfolio weights. This does NOT mean sell the whole position. You pluck the tomatoes off the vine, not yank the whole plant from the ground.

2) WEED: Sell losers and laggards and remove them garden. If you do not sell losers and laggards, they reduce the performance of the portfolio over time by absorbing ‘nutrients’ that could be used for more productive plants. The first rule of thumb in investing ‘sell losers short.’

3) FERTILIZE AND WATER: Add savings on a regular basis. A garden cannot grow if the soil is depleted of nutrients or lost to erosion. Likewise, a portfolio cannot grow if capital is not contributed regularly to replace capital lost due to erosion and loss. If you think you will NEVER LOSE money investing in the markets…then STOP investing immediately.

4) WATCH THE WEATHER: Pay attention to markets. A garden can quickly be destroyed by a winter freeze or a drought. Not paying attention to the major market trends can have devastating effects on your portfolio if you fail to see the turn for the worse. As with a garden, it has never been harmful to put protections in place for expected bad weather that didn’t occur. Likewise, a portfolio protected against ‘risk’ in the short-term, never harmed investors in the long-term.”

With overall market trend still bullish, there is little reason to become overly defensive in the very short-term. However, I have this nagging feeling that the “spring” is now wound so tightly, that when it does break loose, it will likely surprise most everyone.