Last week, I stated the market was approaching a fairly important decision point. To wit:

In this week’s issue: 

• Weekly Commentary
• Strategy of the Week
• Stocks That Meet The Featured Strategy

n This Week’s Issue:

– Stockscores’ Market Minutes Video – Are You Expecting
– Stockscores Trader Training – The Plain Fool
– Stock Features of the Week – The Oversold Bounce

Stockscores Market Minutes Video – Are You Expecting
Traders who focus on the process instead of having expectations for profit are more effective because their emotion is reduced. That plus this week’s market analysis.Click Here to Watch To get instant updates when I upload a new video, subscribe to the Stockscores Youtube Channel.

Trader Training – The Plain Fool
It’s better to miss a good trade than to take a bad one. Missing a good trade doesn’t deplete your capital-it only fails to add to it. A bad trade will not only reduce the size of your trading account, it will eat up emotional capital and your confidence. A losing trade is not a bad trade because a bad trade is the one that you make despite it not meeting your requirements. Bad trades come from working hard to see something that’s not there, guided by your need to trade rather than the market offering a good opportunity.

I have read very few books about the stock market, but one that I’ve read more than once and that I think is a must-read for every investor is Reminiscences of a Stock Operator by Edwin Lefevre. Here is a wonderful quote from that book that captures the essence of what this chapter is about:

What beat me was not having brains enough to stick to my own game-that is, to play the market only when I was satisfied that precedents favored my play. There is the plain fool, who does the wrong thing at all times everywhere, but there is also the Wall Street fool, who thinks he must trade all the time. No man can have adequate reasons for buying or selling stocks daily-or sufficient knowledge to make his play an intelligent play.
-Reminiscences of a Stock Operator

I advise all my students that they will make more money by trading less, at least so long as trading less is the result of having a high standard for what they trade. If you tell yourself you’re limited to only making 20 trades a year, you’re probably going to be very fussy about what trades you take. With less than two trades to be made each month, only the very best opportunities will pass your analysis. All of the “maybes” or “pretty goods” will get thrown out.

We take the pretty good trades because we’re afraid of missing out. It’s painful to watch a stock you considered buying but passed on go up. You remember this pain and the next time you see something that looks pretty good, you take it with little regard for the expected value of trading pretty good opportunities. Pretty good means the trade will make money some of the time and lose some of the time, and the average over a large number of trades may be close to breaking even. The fact that one pretty good trade did well is reasonable and expected. In the context of expected value, taking those pretty good trades many times will lead to less than stellar results when the losers offset the winners.

You shouldn’t judge your trading success one trade at a time. You must look at your results over a large number of trades. To maximize overall profitability requires you to have a high standard for what trades you make. Maintaining that standard will be easier if you take the trades that stand out as an ideal fit to your strategy, not by taking those that are marginal and require a lot of hard work to uncover.

Oil and energy stocks have been really beat up over the past month and that sets up for a short term trade that savvy traders can take advantage of. With the sentiment overwhelmingly negative, it is likely that the sellers are getting exhausted in the short term and that will bring a bounce in both Oil and Energy stocks.

We should never try to buy the bottom, it ends up being the most expensive way to take a position because trying to catch a falling knife is rarely successful.

It is also important to stress that Oil and Energy stocks are in long term downward trends and I don’t see any reason to change the bearish view. I simply think that there will a short term bounce back, much like we saw in late January and mid March that is very tradeable.

What you want to look for is a show of buyer support on the short term chart. I recommend watching the 30 minute chart of the index ETF, like T.XEG or XLE. Look for the three phases of a turn around; break of the downward trend, formation of a rising bottom and then a break higher from a rising bottom. When that happens, you can either trade an ETF or pick a couple of stocks to benefit from the bounce back.

These bounces occur because those who are short want to take their profits and bargain hunters act on the lower prices. It is only when the perception of fundamentals starts to turn that the long term trend can reverse. These bounces typically just take prices back up to the longer term downward trend line before the sellers get motivated to act again.

If you have the time to watch the market closely through the day, look for the signs of an oversold bounce in Energy sometime in the next week or two.

1. T.XEG

2. XLE

References

• Get the Stockscore on any of over 20,000 North American stocks.
• Background on the theories used by Stockscores.
• Strategies that can help you find new opportunities.
• Scan the market using extensive filter criteria.
• Build a portfolio of stocks and view a slide show of their charts.
• See which sectors are leading the market, and their components. 

Disclaimer
This is not an investment advisory, and should not be used to make investment decisions. Information in Stockscores Perspectives is often opinionated and should be considered for information purposes only. No stock exchange anywhere has approved or disapproved of the information contained herein. There is no express or implied solicitation to buy or sell securities. The writers and editors of Perspectives may have positions in the stocks discussed above and may trade in the stocks mentioned. Don’t consider buying or selling any stock without conducting your own due diligenc

Increasingly concerned about the markets, I’ve taken more aggressive action than in 2007, the last time I soured on the equity markets. Let me explain why and what I’m doing to try to profit from what may lie ahead.

I started to get concerned about the markets in 2014, when I heard of a couple of investment advisers that increased their allocation to the stock market because they were losing clients for not keeping up with the averages.

Earlier this year, as the market kept marching upward, I decided that buying put options on equities wouldn’t give me the kind of protection I was looking for. So I liquidated most of my equity holdings. We also shut down our equity strategy for the firm.

Of late, I’ve taken it a step further, starting to build an outright short position on the market. In the long-run, this may be losing proposition, but right now, I am rather concerned about traditional asset allocation.

Fallacy of traditional asset allocation
The media has touted quotes of me saying things like, “Investors may want to allocate at least 20% of their portfolio to alternatives [to have a meaningful impact on their portfolio].” The context of this quote is that because many (certainly not all!) alternative investments have a lower volatility than equities, they won’t make much of a dent on investors’ portfolios unless they represent a substantial portion of one’s investment. Sure, I said that. And I believe in what I said. Yet, I’m also embarrassed by it. I’m embarrassed because while this is a perfectly fine statement in a normal market, it may be hogwash when a crash is looming. If you have a theoretical traditional “60/40” portfolio (60% stocks, 40% bonds), and we suppose stocks plunge 20% while bonds rise 2%, you have a theoretical return of -11.2%. Now let’s suppose you add a 20% allocation of alternatives to the theoretical mix (48% stocks, 32% bonds, 20% alternatives) and let’s suppose alternatives rise by 5%: you reduce your losses to -7.96%. But what if you don’t really feel great about losing less than others; think the stock market will plunge by more than 20%; and that bonds won’t provide the refuge you are looking for? What about 100% alternatives? Part of the challenge is, of course, that alternatives provide no assurance of providing 5% return or any positive return when the market crashes; in fact, many alternative investments faired poorly in 2008, as low liquidity made it difficult for investors to execute some strategies.

Why?
Scholars and pundits alike say diversification pays off in the long-run, so why should one deviate from a traditional asset allocation. So why even suggest to deviate and look for alternatives? The reason is that modern portfolio theory, the theory traditional asset allocation is based on, relies on the fact that market prices reflect rational expectations. In the opinion of your humble observer, market prices have increasingly been reflecting the perceived next move of policy makers, most notably those of central bankers. And it’s one thing for central bankers to buy assets, in the process pushing prices higher; it’s an entirely different story for central bankers trying to extricate themselves from what they have created, which is what we believe they may be attempting. The common theme of central bank action around the world is that risk premia have been compressed, meaning risky assets don’t trade at much of a discount versus “risk-free” assets, notably:

• Junk bonds and peripheral government bonds (bonds of Spain, Portugal, Italy, etc.) trade at a low discount versus US or German bonds; and
• Stocks have been climbing relentlessly on the backdrop of low volatility.

When volatility is low and asset prices rise, buyers are attracted that don’t fully appreciate the underlying risks. Should volatility rise, these investors might flee their investments, saying they didn’t sign up for this. Differently said, central banks have fostered complacency, but fear may well be coming back. At least as importantly, these assets are still risky, but have not suddenly become safe. When investors realize this, they might react violently. This can be seen most easily when darlings on Wall Street miss earnings, but might also happen when central banks change course or any currently unforeseen event changes risk appetite in the market.

Relevant with regards to my concern over a more severe correction is that it is complacency that drove the tech bubble to ever new highs in the nineties; and it was similar complacency that drove housing into the stratosphere ahead of 2008. Bubbles are created when investors have the illusion that there’s no or little risk with the strategy they are pursuing, bidding up asset prices.

Did I mention that I’m concerned about stocks and bonds? That may not make sense to some, as bonds are the historic refuge when stocks tank, but just as stock and bond prices have both been rising, it is possible for both of them to fall simultaneously.

Why now?
Historically, it’s difficult to say when markets top, when bubbles burst. In my analysis, relevant is the rise of volatility, i.e. the return of fear. With hindsight, we will attribute that fear to a specific event, but to me, it’s secondary whether it is concerns about China, Greece, the Fed, Ebola, or what not. Remember that the market has been climbing a wall of worries? Well, similarly, the market can fall on good news or bad news. The question is what will get investors to think the glass is now half empty rather than half full.

As such, it’s difficult to get the timing right. It was in December 1996 that former Fed Chair Greenspan warned about irrational exuberance, yet the markets continued to rally until the spring of 2000.

I don’t claim to have a crystal ball, either. But I do know that if we have a severe correction, I prefer to be early than late: the time to prepare one’s portfolio for what may be ahead is before it happens. That’s why I explained I’m taking increasingly aggressive steps to protect myself, at this stage “starting to build” a short position. I can’t know for certain where my analysis will take me in the future, but should the market continue to climb, I don’t see that as a failure, but as a potential opportunity to increase my short position.

Part of the reason I’m willing to short the market is because, aside from the potential expansion of risk premia as the Fed is trying to engineer an exit, there are other red flags that suggest to me a more pronounced downturn may come sooner rather than later:

• Glass half empty. In our analysis, the market has increasingly been reacting negatively to news. We see little sign of a market climbing a wall of worries.
• In our analysis, market breadth has deteriorated. It was last in the late 90s that the Nasdaq reached new highs, but the number of shares reaching new lows on a fifty-two week basis exceeded those reaching new highs. In plain English, few stocks are driving rallies, a sign of a market that’s tired.
• Stale revenue. Too many firms, in our assessment, don’t have revenue growth.
• P/E ratios. All else equal, low interest rates warrant higher price-to-earnings (P/E) ratios as future earnings are discounted at a lower rate. As interest rates rise, we expect “multiple compression”, i.e. lower P/E ratios.
• Share buybacks. Earnings per share for many businesses move higher despite stale revenue or higher costs because of share buybacks. As many firms borrow money to buy back shares, buybacks may become much less attractive as rates rise. They’ll have the additional headwind that they’ll then have to pay higher interest on the money they borrowed to buy back their shares.
• Whisper numbers are back. Some tech stocks get burned for not making “whisper numbers,” i.e. elevated expectations that go beyond what analysts have forecast. Investors expect that optimistic expectations are beat, a recipe for disappointment.
• The strong dollar. The strong dollar is another headwind, as well as a great excuse when companies miss earnings, masking underlying weakness.
• Global slowdown. In our analysis China is slowing down; many firms that have tried to sell to the ever more affluent Chinese middle class may be facing headwinds.
• Valuation. We don’t think stocks or bonds are cheap. We list this last, as everyone has his or her own preferred measure of valuation (in bull markets, investors are very creative in how they justify valuations). All I would like to add here is that any pundit that tells you “stocks can go up 10% from here” has no clue what he or she is talking about in my experience, that’s what pundits say if they have stocks to sell.

The biggest argument and one I take very seriously as to why none of the above means the market is going to fall is that the above points are rather obvious. The question is when will the market start to care about any or all of the above.

Note that I believe the Fed will raise rates, but will “remain behind the curve.” That is, we believe the Fed will be rather slow in raising rates, keeping nominal rates (i.e. interest rates net of inflation) near zero, if not negative. The Fed is well aware of past “temper tantrums” which contributes to its reluctance to raise rates. As such, it’s well possible that risk premia may not expand rapidly, thus keeping complacency alive and well. However, my base case scenario is that the Fed’s gradual approach will still get risk premia to rise, thereby toppling the markets. More so, Fed Chair Yellen has not experienced a major correction as Fed Chair; as such, she may well be late to succumbing the pleas of the market to back off. But given that much of the recovery may be based on Fed induced asset price inflation, a deflating of asset prices may cause significant headwinds to economic growth. As a result, I expect volatile Fed policy going forward; a Fed insider would more likely call it “fine tuning” of policy rather than volatile you choose.

How to profit?
So what is one to make of this? Again, we can’t give specific investment advice here, but I can tell you that for myself:

• I have eliminated most of my equity exposure;
• I have started to build a short position in stocks;
• I wouldn’t touch bonds with a broom stick;
• Aside from cash in U.S. dollar and hard currencies, I focus on alternative investments.

What alternatives? A commonly cited alternative is gold. The price of gold, over the long run, has had a low correlation to equities and bonds. Having said that, gold has been most out of favor. Well, that’s part of the reason I like gold, as so many other things are in favor. As I indicated before, I don’t expect real interest rates to move up much; it’s high real interest rates that are the key competitor to gold. More so, our analysis suggests the dollar rally over the past year might have been extreme. In fact, I would not be surprised if, in a year from now, the U.S. would be on a flatter tightening path than some other central banks. Differently said, we see the greenback as vulnerable. Long-term, we like gold because we don’t think the U.S., Europe or Japan can afford positive real interest rates a decade from now.

Talking about out of favor stocks, I have recently bought some gold miners. Again, just like anything else in here, this isn’t an investment recommendation. Importantly, gold miners come with their own set of risks they are certainly not safe.

Beyond that, I have dedicated much of what I have available to invest to my home turf, the currency markets. The beauty of the currency market, in our assessment anyway, is that one can design a portfolio that has a low correlation to other asset classes. In a “long/short” currency portfolio that takes a relative position of, say, the Swedish krona versus the Euro, the returns generated are highly unlikely to be correlated to equity returns. That’s exactly what I’m looking for. And as the liquidity in the currency space is high, I don’t have the same fear I would have with many other alternatives. As always, I’m putting my money where my mouth is; amongst others, as a firm, we have built out our infrastructure, so we can offer long/short currency overlay services to institutional investors; we think that if/when markets plunge, they’ll be scrambling to learn more about services such as the ones we have been building.

Of course there are other alternatives. They all have their own pros and cons, they have their own risk profiles. Note that there’s no easy answer should this analysis be right. And there’s certainly no assurance I’ll come out as a winner. But I firmly believe that just as former Fed Chair Bernanke talked about his toolbox, investors should consider having a toolbox.

Originally published July 31st, 2015.

In this update on the broad market S&P500 index we are going to look at no less than 5 charts for it, covering different time frames, the reason for this is that there are different points to make on each of these charts.

Before looking at the charts for the S&P500 index we are going to review first a range of charts, including the latest charts for Margin Debt and NYSE available cash. These charts provide the direst warning imaginable of impending trouble.

The NYSE Margin Debt chart shows that it is “through the roof” – way higher than it was at the 2000 and 2007 market peaks. When the wheel comes off, out will go the margin calls setting off a brutal self-feeding cycle of liquidation…

Chart courtesy of www.sentimentrader.com

The chart for NYSE Available Cash shows a shocking extreme negative cash situation far worse than that at the 2000 and 2007 market peaks, which is of course due to extreme leveraging on capital being employed to play the market. Once the market starts falling, this leveraging is going to work in reverse.

Chart courtesy of www.sentimentrader.com

The two charts above don’t suggest an ordinary bearmarket decline – they point to a devastating crash soon.

Next we take a quick look at a pair of charts that appeared in Zero Hedge, which show what happened to Junk Bond prices in 2008 ahead of the crash, and what is happening now. As you can see the same divergence is already evident, and it means trouble. The top chart shows the lead up to now, the bottom chart the lead up to the 2008 crash…

Now we will look at the latest Volatility Index (VIX) chart, which makes plain that a lot of investors are sitting contentedly in their comfy armchairs, perfectly happy with the current state of affairs, completely unaware that very soon their armchairs will be upended and they will find themselves sprawled on the floor….

It’s time to move on to consider a range of charts for the flagship S&P500 index. We are going to zoom in progressively, starting with the long-term 20-year chart.

On the 20-year chart we can see that, purely on a cyclical basis, we are overdue for a bearmarket after an 6-year bullmarket with no significant correction since 2011. What is most bizarre about this bullmarket is that it hasn’t even been the result of an economic recovery. It is has driven by printing money, misallocation of capital fuelled, by ZIRP and on company share buybacks, which in terms of genuine progress is about as effective as you climbing into a bucket and trying to lift yourself up by the handle. When you factor in inflation, this market hasn’t even made a new high – hasn’t got above its 2000 top.

Next we consider the 8-year chart, on which we see that the bullmarket from early 2009 has taken the form of giant bearish Rising Wedge, with volume steadily dwindling, which is bearish. With this Wedge having closed up and the market advance fizzling out, it is on the point of breaking down from it, and when it does the abrupt change in psychology will result in a devastating plunge, with the first two charts above suggesting that it will quickly become an absolute bloodbath. Bear ETFs will soar in price, especially the leveraged ones, and Puts will skyrocket.

On the 4-year chart, within the Rising Wedge shown on the 8-year chart, we see that all of the advance from late 2011 has occurred beneath the confines of a giant Distribution Dome, and the geometry of this Dome explains precisely why the advance has ground gradually to a halt this year, as it comes up against resistance at the top of the Dome. Unless it breaks out of the top of the Dome, which looks highly unlikely given the charts that we have already reviewed above for Margin Debt and NYSE Available Cash, not to mention the terrible breadth of the market now and declining Advance – Decline line etc, then the Dome must now force the market lower – and into quickly breaking down from the Wedge shown on the 8-year chart, with the dire consequences already outlined.

Zooming in closer still on the 1-year chart, we can see how the market’s advance has completely ground to a halt this year, with a horizontal resistance level at the top of the Dome now capping advances to the highs. A dangerous diminution of upside momentum is shown by the weakening MACD indicator at the bottom of the chart, and the current “bunching” of the index and its principal moving averages is what typically precedes a major change of trend. Once the support at the March low fails, which is at about 2040, things are likely to get ugly in a hurry – this is a key level to watch.

Finally we look at the 6-month chart on which we can see recent action in detail. This chart helps us to time further purchases of bear ETFs, and options, which are becoming steadily more attractive. We can see that we have had another weak rally from the 200-day moving average in recent days, following the Fed meeting, and as it approaches the resistance at the highs, the prices of bear ETFs and Puts of course improve. So this is the time to buy them. Note, however, with the Dome now starting to descend, the index may not make it as far as previous highs, so it is considered appropriate to buy before it gets there and with it looking like it is stalling out as this is written, now looks like a very good time.

Inverse ETFs based on the major market indices are a very good play here, because the major market indices are the façade of the market, which to many still looks OK, but beneath this façade the run rots deep, with the market’s Advance-Decline line in a negative trend and many stocks already below their 200-day moving averages. The market is very like one of those shiny red apples which has been left too long in the fruit basket – looks great on the outside but when you bite into it you make the distasteful discovery that it is brown right through and has been rotting from the inside out. THAT is the state of affairs that exists now, and it is precisely because these bear ETFs are based on the major indices, which are the shiny façade of the market, that they represent such great value now – once the façade comes crashing down these ETFs are going to soar, especially the leveraged ones. The sequel to this update is the article PREPARING FOR THE CRASH – Bear ETFs Shortlist, including leveraged ones, now up on www.clivemaund.com and we will soon be looking at a range of Put options for the crash on the site.

Perhaps rather strangely, gold could soar on this market crash, in contrast to what happened in 2008. Certainly this is what is implied by its latest COT chart shown below, which is the most bullish I have ever seen. The Commercials, who have never been long gold, have scaled back their shorts almost to 0, so they are clearly getting ready for something. What this implies is that, unlike in 2008, the dollar is going to drop with the stockmarket, which further implies that the flows of funds into the US will decelerate.

Posted at 1.40 pm EDT on 31st July 15. COT chart and interpretation added later.

Other than purchasing select stocks with very good fundamentals and chart patterns, for over a year now I have been warning you that a steep stock market correction was coming. So much so, that many are now calling me “a stopped clock.”

That’s fine. I can handle it. But the facts are these:

A. The Dow Jones Industrial Average is now down 1.5% since the first of the year and down 4.3% since its record high of 18,351.36 in mid-May.

Moreover, the Dow Industrials are now trading at the same level they were in November 2014. Meanwhile …

B. The Dow Jones Transportation Average is down a sharp 11.28% since the first of the year and 13.29% since its high of 9,310.22 in late November 2014.

That in itself is a very bearish sign for the Dow Industrials, for historically, it has trouble rallying — and often starts sliding — when the transports are doing poorly.

C. The Dow Utilities is down 10.27% since the first of the year and 14.37% since its high in late January.

True, the Nasdaq has hit new highs this year and the broad S&P 500 Index has also. But that’s deceiving.

In the Nasdaq and on both the AMEX and NYSE (where most S&P 500 stocks are traded), since the start of the year, far more stocks have been declining than advancing.

You can see the trends on these three charts here, each one showing that the number of advancing stocks minus the number declining is getting smaller and smaller.

Healthy markets? No. When taken together all of the above are signs that tell me a sharp, severe pullback is still in the offing.

And those are just some of the internal weaknesses in the broad equity markets. There are many more bearish signs, including record investor complacency, declining volume, pressures from the stronger U.S. dollar, cyclical forces and more.

So how low could stocks go? How bad could a correction be? No one can tell you with 100% accuracy, but here’s what my work tells me:

A. The Dow Industrials has weekly support at 15,672 and 14,395. Worst case I see the Dow falling no lower than long-term support at the 13,938 level. Yes, it could get that nasty.

B. In the S&P 500, major support lies at 2,025 and 1,893.50. Worst case I see it falling no lower than long-term support at the 1,709.75 level.

C. The NASDAQ has support at 4,380 and 3,756, which would be a worst-case scenario.

So I maintain my views:

A. The long-term bull market in stocks is still in play, and the Dow will explode higher to over 31,000 over the next two to three years. The S&P 500 and Nasdaq will lag but still experience terrific gains. 

But …

B. There will be no further gains in any of the major averages until a very sharp, sudden correction occurs, one that causes the majority of investors to panic.

The line in the sand on the upside remains Dow Industrials 18,500.

Keep in mind that any pullback though, as sharp as it may become, will  merely be a healthy correction, one that will actually serve to re-energize the markets by forcing die-hard bulls to sell, thereby giving the market new buyers once the correction plays itself out.

My suggestion remains the same: If you have equity positions you cannot or do not want to exit, for whatever reason, consider hedging those positions via an inverse ETF such as:

 ProShares Short S&P 500 (SH)

 The two times leveraged ProShares UltraShort S&P 500 (SDS)

 ProShares Short Russell 2000 (RWM)

 For small caps, Direxion Daily Small Cap Bear 3X Shares (TZA)

 For tech stocks, ProShares UltraShort QQQ (QID)

What can one expect after a correction?

My answer: Europe’s equity markets will not recover and instead enter the realm of longer-term bear markets, while most Asian equity markets — excluding Japan — will soar higher again with U.S. markets.

As I have said all along, don’t get caught up in economic stats, earnings reports, or the like to understand how markets are going to be moving from here on out.

Why? It’s simple: The world is entering a major sovereign debt crisis and that’s going to turn many markets inside out and upside down.

Everything you thought you knew about economics, about markets, about relationships between asset classes — will change right before your very eyes.

Best wishes and stay safe,

Larry