CONCLUSION—More Selling Pressure is Likely

Our last two monthly updates began warning of increasing risks in the stock market, and in the past two weeks, that became a reality, with the S&P 500 dropping over 11% in just six days, before rebounding sharply.

Nothing has changed in that outlook. In our view, the major trend is down until proven otherwise (see the chart and additional commentary below). Remember, neither the depth of such a decline, nor its duration, can be predicted. But, I can offer some clues to the coming weeks, based on the prior history of similar sharp declines.

After a selling climax such as last Monday’s, when the Dow Industrials were down over 1000 points in the morning, markets tend to recover, with the bounce typically lasting several days to several weeks.  Once the bounce is over, the market then either retests the low, or undercuts it.  That’s what typically happens.  The real question, though, is this just a “healthy” market correction, or is this the start of a major bear market?  We’ll find out in the coming months.

The Long Term Trend

Below is a weekly chart of the Dow Jones Industrial Average, going back to 2006, courtesy of www.stockcharts.com.

The main message I want to convey from this chart is that every important support trend line for the Dow since 2009 has been broken.  That’s negative, and implies the stock market as a whole is transitioning from a six-year bull market to a bear market of unknown proportions.  The reason I lean towards this view is that almost every one of our longer term stock market risk models have turned negative (some of them, for the first time in a few years).

Investment Strategy—What Does 30% invested mean?

Our portfolios have had very little activity the past four weeks.  We actually covered a portion of our short position (inverse funds) on Monday, August 24, and that was reinstated on Monday, August 31 (yesterday).  At present, equity allocations in tactical accounts are at about 26%, and that will go lower today as another longer term model turned negative at month-end.  We remain out of real estate funds, high yield bond funds and the Loomis Sayles Bond Fund, but remain invested in PIMCO GNMA.

I thought it might be instructive to explain the above question—when we say we are X percent invested, what does that mean?  Let’s use a Moderate Risk account as an example.  For Moderate accounts, our maximum equity allocation is 55% of the overall account (therefore, the other 45% is in bonds/fixed income funds).

So, if we say as above that our tactical equity exposure is 26%, we mean it is 26% of about 48%, as the other 7% of equity allocations is represented by a 5% weighting in real estate and about 2.5% in the Leuthold Core Investment Fund.  If all of our stock market risk models were bullish, we would be 100% invested, and that would represent 48% of 48%.  But, 26% of 48% equals about 12.5%.  Since we have no real estate at the moment, and Leuthold is only 38% invested, that adds only about 1 percent of additional equity exposure.  All told, right now, our Moderate accounts have about 14% of their entire total balance in equity exposure.

Another way of saying that is, for every $100,000 in an account, a Moderate account has about $14,000 at risk in stocks.  For Conservative accounts, this percentage is a tad less, and for Aggressive accounts, a tad more.

Needless to say, this is likely to be quite different from the majority of the rest of our industry.  But, to get different results, one has to have a different process.  We aren’t really concerned with the 5 to 10% drops that take place from time to time.  There is little an investor or trader can do with those.  It’s the serious bear markets where we are trying to minimize the damage.  At some point, our risk models will be bullish again, and we’ll happily move to 70% to 100% invested.  It would be great if prices are significantly lower at that point.

The Fed and China

Has there ever been a financial story more written about than “When is the Fed going to raise interest rates?”  I’m not sure, but for me, one thing is certain.  I’m sick of reading about it.  It reminds me of the aftermath of the Super Bowl when the Denver Broncos upset the Green Bay Packers, and the reporter asked Broncos linebacker Bill Romanowski after the game about how the Broncos felt about all the hype prior to the Super Bowl about Brett Favre and the Packers.  His response—“We were so sick of hearing about the Packers, we all just wanted to puke.”

That’s how I feel about the Fed.  Follow the NIKE slogan.  Just Do It.  Get it over with.  My goodness.  If the U.S. economy is that fragile that it cannot withstand a 0.25% increase in interest rates, then there really are problems.  By the way, we have no idea what the Fed will do, nor its impact on markets.  But, remember this.  In a bull market, bad news is good and good news is good.  In a bear market, bad news is bad and good news is bad.

As far as China is concerned—recall the old campaign to discourage drug use?  Just Say No.  That’s what investors worldwide should do in regards to China.  In last week’s Los Angeles Times, a quote from a Chinese 36-year-old landlord, Kevin Zhang, said it all.  “China’s stock market is controlled by the government,” he said.  “No ordinary understanding of economics will tell you what’s going on in there.”

In addition, the same LA Times report indicated that China’s government forced the media there to “discontinue discussions, expert interviews and on-site live coverage.”  This is what happens when a government interferes with what is supposed to be a free market (oops—it is not a free market in China).  All in all, be thankful we live in the United States.  Things could be worse.

Material of a Less Serious Nature

By trade, my Dad, Harry Kargenian, was a mortician, and a really good one.  He had a great sense of humor, which apparently, he took to the end, as he passed away on March 7, 1995, the day of my third wedding anniversary.  Perhaps he was saying—hey, remember me!  So, here’s to you, Dad.

Three friends from the local congregation were asked, “When you’re in your casket, and friends and congregation members are mourning over you, what would you like them to say?”  Artie said, “I would like them to say I was a wonderful husband, a fine spiritual leader, and a great family man.”  Eugene commented, “I would like them to say I was a wonderful teacher and servant of God who made a huge difference in people’s lives.”  Al said, “I’d like them to say, ‘Look, he’s moving!'”

Here’s wishing you a great Labor Day holiday weekend.

Sincerely,

Bob Kargenian, CMT
President

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