The Robot Says “Danger, Danger!”

CONCLUSION—Stocks Are Lost In Space

Remember the television show which debuted in 1965 called Lost In Space, featuring Jonathan Harris as Dr. Smith and the Robot? With its master, wandering around whatever planet they were on, whenever the Robot’s computers would sense something was wrong, it would flap its artificial limbs and yell, “Danger, Danger!”

Well, growing evidence suggests this long bull market, which began in March 2009, is either entering its final phase or has already begun the transition to its opposite—a bear market, commonly defined in the industry as a decline of 20% or more. We believe the next big move in stocks will be down.

Several key indexes, including the Dow Industrials, Transports, and Utilities, along with the Russell 2000, Value Line Index, Advance/Decline line and Emerging Markets Index are all below their respective 200-day moving averages, and market stalwart Apple Computer slipped below this key level last week.

The S&P 500 and Mid Cap Index are the lone holdouts, and they are just a few points above the threshold. It is likely just a matter of time before they join the others. I’ve been writing about the increased selectivity of the stock market for several months. This past week, on the NYSE, 555 stocks made new 52-week price lows, while only 215 made new 52-week price highs. I don’t believe that is indicative of a bull market.

It is illustrated quite well in the chart below, courtesy of Ned Davis Research.

As you can see, last week, nearly 17% of the issues traded on the NYSE made new lows, while just under 7% made new highs. Not a healthy sign in my opinion. Major uptrend lines dating back to 2011 have been broken on almost all indexes, but there’s been very little apparent damage thus far, because the biggest of the big, the S&P 500, has not yet broken key support.  That is around the 2070 level first, and then 2040.  As I finish writing this on Monday morning, it is quite apparent this is a critical level for the stock market, as stocks are once again rallying strongly off this level, and may even advance to new highs in coming weeks.

Reinforcing the selective nature of the market was a story a couple of weeks ago in the Wall Street Journal that noted six stocks—Amazon, Google, Apple, Facebook, Gilead Sciences and Disney, had accounted for more than the entire gain in the S&P 500. Diversified portfolios are not keeping pace at the moment, but I don’t think that is a reason to abandon diversification.

Investors Should Reexamine Their Risk Tolerance

The latest issue of the Hulbert Financial Digest, a newsletter I’ve been reading for many years, had its latest issue titled, “How Much Are You Prepared To Lose?” He went on to say that now is the time to ask yourself that question, not after the stock market has declined over 40%. That’s not a hypothetical situation, either. The average stock during the 2007-2009 bear market fell more than 50%. As the chart below from Ned Davis Research shows, that could easily happen again in coming years.

The chart above is the median price/earnings ratio of the S&P 500. In the last 6 years, this ratio has advanced from just over 12 to almost 22, and now the index is overvalued by about one standard deviation relative to its 50-year norm. To get to fair value, it would require a 23% drop from current levels and to get to undervalued would require a 46% drop.

Investment Strategy

Before getting to these details, let me make one thing quite clear.  I’m not forecasting a decline of this magnitude.  No one can do that consistently, with any method.  And, I’m reminded of some great feedback about one year ago from a client who encouraged me to be more balanced in our communication with clients—especially to not be too negative.

That is great advice.  But I also realize playing it “safe” all the time is not the way to go.  We owe you, our clients, the truth as we see it.  I believe this will better help our clients achieve their goals.  Earlier this year, our overall indicators and models were mostly bullish, and we said so.  Now, they are not, and we are saying so, again.  Our headlines above are not meant to imply stocks are about to fall off a cliff.  Rather, we’re trying to convey that RISK is very different today than six months ago, and we’re acting accordingly within our disciplines.  How long stocks stay elevated is anyone’s guess, but we are in the more unfavorable six months of the year, which will extend into late October/early November.

We believe it is very important to have a long time horizon when investing in the financial markets, because inevitably, there are going to be some negative cycles.  And, in our view, it is critical to have a disciplined plan to deal with these environments, which is what TABR is all about on the investment side.

What Are We Doing?

Much like a month ago, equity allocations in tactical accounts are at 30%, and our risk models for real estate, high yield bond funds and the Loomis Sayles Bond Fund are all negative.  The majority of assets in our bond strategies are in short term bond funds.  In other words, we are in a very defensive position, but all we are doing is following our plan, which is what our clients pay us to do (along with on-going planning and guidance).

For those investors and clients who have fully-invested passive portfolios (401k accounts for example), there is nothing to do but grin and bear it.  OK, that was a terrible pun, but that is, in fact, the strategy.  Do nothing.  The only thing we do in that area with clients is to make sure they have rebalanced to their asset mix, especially if they have not done so in the past year or more.  Holding cash or too much in bonds the past few years, as we will be writing about in our coming quarterly newsletter, has simply been harmful to one’s bottom line.  The odds are, that is about to change.

Material of a Less Serious Nature

A STORY FROM AN IRISH SUNDAY SCHOOL TEACHER

I was testing children in my Dublin Sunday school class to see if they understood the concept of getting to heaven.  I asked them, “If I sold my house and my car, had a big garage sale and gave all my money to the church, would that get me into heaven?”

“NO!” the children answered.  “If I cleaned the church every day, mowed the garden, and kept everything tidy, would that get me into heaven?”

Again, the answer was “NO!”  “If I gave sweets to all the children, and loved my husband, would that get me into heaven?”

Again, they all answered “NO!”  I was just bursting with pride for them.  I continued, “Then how can I get into heaven?”

Finally, a little boy shouted out:  “YUV GOTTA BE FRICKIN’ DEAD!”

Bonus Comment This Month—You Can Never Start Them Too Young
On our summer vacation a few weeks ago at Family Camp in Northern California, our daughter Caroline and her dear friend Caitlyn contributed to the humor box, which apparently had the 5th and 6th grade girls laughing hysterically.  So, here goes.

Why did the snow turn yellow?
Because, Elsa LET IT GO.

On that note, it is just about time to send them back to school. . . . .

Sincerely,

Bob Kargenian, CMT
President

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