7.6 C
New York
Thursday, March 28, 2024

3 Things Worth Thinking About (Volume 3)

Courtesy of Doug Short.

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.


Yesterday, I discussed how large a potential “real” correction might be with a specific look at technical support levels. As I stated:

“There is no exact answer to the potential magnitude of a correction in the markets. ‘This’ depends on ‘that’ to occur which is why trying predict markets more than a couple of days into the future is nothing more than a ‘wild ass guess’ at best. However, from this analysis, as shown in the table below, we can make some reasonable assumptions about potential outcomes.”

Click to View

“Currently, there is a convergence of points between 1650 and 1700 on the index that will present rather important levels of support for the market currently. Not only would a correction to such levels be a ‘healthy’ event in order for the current ‘bull market’ cycle to continue, it would also likely present a fairly decent opportunity to increase equity exposure in portfolios. As I noted above, a correction of 14-16% is far outside of the expectations of the market currently. Such an event will likely ‘feel’ much worse to individuals that have inadvertently taken on excessive risk in their portfolios by ‘chasing’ markets and ‘yield.'”

This week’s “3 Things” is a brief focus on some of the issues that I am watching that could contribute, or potentially exacerbate, a market correction.

Stock Buybacks

I have touched on the impact of stock buybacks in the past (see here and here) as it has related to the “fudging” of corporate profitability. However, another side of stock buybacks is the impact on the stock market itself particularly in a low volume environment. As shown in the chart below (via FactSet), there is an extremely high correlation between stock buybacks and the S&P 500 index.

Click to View

What is important to notice is that the level of share buybacks has now reached, once again, levels only seen prior to the last market peak. While I am not suggesting that share buybacks are about to plunge, the impact of stock repurchases needs to be considered.

Corporations are not as profitable as they appear. Stock repurchases have been the primary tool used by corporations to boost earnings per share, in order to meet investor expectations, as the effectiveness of “cost cutting” and “employment reductions” have run out.

Click to View

As I stated previously:

“The problem with cost cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness.”

Share buybacks are also finite in nature. While it is expected that corporate profitability will continue to surge indefinitely into the future, history suggests otherwise.

Click to View

With interest rates so low, companies have been relevering balance sheets to repurchase shares and increase dividend payouts. This has been a boon to investors by lifting share prices and increasing dividend income. However, with the Fed now threatening to increase borrowing costs in the not so distant future the benefits of borrowing will become much less attractive.

Eurozone Deflation Likely Heading Our Way

I discussed earlier this week that the Federal Reserve may be mistaken in their expectations of rising inflationary pressures in the economy. The reason I made that statement was due to the following chart:

Click to View

With Italy slipping into a “triple dip” recession, and German bonds printing “negative yields,” the decline of economic stability in the Eurozone is leading to ever greater deflationary pressures. As shown in the chart below, there is a very high correlation between the Eurozone and U.S. inflation gauges. This should not be surprising considering how globally connected both area and the fact that, as trading partners, there is a delicate balance between economies.

Click to View

It is unlikely that the current divergence between the U.S. and the Eurozone is sustainable. Either, the economies in Europe are on the verge of turning sharply higher, or the already vulnerable economic environment in the U.S. will succumb to the tide of pressures from overseas.

A resurgence of deflationary pressures in the U.S. will not only threaten the financial markets but will also put the Federal Reserve “back in the box” regarding further tightening of the current levels of accommodation.

Buy The Dip Or Sell Rallies

In addition to the technical analysis of a potential pullback, as discussed above, there is also a significant deterioration in the “health” of the market. Doug Kass, via theStreet.com, made the following points this week:

“With breadth deteriorating and new highs falling, the market’s character has changed, and numerous negative market tells abound (and have been heretofore dismissed until the past week).

  • Throughout the 2013-2014 rally shallow market declines responded positively to favorable news, but the Thursday waterfall drop followed better-than-expected economic news — namely, a 4% second-quarter 2014 real GDP reading.
  • I have often opined that some of the worst market declines occur when investors can’t identify a catalyst for the drop or when good news is ignored — such as it might be at the current time.
  • Just as rising markets tend to result in investors and traders focusing on good news (e.g., the specter of low interest rates and central bankers’ more cowbell), the focus in a more significant drop might move toward the bad news — and there is a lot to worry about (including a subpar global economic recovery, geopolitical risk, Washington dysfunction, the schism between the haves and have-nots, etc.).
  • The notion of buying the dip has remained ingrained — equity inflows into domestic equity funds and ETFs continue strong. This is unhealthy and when in the extreme, historically points to more substantial declines.
  • Importantly, the quality of the recent advance and the internals has deteriorated with numerous classical technical divergences. The August-to-October period, as previously mentioned, is among the most seasonally weak periods in history.
  • Large-cap, multi-industry stocks with above-average dividend yields have led the market advance, but these stocks are now starting to lose strength. If the drop gathers momentum, these are vulnerable and heavily weighted in the indices, making them likely liquid candidates used to raise cash.
  • Generally speaking, the global equity rally is also beginning to get more selective — another signpost of late bull market behavior.

I have contended in numerous postings that stock valuations are higher than meets the eye, as profit margins lie 70% above the six-decade average. Hence, earnings power is less than the 2014 consensus for the S&P 500 of $119 a share. Normalizing of profits (and profit margins) produces current P/E multiple readings that are well above generally thought of valuations and higher than historical averages.

But what make the recent correction likely to morph into something more than a few percentage points decline are considerations of a credit-kind.

Credit, even more than equity, is the lifeblood of economic growth.

When taken to the extreme (as we witnessed in the mid-2000s), our economic and investment world turns upside down when credit conditions tighten and/or deteriorate.

There is, to this observer, a bubble in elements of the credit market.”

These are points that I, along with others, have made in recent months which have continually fallen on deaf ears as markets surged to “all-time highs.” However, it is worth remembering that stocks have ALWAYS achieved “all-time” highs just before spectacular “mean reversions.”

Is this another “buy the dip” opportunity for investors to increase equity exposure in portfolios? Possibly. However, I agree with Doug that there may be a more significant “storm brewing.” If this is the case, then this is likely an opportunity to begin “selling rallies” and fortifying portfolios in the near term until the “weather clears.”


Originally posted at Lance’s blog: STA Wealth Management

© STA Wealth Management
stawealth.com

Subscribe
Notify of
0 Comments
Inline Feedbacks
View all comments

Stay Connected

157,450FansLike
396,312FollowersFollow
2,280SubscribersSubscribe

Latest Articles

0
Would love your thoughts, please comment.x
()
x