The Trend Is Still Up
4/14/2014 7:37:49 PM
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Market Summary

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The stock market price pullback this week has not yet done significant damage to stocks overall. The major downdraft basically swallowed the priciest and riskiest issues primarily in the Biotech and Tech sectors. The recent turbulence started as a reaction to the Federal Reserve’s announcement of plans to reduce the stimulus that has been the life blood of the market the in recent years. The chart below shows the S&P 500 index heading south (red line) compared the gold as represented by the GLD ETF. This shows safe haven asset classes are where investors are stashing funds until the stock price drop plays out.

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Along with gold, a lot of investors trade Treasury’s to hedge against stock moves. The chart below shows how equities and treasury bonds usually move in opposite directions. The red line in the chart is tracking the current downward move in stocks while treasury bonds rally. Similar to the chart above, investors are looking to safe assets to park funds.

The chart below confirms the Biotech sector has been slammed into full blown correction mode with no bottom in sight. Biotech stocks have fallen for seven straight weeks down 21% from the record high at the end of February. The last time this much damage was done to Biotech’s was the summer of 1998. The bleeding in the Biotech sector will probably continue for a while as even with the current price crash, valuations are still grossly overdone. The Nasdaq Biotech Index price-to-earnings ratio is 34.40 versus 14.90 for the S&P 500 Index.

Similar to the Biotech Index above the Technology Index chart below affirms investors turning a cold shoulder toward risk. The Tech Index has been pounded down to its 200- day SMA and along with Biotech’s are taking the brunt of the current downturn.

Believe it or not, despite the recent price drop, investors are still pouring funds into stocks. Investors deposited $8.9 billion in stocks funds for the week ended April 9th, the largest net inflows in four weeks. This cash infusion probably came at the expense of U.S. Treasury funds as they reported net outflows during those four weeks according to Thomson Reuters’ Lipper service.  But the chart below suggests some of the cash going into stocks is headed toward emerging market funds. The black line is the emerging market fund ETF at yearly highs as the red line representing the S&P 500 Index heads down.

Market Outlook

At lot of financial analysts have a very strong appreciation for the American Associate of Individual Investors (AAII) sentiment survey as a reliable contra indicator of market direction. Based on the perception that most retail investors usually are on the wrong side of the trend, sentiment extremes usually signal the market will do the opposite. Take a look at the most recent AAII survey results below. Pessimism has risen to a nine week high while neutral sentiment stayed above average for the fourteenth week and optimism languishes below the normal level. At current levels, the bullish percentage is very close to the point where it would be considered an unusually low reading. The drop in optimism appears to be fallout from the S&P 500 index dropping 2.6% and the Nasdaq down 3.7% over a few days. A poll of AAII membership points to concerns about the possibility of a prolong correction, elevated stock valuations, slow revenue growth and economic expansion, Washington politics and the Feds QE tapering plans.

The market stability concerns mentioned by AAII membership are some of the issues raised by market watchers over the past year as stock indexes continued to hit new highs. If the AAII surveys reputation as a contra indicator holds up, expect stock prices to stabilize and return to recent highs as earning season progresses.

AAII

The use of the AAII survey results to predict a change in sentiment appears to be supported by the S&P 500 Index (SPX) weekly chart below. As highlighted in the chart, over the past year or so stock prices have struggled heading into quarterly earnings announcements. And you can see in the chart, as earnings season progressed stock prices consistently moved higher and higher. If this behavior remains consistent it is another reason we should expect higher prices over the coming weeks.

SPX Weekly

Also keep in mind that companies have a very low bar to clear related to earnings expectations as estimates have fallen sharply with many businesses putting the blame on the brutal winter. Profit growth for the S&P 500 companies is currently projected at a lowly .9% for the first quarter over year ago. The latest growth estimate is down significantly from 6.5% forecast at the beginning of the year according to Thomson Reuters.

Trading Strategy

You don’t want to try to catch a falling knife, meaning we don’t start buying stock on the premise that you anticipate an impending bottom to a price drop. This strategy is a sure fire way to lose a lot of money – real fast. Even with the current bull market and its’ sometime straight up price moves, stocks tend to rise to new highs in a relatively orderly fashion. Down markets are a different animal, prices corrections are typically rapid, violent and associated with higher volatility. As prices fall there is usually a hard counter-trend bounce that seduces investors into betting the worst is over – like this past Wednesday’s price bounce. Everybody wants to be the market guru who sells at the top and buys at the very bottom. Betting on market tops and bottoms is absolutely not worth the risk and if someone does happen to win once, it was pure circumstance and not because of a ‘system’.

There is plenty of profit in between a market bottom and the top so that you can minimize the risk of loss by waiting on confirmation of price direction. I like to use the analogy that the stock market is similar to a drop-dead gorgeous woman at a party. She is totally unpredictable and can get away with doing a lot of things that don’t make sense or nobody expects. A lot of people at the party will ask her to dance as they get faked out thinking she will dance with them. But ultimately whenever she is ready the signs will be clear. Eventually the stock market will send out definitive signals on whether the trend is up, down or neutral, you have to be disciplined to wait your turn and have your trades ready.

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At this point investors will be watching to see if the bleeding has stopped or if the damage becomes significant and infects the overall market. Thus far the major difference between the current market pullback and the steep drop to start the year is the current losses are primarily focused on high priced risky Biotech, Technology and small company stocks. Conservative blue chip names are holding up well and investors with diversified portfolios have suffered minimal damage. If stocks continue to avoid broad-based selling and maintain during earnings season, this should bode well for the near term market. 

If the current market action is merely sector rotation and the consolidation of overbought conditions from recent highs a few weeks ago, a good move is to identify and monitor stocks you like but were too expensive in the past. But avoid the recent high-flyers that are now tanking, that would probably be a bad move because of the risk involved. Also, if this is a price pause before moving higher we can map out some bullish trades where you also have downside protection in case a move higher is just a counter-trend action and stocks continue downward.

And of course there is always the possibility that stocks are in the early stages of an overall market correction that we have not seen in a while and that some analysts claim is overdue. The bears are waking from hibernation and bearish trades have been good the past few weeks. We can keep those bear market trades on deck in case prices bounce higher before stalling out and drop again. This includes bearish trades that protect against prices surging to the upside.

The best bet is probably range bound trading with prices fluctuating between recent highs and wherever prices bottom out. Therefore setting up potential market neutral trades is a good move in case this is what the price action will be. Whatever you trade, right now is the time for patience and discipline with tight stops and conservative risk appetite.

Regards,

Gregory Clay

Options Strategist

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