Zeller Kern’s Investment Monitor

The Difference Between January and Now

April 10, 2018

By Steve Zeller                                         

The market received a thrashing last Friday as the Dow Jones Industrial Average was down over 600 points during the day, closing down 572.46 points, at 23,932.76, for a -2.34% decline for the day. The S&P 500 Index closed down -2.19% to close at 2604.47. Year-to-date, as of the close on Friday, the Dow Jones Industrial Average is down -2.62%, while the New York Stock Exchange Index is down -3.59%. The S&P 500 Index is down -2.10%, and the Russell 2000 Small Cap Index is down -1.12%, year-to-date (source: Morningstar.com -  all returns include the reinvestment of dividends). March was the second month in a row with negative returns in the market, something that hasn’t happened for a long time.

From the market top that was achieved on January 26th, the S&P 500 is down over 9%. Many sectors within the equity market have been hit harder than the broad indexes. For example, as of the market close on Friday, the Morningstar Basic Materials Index is down -5.70%, year-to-date, the U.S. Real Estate Index is down -7.01%, and the U.S. Consumer Defensive Index is down -6.33%, year-to-date.

As we have been mentioning in the past two previous issues of the “Investment Monitor”, there is a possibility that the market high on January 26th, was the grand top of the 9 year cyclical bull market. We shall see how all of this develops, but we would argue that the high posted on January 26th was the top many because of the things that were in place. As the saying goes, “Bull markets don’t end in bad news, they end on great news.” The level of optimism that occurred in January was robust. By some measurements, investor sentiment was at an all-time high, arguably fueled by the tax cut passed at the end of December; throw in the level of margin debt on investment accounts at an all-time high, and it becomes very difficult to get any more extreme than that.

Cover of the New York Post on January 18, 2018 –
8 Days Before the Market High on January 26th

Money market balances within investment accounts at Charles Schwab reached an all-time low of around 11% in the 3rd quarter of 2017, and remained at those levels leading into 2018. To put it into perspective, in the first quarter of 2009, money market balances were just above 23%. (Click to enlarge charts)


What this tells us is that investor confidence had reached an extreme, driving the market to a record high. When all of these conditions are at extremes, it is very difficult to push the market much higher, though not impossible. The challenge is that investor sentiment and social mood, drives the direction of the market, and arguably, all of that peaked in January - coupled with the fact that we are 9 years into the current cyclical bull-market, stock valuations are extremely expensive, and the economy is now coming into question, lower stock prices or even an extended period of falling stock prices maybe in the forecast.

However, with a positive outcome in historical negotiations of trade and tariffs with China, the market could rally to a certain extent.

The Mindset of No Stopping the FAANG – In the last issue of the “Investment Monitor”, titled “Is the FAANG Getting a Little Long in the Tooth”, we discussed investors had become so bullish on the big tech stocks and tech stocks in general, that it was and still is, truly reminiscent of the dot.com bubble. We also pointed out how the growth of the market had become so dependent and dominated by the FAANG stocks, being Facebook, Apple, Amazon, Netflix, and Google.  In November of last year, Bloomberg published an article, “Investors Are Celebrating the Tech Revolution”, which illustrated a picture of investors celebrating in party like fashion. The article discussed how economic transformation makes an era of steady growth and low inflation possible, and rationalized the unbridled enthusiasm for tech shares which brings on the animal investor mania instincts of “buy it and hold it forever, it will never go down” mindset. The article gives a rationalization of the never ending boom in technology and tech stocks because of the new technology platforms that are being introduced that are having transformative effects. They may be correct, but it does show a mirrored mindset of the 2000 era when it was coined as "the new paradigm" for stocks.

Photo from November 2017 Bloomberg Article Titled: “Investors Are Celebrating the Tech Revolution

Fast forward to March and April of 2018, and we are now experiencing the early stages of a backlash towards technology companies. As noted in the April addition of the Elliott Wave Financial Forecast, these instances occurred with RCA in 1930, AT&T in 1968, and Microsoft in 2000, all around bull market top time periods. Now it appears we could be entering into a negative period for tech companies, and it is showing up in the media’s headlines. An example of these headlines includes an article in Fortune Magazine’s “Data Sheet” section in the March 16th edition titled: “What’s Behind Apple and Google’s Plummeting Public Reputations”; In the April 2nd issue of Forbes, there is an article titled: “Facebook Keeps Saying ‘Trust Us’: Is it Finally Time to Say No More?” The negative headlines are mounting, and from a mania and social mood standpoint, this trend is predictable and its consequences could be detrimental to its shareholders.  And of course, with President Trump being the Populist that he is, is attacking the tech giants and his approval ratings are rising.

Putting all of this into consideration, we can’t rule out that the market just might be in the early stages of a bear market, so we’ll just have to see.

There are a few other warning signs for the equity market to fall off the rails, one in particular is the soaring LIBOR, which has reached its highest level in 9 ½ years. Libor is a benchmark rate that banks charge each other for short-term loans. Many loans within the market place are also tied to LIBOR. So as the LIBOR (London Interbank Offered Rate) increases, then so does the rates for many loans, putting pressure on the economy.

The recent declines have been blamed on the uncertainty from the Trump Administration fueled by the threat of tariffs leading into a trade war with China. However, one way to look at the tariffs is not the cause of a market decline, but rather, tariffs and a protectionist trend is a manifestation of a changing social mood. Keep in mind that last summer, the administration had already imposed duties on imported Chinese aluminum. The market reacted in the opposite, and continued to rise into January of this year. The Smoot-Hawley Tariff Act was passed in June of 1930, after the market had already made its initial wave down, beginning in October of 1929. There are lessons in history that prove that tariffs are destructive for the economy, but they aren’t necessarily the cause of bear markets.

In the meantime, we’ll have to see how long the “buy the dips” crowd remains intact – they may one day find themselves being the “dips that buy”, if there is a real trend reversal currently underway. The last counter trend rally that occurred in February, after the steep and abrupt climb, proved that the “Buy the Dips” crowd was out in full force. According to Elliott Wave International, Large Speculators, a group of traders mainly comprised of hedge funds, and small traders, mainly retail investors, increased their bets in March. According to the Elliott Wave report, large speculators hold their largest net long position as a percentage of open interest since August of 2016, while small traders hold their largest position since May 2015.  The point being is that large speculators have the tendency to make “wrong way” bets near the start of a trend reversal, and the fact that the small traders are also aboard increases the significance of a bearish signal, from a contrarian standpoint.

Another indicator that raises the risk of a bear market is the amount of IPO’s (initial public offerings) initiated by companies that have negative earnings for the last twelve months. The level of these offerings has entered back into record territory. According to Jay R. Ritter, a professor of finance at the University of Florida, who has been tracking the number of IPOs since 1980, states that the numbers show that for 2017, we’re already within reach of the record set in 2000, when 80% of the companies that filed IPO were losing money. In 2017, more than 75% of the companies that made initial public offerings of their shares were losing money – we haven’t seen that high of a percentage since the dot.com mania back in 2000. 

As far as the economy goes, let’s hope we still have some steam and positive momentum left. We all benefit from an increase in GDP. But, there are a few warning signs of a possible stall ahead. Mish Shedlock mentioned in a recent article that the Philadelphia Fed’s Coincident Economic Activity Index suggests that the economy may be nearing a recession. The coincident indexes combine four state-level indicators to summarize current economic conditions in a single statistic. These variables include nonfarm payroll employment, average hours worked in manufacturing by production workers, the unemployment rate, and wage and salary disbursements deflated by the consumer price index (U.S. city average). The trend for each state’s index is set to the trend of its gross domestic product (GDP), so long term growth in the state’s index matches long-term growth in its GDP. On a year-over-year basis, recessions have started when the year-over-year CEI was around 2.5%. (Click to enlarge chart)

In the short run, the recent volatility has been partly due to increased uncertainty. Uncertainty from the current administration’s trade policies, and uncertainty of the new Fed Chairman, who is turning out to be more hawkish than people expected. But even though there is an increased level of uncertainty, and even though the Phily Coincidence Index is sending us potentially negative signals, the underlying fundamentals of the economy are still positive.

Monthly employment gains have averaged 188,000 during the past year, with annual growth of 1.5% year over year. Furthermore, employment has been driven by full-time jobs, which rose to a new all-time high in February. Compensation is continuing to be in an improving trend. Hourly wage growth was 2.7% year-over-year in March. These are the highest numbers that we’ve seen in the past 9 years. Real demand growth has been 2-3%. But in February, real personal consumption growth was 2.8%. Retail sales, excluding food, grew at 1.9%, year-over-year in February. Although, now, it looks like real estate is softening, new home sales grew .5% year-over-year in February, and housing starts were at the highest level within the past 10 years. And Lastly, Core durable goods rose 6.6% year=over-year in February, which is near the best annual growth rate in four years.

The BLS Employment Report came out on Friday, with total nonfarm payroll employment edging up by 103,000 in March, leaving the unemployment rate unchanged at 4.1%, and coming in below expectations. Employment increased in manufacturing, health care, and mining. One interesting observation with the chart below is that unemployment is where it was in 2000 and below where it was in 2007. From a contrarian standpoint, it gives us very little room for a better environment, comparatively speaking. (Click to enlarge chart)


But outside of the favorable economic data, the Trump attack on China with tariffs, and the attack on Amazon, served as an added fuel to a trend reversal in the markets. But also, the real estate market may be lining up to cause some trouble, with markets such as New York City that just experienced a 25% decline in year-over-year sales in Q1, which is the worst decline since 2009.

We’ll have to see how all of this pans out. Worst case scenario is we go into a bear market. But what’s more certain is low volatility and a steady climbing market appears to be over.

Looking at economic reports coming out this week, they are virtually nonexistence. On Wednesday, we will see the FOMC minutes and of course Thursday’s jobless claims, and then on Friday will see consumer sentiment. However, none of these are likely to be material to change market sentiment.

A Look at Last Week

Last week was a losing week for the equity market and it was a very volatile one as well. The major indices were all over the place with a barrage of headlines that played into the fears about trade wars and rising interest rates.

Last week’s action in the Dow Jones certainly demonstrated the extreme volatility as it was 1100 points between the low on Wednesday and the high on Thursday. Then, Friday declined as much is 767 points before settling down 572. Also, last week the Russell 2000 was down 1.1%, the S&P 500 declined 1.4% and the NASDAQ composite was down 2.1%. This pushed the markets down to their lowest levels that we’ve seen for the past several weeks.

The trade talk dominated the market narrative as the Trump administration proposed a $50 billion tariff plan on Wednesday followed with an order for an additional $100 billion of tariffs on Chinese imports. China quickly retaliated with a $50 billion tariff import plan on 106 products imported from the US and said it would protect its interest at any cost. But they are almost out of bullets already because the trade imbalances are so lopsided there’s little they will be able to fight back with. The bottom line is China needs us more than we need them.

But just like magic, on Wednesday the stock market was able to overcome their trade concerns and the markets rallied only to be reversed on Friday’s action once everyone realized that there is a huge potential for the economy to falter at this time. To emphasize the issues with the trade balance and confirming Trump’s strategy was February’s trade imbalance was the highest it’s been in 10 years at 57.6 billion. It’s hard to argue that renegotiating our trade is not the right thing to do.

The unemployment report was a mixed bag. A key takeaway was that it was not too hot or too cold for the Federal Reserve to rethink its monetary policy. To emphasize that the Fed will not falter, John Williams an FOMC voter who will soon be the New York Fed President, said after the close that he sees 3 to 4 rate hikes this year. As I have said before, the Fed cannot change their project tree at this point. It will only indicate weakness and market participants will react negatively to that event should it occur.
Friday’s action saw the market decline back below the 40-week moving average at 2603.74 with the low of 2586.27. Once again, the Algo traders turned on the machines to rally the market off the lows to finish just at 2604.47, just above the 40-week average. In spite of this slight rally off of the lows, the market closed below the 10-day moving average at 2621.36. The key level on the upside today will be 2617.80. A penetration of this level will signal a move toward the 2632.70 level.

However, the weekly/intermediate charts suggest that the markets are unlikely to rally above 2632 this week, should we see a continued bias to the downside with the minimum target of 2576/2545. A penetration of 2632 would indicate a further rally toward 2663.70. However, there is currently only a 30% probability for this to occur.
The configuration suggests that the markets are likely to retest the 200-day moving average at 2594. A close below this level for Monday would indicate a further decline to retest the key lows at 2532, ultimately moving down towards 2427/2385.Long-term charts are beginning to lose substantial momentum as the S&P 500 remains below the 10-month moving average which is currently at 2614.07. This average is still rising suggesting that the longer-term trends could continue to dominate suggesting that we are likely to stay above the 2600 level this month.

A failure to do so would indicate a minimum move down to 2440/2425 over the next several weeks. This will be the key pivot level suggesting that the market will trade on either side of this moving average for at least two more months.
The key pivot number on the upside is 2725. It would take a close above that level to negate the downward pressure on the intermediate and short-term charts.

Best Wishes,

Zeller Kern Investment Committee