Followin' the Money

Followin' the Money

Because mainstream media uses the SP500 or Dow Jones Industrial average as their proxies for the US stock market, most investors don’t know about XII, the institutional index. The NYSE Institutional Index (XII) is a capitalization weighted index of 75 stocks most widely held equity investments among institutional equity portfolios. If you are managing money and making investment decisions based upon market movement I would posit watching this index is more valuable.

Since it is estimated that institutions manage between 80-90% of stock market assets it makes perfect sense to watch what they are doing and insure you are NOT going against their movements. Doing so for long periods can be disastrous to one’s portfolio.  Since they make up the majority of the market, they dictate its movement.

Below is a chart of the institutional index over the past 26 months. As you can see it has been in a very nice uptrend and, up until December, price has carved out a series of higher highs and higher lows which is the definition of an uptrend.  The good news right now is index is still bullishly configured but there are some reasons for concern. Firstly, our momentum indicators (in the top and bottom panes) are pointing down which reflects a slowing price.  Slowing price by itself is not the issues, it’s what happens after that matters.  If momentum continues to fall, eventually prices will follow along. For now what has happened is the slowing momentum has caused price to make no progress higher for the past 4+ months. You can see each time we attempted to breakout higher we stalled out around the same level.  From a market internals standpoint this tells us there aren’t enough buyers to overwhelm sellers and as such, price remains within a consolidated trading range (highlighted red area) until more buyers step in.

Consolidations should be looked at as a necessary breather to any trending market (up or down). Think of it as a runner who slows down to hydrate and refuel. Sometimes that is just what the runner needs as he builds up additional energy to continue on. Other times, the runner has spent all his energy and no matter how much hydration and refueling he gets, he is done. The market is at that stage right now. Prices will continue to chop around until buyers and sellers settle their current impasse. To continue the bullish trend, prices will need to break above the consolidation area  (828) and hold for me to be willing to add more exposure to the market. If, on the other hand, prices break below the consolidation area (805) and more importantly, below the lower blue trend support line and prior low (790) , this is warning that “big money” is selling and it would best to think long and hard if going against their actions is in your best interest.

April 29, 2014 - Household debt

I was traveling and apologize for the late post but bad weather (Arkansas tornados), remote location and delayed travel hindered me from actually being even a little productive. As such this week’s blog post is not from me but rather a recent one Tom Mclellan posted which I thought was quite interesting and definitely worth watching going forward. If you have not visited his site or aware of his work, I would encourage you to dig a little deeper at www.mcoscillator.com

Debt is bad, at least for you and me.  But debt held by others can be a wonderful thing, as long as it is increasing. Debt is only a problem at the point somebody decides to do something about it.

The unfortunate fact for stock market investors is that household credit market debt as a percentage of disposable personal income has been shrinking ever since the peak back in 2007.  Normally it is bullish for stock prices to see household debt increasing, and bearish to have household debt decreasing.  But occasionally the two can go in opposing directions, which is the condition we see right now.

Historically when such a divergence has happened, the stock market eventually realized that it had wandered off track, and it worked extra hard to get back with the program.  But here we are, almost 7 years into a decline in household debt versus income, and thus far the stock market shows no sign of recognizing its off-track condition.  It is a bigger and longer divergence that we are accustomed to seeing in past episodes, such as those labeled in the chart.  The most likely explanation is that the Fed is helping to push up asset prices, in hopes that such action will eventually help push down unemployment rates and other indications of economic malady, and that this action by the Fed is continuing the divergent condition much longer than normal. 

The Fed's data on household credit market debt only extend back 62 years, which is just barely one interest rate cycle period, but is still a pretty long period of time.  And in that time, there has never been an instance of stock prices moving up while the debt to income ratio moved down that did not resolve itself by having stock prices moved hard downward to get back on track.  I do not see it as good news that the stock market is now going for its longest divergence ever in this regard.  I instead see that as a sign of trouble that will eventually have to be paid back double once the reckoning commences. 

It is understandable at this moment in history that we are seeing debt decrease, or perhaps I should specify PRIVATE debt.  U.S. government debt, on the other hand, has doubled in the past 8 years.  Through either willful action or neglect, Congress has been taking up the slack in the debt market.  But while Congress is still on a spending spree with other people's money, Baby Boomers are facing retirement from an ever closer vantage point, and realizing that piling up 2nd and 3rd mortgages on McMansions is not a great way to prepare for the day when the paychecks stop coming.  So they are doing the wholly rational action any reasonable person would do, increasing their savings and reducing their debt. 

The big problem, though, is that there are a whole lot of us Boomers trying at the same time to reduce our debt and get ready for retirement.  The "echo boomers" and millenials are not feeling any compulsion to take up the slack.  They would rather live in Mom & Dad's basement than take out their own mortgage to relieve the Boomers of those McMansions, which leaves the housing market moribund, the banking system seeking yield wherever it can find it, and the Fed trying to fill the void with free money.  So far that has not reached a trigger point that would cause the stock market and the banking system to reverse course, but I have to figure that such a reckoning day is coming.  It always has before, eventually.  And if the crude oil leading indication is right, it could take until 2018 before that reckoning point will appear and start to matter. 

Ironically, if Congress ever decides to mend its ways and step back from the ever-increasing debt levels, then history shows that the stock market could be in for real trouble.  As long as we are spending somebody else's money for whatever we want, the party goes on.  The only time that the problem manifests itself is when somebody tries to do something to solve the problem. 

April 21, 2014 - AD Line

From a market technician’s aspect there is only one thing that matters and that is price as it reflects all known information.  Most newcomers to the market can find interpreting price movement ethereal and as such attach mystical significance to indicators because they come with better “instructions”, provide simple buy-sell signals and, in general, require a lot less experience to manage.  Sadly though, the Holy Grail of indicators does not exist. That being said indicators are extremely helpful and can provide additional depth to market analysis than just price provides.  I find one without the other is like peanut butter without jelly, bananas, or chocolate.

One of my favorite indicators when looking at the health of the overall market is the Advanced-Decline line, or AD line for short. The AD line measures market breadth or simply the sum of the number of advancing stocks minus the number declining in the NYSE index.  It’s such a clean and simple concept because for a market to move higher the number of stocks moving up has to be more than the number moving down over time.  The AD line is a leading indicator meaning it moves ahead of market price. For example when the market is moving up and a correction is coming, the AD line makes the first move down as more and more stocks begin to fall. The market won’t actually begin its fall until the number of stocks going down eventually overwhelm the number increasing. Market strength is undermined when fewer stock participate in an advance.

Don’t let all this talk about the AD line and market falling leave you the impression the AD line is only good for warning of potential declines, it is in fact an equal opportunity indicator working equally well warning of potential rises or declines.

Let’s take a look at the current AD line and see what the health of today’s market.  In the 80-month chart below I have plotted the AD line in the top pane and a US stock market proxy (SP500) in the bottom. You can see the AD line began moving down in January of this year while SP500 price continued to move up during the same period.  This reflects fewer stocks moving up but because the total falling have not yet overtaken the number increasing, stock market prices push higher.  This (negative) divergence is a warning flag. To provide some historical references and why I find this indicator so persuasive, I have highlighted all prior negative divergences with blue vertical bands to help illustrate what happened subsequently.

While not reflected in this chart, there are times when the AD line warned of a change but the market never followed along. Contained within this back-tested period the AD line does a good job warning of potential market reversals but the exact timing and magnitude are unfortunately left undefined. Regrettably there is no perfect indicator and the AD line is no exception but when used to confirm price it can do wonders to keep investors on the right side of market trends.

April 14, 2014 - Workday - A case study

About 3 weeks ago I readied a post regarding how I felt it was time to short Workday (WDAY). I instead decided to shelve it and published something else. The reason I decided against it was because as a Registered Investment Advisor the SEC views anything I post on a public forum (my blog for example) as an advertisement.  Since I was not suggesting readers short the stock (rather just the fact I was going to) I had to pull the post so as not to put myself at risk.  Investment advisors walk a fine line posting publicly because if something is written and a reader views, takes action and then loses money they are at risk of being sued.

A little bit about Workday … It’s a good company, they have good products, a good business model and just as importantly, if the execute they have a bright future.  I have owned their stock for both my personal holdings and my client’s. At the time I wrote the original post I just didn’t like the price action.

I find it valuable to go back and look at examples of market crashes and booms and what can be learned.  I am not picking on WDAY as they are no different than hundreds of other stocks that go through the exact same scenario. Its human emotion that drives these repeatable patterns and until human emotions change (it hasn’t since the beginning of time) it’s going to happen again. Rinse. Wash. Repeat.  Because of this, those who recognize and take action can find it immensely profitable.

Now let’s dig into the WDAY’s chart and look at the numerous warning signs it provided. These are presented in order of occurrence. As you can see the stock was in a steep but linear uptrend and contained within its (second) channel defined by the blue trend lines from November of last year until March of 2014. 

Point #1 - At the end of February the stock gapped up more than 15% in one day and moved above the channel it was in. A huge move in a short period that changes the shape of the uptrend from linear to parabolic should be viewed with major skepticism. Next, notice that the entire 15% move up was completely taken back within the next two days. This was the first indication that those who were long should be looking to exit and those who weren’t long could consider a short position. Such strong moves up will consistently be confirmed by a major overbought condition and WDAY was no example as you see in the falling RSI.

Point #2 - We had huge volume on both that huge single day up and the following move down which was the confirmation the move was a temporary flash and warned of exhaustion. As a reminder exhaustion buying is when all buyers have purchased and the only people left are sellers.

Point #3 - Price moved back into the original channel which was constructive for WDAY bulls. The concern at that point was whether or not the selling was over.  If so, we would expect price would resume its prior linear move up.

Point #4 – a few days later the bottom of the channel provided support as price stopped exactly there … but only for one day. We found out the following day the bears were still in control as selling resumed in earnest. That provided the next signal to those who were still long should be recognizing the boat was taking on massive water and it was time to jump ship (unless you were the captain of course who are paid to stay with the ship). Those who were short got what they needed, further confirmation to hold their position as selling pressure would most likely push price down to the next support level.

Point #5 - This was the next major support line once the channel was broken to the downside. There was a brief rally  in between the two support/resistance lines where price went right back up to test the resistance line (remember support lines once broken becomes resistance) and once again began its fall all but confirming much more downside was to come.  Those who weren’t short found another good entry point at the retrace back to the top resistance line. Those that were still long and had missed prior opportunities to sell were given a gift to unload their shares before the onslaught of further selling took hold.

Point #6 - This was the next level of support below point 5. Once again price stopped right on the line .. but just as with point 5, it only lasted one day and the fall resumed.

Point #7 – This was the start of a short counter trend 3-day rally that brought price up to the green 200 day moving average. As expected that provided resistance and price commenced to the downside.

Point #8 - This takes us to today where prices are still in free fall. When I wrote this post initial my final worst-case target for this decline was the 200DMA (point 7) or if it got really bad, point 8 which is a major support level from one year ago.  As you can see we closed very close to that level on Friday.

Besides being a WDAY proponent I have also been one of their biggest stock price skeptics of late solely because of fundamentals.  Any company with zero earnings yet share price > $100 in my opinion cannot sustain that level forever. We learned in 2000 and 2008 for example, when the bull market gets long in the tooth that fundamentals eventually matter.  This recent correction is a humbling experience to those who were heavily aboard the momentum stock train. The companies with good earnings, solid balance sheets and good fundamentals have barely a scratch.

What I have attempted to do here by analyzing WDAY price movement is identify those very repeatable stock price patterns that occur time and time again. Investors who recognize and identify this action should now have a framework on what to expect and the right course of action.  In a nutshell anytime you see the following all occurring you should seriously consider taking evasive action:

1.       A parabolic move up followed by

2.       Volume confirming price action followed by  

3.       Continued violation of multiple major support lines (price is especially vulnerable in long running bull markets)

Regarding WDAY right now ... it has moved into oversold territory and is creating positive momentum divergence which is telling me this major selloff should soon be coming to an end.  Once this near term bottom has been found it should provide a nice lower-risk, short-term opportunity on what is now a much more attractively priced stock.

April 7, 2014 - Energy strength

The energy sector has had a strong week and has been the strongest sector in the S&P 500 over the past month.  A look at the Energy SPDR ETF (XLE) chart below shows the sector breaking out to new all time highs.  You can see the area highlighted in red has, up until now, provide strong resistance as each time it has been reached in the past prices have fallen. This area was breached on March 28th in the form of a gap followed by a large move up.  This type of action is usually indicative of the potential for continued strength.    One other important thing to note in this move is the lack of divergence in our momentum oscillator which is something we look to avoid (or sell into).

For those that missed the breakout, there is always the chance of a retracement back to levels of support. If that occurs and it holds, that could provide an excellent opportunity. Since resistance that has been broken through becomes support, investors who caught and bought the breakout needs to keep a close eye on the red area in case we get a correction.  Any breakdown below that support is your warning of potential bigger problems ahead.