With More Signs Fickle, Don't Leave Yourself in a Pickle and Consider Selling

 | Nov 10, 2017 | 11:00 AM EST
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"On Tuesday, it was as though a light bulb came on for so many market players. I call it realization day. It's the day they realize the market has a breadth issue. Not only was my inbox full of folks who wanted to discuss it. But my Twitter timeline was as well. But I knew it had finally been realized when I saw the folks on television discuss it.

I mean, they spend more time on the fact that the Dow eked out an eight-point gain than they do on the fact that the travel stocks collapsed by double-digit percentages...So in some respects, the realization that small-caps have underperformed so much makes sense, considering it's been going on for five or six weeks. Realization days tend to come after the trend has been in place for a few weeks (or more). But it is my opinion that it was the selling in the bank stocks that bothered folks the most. The Bank Index hasn't gone anywhere in weeks and then it gave up two weeks in a day. It has filled the gap, so this will be a test to see how well it can hold up. When gap fills don't lead to a bounce, there is more weakness underneath than meets the eye."

--Divine Ms M. (Helene Meisler), "Folks Finally Smell Market's Bad Breadth"

"It was still a red day for the indices, but they all finished well off the lows and near their highs of the day. Breadth was negative and we had more new 12-month lows than highs. ... In some ways, what happened today was that the small group of leaders that have been pushing the indices higher corrected a little and are slightly more in line with the broad market. The average stock has been lagging badly and the gap between the leaders and the average stock has to narrow in some way sooner or later."

--James "Rev Shark" DePorre, "Market Bears Just Can't Keep Their Paws on a Good Thing"

Stated simply, for those with a three- to six-month time frame, I would sell with the following qualifications and move toward lower exposures.

It remains my view that the only certainty is the lack of certainty. No one has a concession on investment truth, thought the talking heads' rearview-mirror observations always are 20/20! I deal not in price targets but in probabilities of scenarios -- economic, market and otherwise. It is that distribution of outcomes that dictates my assessment of reward versus risk and strategy.

I have the scars on my back that indicate how uncertain things can be at times in the investment business and how they can run contrary to common sense, analysis and reason. To be sure, global central bank liquidity programs, the proliferation of passive investing (ETFs, machines and algorithms), the reduction in the number of publicly held companies from about 7,800 in 2000 to 3,800 and the near-20% contraction in the number of shares outstanding in the remaining public companies (thanks to corporate buybacks are all contributors to the investment tailwinds over the last decade.

I now would argue that the preponderance of influences -- subjective and objective -- are moving or have turned negative.

The possible delay in tax reform -- something I have highlighted as likely for months -- may have been the proximate reason for yesterday's woosh lower.

But there are broader issues that have been fomenting under and above the surface, not the least of which are the "short volatility bubble," the Fed no longer being the market's friend, and the presence of too many market players on the same side of the boat (long and bullish). Moreover, as expressed in "It's An Earnings-Driven Market? Not So Fast, Kids," the market has been elevated not by earnings growth but by valuation expansion on the hope of tax reform and other growth catalysts.

As I discussed this morning with my pal Peter Boockvar, chief market analyst of The Lindsey Group, a major headwind as we move closer toward 2018 is a dramatic reduction in the pace of central bank easing. In the first quarter of 2018 alone, the Fed will suck another $60 billion out and the European Central Bank (ECB) will buy 90 billion euros, or 104 billion euros less than its current run rate. The effect of those moves only will be compounded as the year progresses as the Fed increases that liquidity draw and the ECB gets closer to ending quantitative easing (QE).

For the first time in quite a while, even "reactionary" traders/investors who follow a more patient strategy of waiting for price to dictate strategy (as advocated by my good friend Rev Shark) should be conscious of a possible change in market character and momentum, as evidenced in the following:

  1. A breakdown in the Russell 2000 Index and a turndown in the junk bond market -- represented by iShares iBoxx High Yield Corporate Bond ETF HYG and SPDR Barclays High Yield Bond ETF JNK -- through certain support levels.
  2. Bad market breadth (conditions recently highlighted by Rev Shark and the Divine Ms. M -- see quotes above).
  3. Reduced new highs vs. expanding new lows.
  4. Evidence of some renewed volatility.
  5. The message of the bond market that domestic economic growth is not as healthy as consensus believes.

I also would note, importantly, that over the last few days, including this morning, that stock futures are declining at the same time that bond prices are dropping and yields are rising. The preceding could be a signpost that the leveraged risk-parity community has begun to take off risk.

My investment mosaic in its simplest form is like a triangle. At the top is the most important angle, fundamentals. The lower left angle is sentiment and market positioning, which is growing in importance to me in measuring risk, and the lower right angle is valuation.

I have the strong view that market participants who worship at the altar of price momentum are being lulled into a false sense of security, in part because of liquidity factors, and have ignored intermediate-term headwinds that I highlighted in yesterday's opening missive.

My mantra has been to approach the market in an anticipatory fashion because of a sense and calculus that the downside risk to upside reward was in an expansion mode and could be as high as 4-to-1 negative. Market participants' positioning is one-sided -- a secular development owing to the growing popularity of ETFs and quant strategies -- and has contributed to a global short volatility bubble.

I have been active this week and last, adding to my index short -- particularly SPDR S&P 500 (SPY) -- as well as adding to five new shorts: General Motors Co. (GM) , CSX Corp. (CSX) and Union Pacific Corp. (UNP) (due to slowing domestic economic growth) as well as Caterpillar Inc. (CAT) and Deere & Co. (DE) (my channel checks indicate a recent slowdown in retail comps).

To a lesser degree I have initiated a new long in Macy's Inc. (M) and have added to my Dillard's Inc. (DDS) long, which rose by nearly $9 on Thursday.

Midday yesterday, I briefly observed:

* Buyers live higher and sellers live lower in an investment world dominated by ETFs and risk-parity and volatility-trending strategies.

* We are in a global short volatility bubble, which has raised the possibility of a large market drawdown/flash crash.

* As I wrote as recently as yesterday, tax reform will be delayed and substantially diluted.

* Investors, as measured by mutual fund cash (historically low) and investor surveys, are in the bullish extreme.

* With many valuations at the 95th percentile, that leaves little room for policy -- both fiscal and monetary -- error. There is little margin of safety in the market, which carries with it, arguably, a poor reward vs. risk.

I believe these considerations and other intermediate concerns are important -- even more important than price momentum.

Bottom Line

My guess is the market's character and direction both may be at an inflection point, as price may be moving lower and volatility could be expanding as risk is woefully underpriced.

This situation should provide opportunities to buy as well to sell in more of a two-way market, which should be exciting to all of us.

I continue to measure the possible market risks at roughly four times the market's rewards; ergo, I am substantially net short.

It is likely a good time (actually, it always is!) to review your portfolio in order to assess your exposure to and appetite for risk against an increasingly uncertain market backdrop.

(This commentary originally appeared on Real Money Pro at 8:10 a.m. ET on Nov. 10. Click here to learn about this dynamic market information service for active traders.) 

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