Feb 24, 2014

Part 3 in this series, this week I wanted to look at market breadth and see what, if anything, it is telling us. Market averages such as the Dow Industrials or S&P500 indices are the most readily available barometers for market conditions. Using charts, it is relatively straight-forward to determine the current trend, and to identify how long this trend has been in place. However, what is even more beneficial is to have an understanding of not only the price trend but the underlying strength of the individual stocks as this will help substantially in determining the likelihood of the trend changing and the relative levels of market risk. Breadth (participation) indicators were developed precisely with this task in mind: to determine the strength of a market trend by looking at its constituent stocks.  Since research has shown that the majority of an average stock’s future price move is due to the direction of the overall stock market, the importance of understanding what market breadth cannot be understated.

If all this is putting you to sleep because it’s too technical, a real simple way to think of this is a stock market can only continue to rise if the majority of the stocks that make up that market are rising. The converse is true too when the market is falling.  Since this series of blog posts is about analyzing market tops if you apply that understanding logically you would not expect a top to be reached until the majority of the stocks in the market are no longer rising and instead falling. While there are many different ways analysts slice and dice the internal market breadth data I am not going to go into detail here rather state that what is most important is trend of that data not each exact value.

The chart below shows the SP500 US stock index (in black) on the top and three different breadth indicators (in blue, green and red). In order to get a good level of confidence in interpreting market participation, I like to look at a few different breadth measurements in hopes they are all telling the same story. If they are, a yellow flag is raised and tells me more intense and frequent monitoring is required. In the case of the chart below, you can see the trends of all three measurements are declining. You should also notice the SP500 price trend is pointing UP. This is divergence and it is warning of the potential for lower stock prices. Either the trend of breadth continues to decline and the SP500 will eventually follow suit or we will need to see greater participation here in the coming weeks.

An interesting observation you can make about the chart is that during the recent correction over one third of SP500 stocks dropped below their 200 MA. This was the first time breadth readings dropped below 75% since late 2012. This shows just how strong the recent bull market has been. The question is, was this sell off an indication of something bigger to come or was it just another correction in the uptrend?

While this is a warning sign it does not mean to me it is time to get out of the market.  This is just one of a many indicators I watch. When the majority of them turn yellow or red and tip the scales convincingly to the side of the bears that becomes my trigger to take evasive action. Until then it doesn’t mean you shouldn’t consider taking some risk off the table due to the increased uncertainty and warning flags that are popping up. But, for now the trend is still up and until it changes it is important to respect it.

Equity-Market-Breadth1

Feb 10, 2014

The stock market dropped 5.2% over the past two weeks, the first such correction in almost 4 months. It appears as if the bears have awakened from their winter slumber.  The question on everyone’s mind should be was that it and are they going to hit the snooze button and fall back asleep. A 5% decline is normal and happens very regularly as do 10%, 15% and even 20% corrections but while we accept the fact they are certain, no one likes the effect they have on our portfolios. As you can see by the chart below, we are very stretched from the average correction for all periods (except for the 5% which completed last week) The other big concern any time you have a decline is whether that last high was “THE” top and have started a new cyclical bear market. The fact is we don’t have enough data to make that call without guessing so we need to closely watch for more signs.  What finally determines whether it was “the” top is what I call hind-site-itis.  The ability to look back in the rear view mirror and say for sure.

While markets do not repeat exactly, they do rhyme. After all, stock prices are driven by human emotions and resultant behaviors to those emotions are what create repeatable patterns. No, unfortunately the patterns repeat exactly otherwise investing would be easy. But because many patterns are analogous to the past, an experienced market technician should be able to recognize them. Knowing what they are and closely monitoring them is the key and then assessing whether taking defensive action is warranted.

What I thought I would do over the next few weeks is take a look at past market tops and see if we can see any indication today’s market looks like anything we have experienced in the past. Obviously, the sooner we can figure it out the sooner action can be taken to minimize any impact to portfolios.  Since there are dozens if not hundreds of variables to look at I will be covering just what I consider to be the most important.

In Part 1 of the series this week I will be looking at price structure.

Let’s take a look at the long term stock prices through the 2 recent complete secular bull and bear cycles. It’s vital to understand that prices only have 2 actions. They either 1) trend or 2) consolidate. The chart below helps to demonstrate this as the areas in green and red represent trends (up and down, respectively) and the areas in yellow are the periods of consolidation.

A trending market is one that goes in one direction or another. A bull market trends upwards, while a bear market trends downward.

A consolidating market is one whose price movement is confined within a set of boundaries or a channel with little or no ultimate change. Consolidation is generally regarded as a period of indecision. It is either the result of exhaustion on the part of market participants or broad market uncertainty.  The key to consolidations are once they have completed they are followed by a breakout in one direction or the other.

The ability to correctly discern and ultimately recognize the type of market you are in (consolidation or trending) and invest accordingly can have a substantial impact on investment returns.

Some of you very astute observers of the above chart will have recognize there were time prices consolidated during the trending periods too and may be wondering why didn’t highlighted those in yellow. For this discussion I only highlighted those consolidation areas in yellow when the trend reversed.

To understand when a reversal occurs it’s important to understand the following: An uptrend is determined by higher highs and higher lows

while a downtrend is just the opposite with lower highs and lower lows.

If we are looking for a reversal to a bull market as we are in today, price would have to put in a series of lower highs and lower lows.  That’s it!  The concept is quite simple but its interpretation in a real life environment can really muck up the simplicity.

Where are we today? – The chart below is a close up view of the current bull market run from the bottom in 2009.  You can see we are in an area of consolidation which I have highlighted it in magenta for illustration purposes (rather than yellow) because we do not yet have a trend reversal. Prices have not yet put in a series of lower highs (none yet established on this daily chart) and lower lows (just one – we need at least two for confirmation).  So as of right now, based upon last week’s closing prices, the price structure of the US stock market is still bullish.

Part 2 in this series will cover price patterns that form during tops.

Jan. 27, 2014

At the start of every year I like to take the time and sketch out a game plan for the year.  Part of that includes identifying major areas of risk and creating a mental game plan on how to respond.  Two weeks ago, I identified interest rates as being one of my major concerns.  When I speak of interest rates I am really speaking of the FED as their open market operations add or subtract to the economic liquidity which helps set interest rates. Its this liquidity (either too much or little) not only has the effect they desire by controlling interest rates but an unintended consequence is its indirect effect on the prices of other assets, such as stocks. So when I hear the FED is reducing liquidity I become concerned as this move in the past has been the catalyst for a market correction. An article from one the Fathers of technical analysis, Tom Mclellan, came across my inbox recently where he does a wonderful job at capturing this relationship and I thought it worthy of presenting its highlights. There are a lot of different indicators and studies that technical analysts use, and all of those tools came into usage due to some degree of merit.  But the one factor which seems to be trumping everything else lately is what the Fed is doing with its QE program.

The chart below compares the SP500 to the total assets held by the Fed.  The plot is made up from the total of the Fed's Treasury holdings and its mortgage backed securities (MBS), which are sometimes referred to as "agency" debt products.  The agencies which that title refers to are Fannie Mae, Freddie Mac,

Putting the chart together this way helps us see just how important the Fed's purchases have been to the task of sustaining the bull market for stocks.  Whenever the Fed has decided to change the slope of the green line, the slope of the SP500 has also changed in a dramatic way.  That makes it such an important question to contemplate a "tapering" off in the rate of growth of Fed assets, or even an outright end to quantitative easing (QE).

The next chart also helps us see just how critical the Fed's actions were in bringing about the awful bear market of 2007-09.  Back then, the Fed just held Treasuries, and it did not start buying agency debt until January 2009.  The Fed's holdings of Treasury debt peaked in August 2007 at $790 billion, and over the next 17 months the Fed sold off more than $300 billion of those holdings.  That's right, in the middle of the worst liquidity crisis in decades, with banks folding and with Congress handing out tax rebates, the Fed was pulling liquidity OUT of the banking system.

When the Fed finally stopped pulling liquidity out of the system and started adding it back in again in early 2009, the market turned upward, and the banking system and economy started working their way back toward health again.

Given the now obvious importance of the Fed's actions on financial market liquidity, why did they decide in 2007 and 2008 to pull so much money out of the system by selling so much of their Treasury holdings during that bear market?  That will be a great question for the historians to uncover.  But what I can say is that the man who orchestrated and conducted those sales, the former president of the New York Fed, left that job in early 2009 to become the new Treasury Secretary.  So you can draw your own conclusions.

While the FED this month will begin slowing down the rate of stimulus (note I did not say stop completely or begin to withdrawal which has caused problems in the past) investors still must be concerned as one would expect at least some sort of impact to the economic bottom line. One reason to not be overly concerned is the FED understands it’s the rate of change that is most important and they have indicated any actions will be gradual in nature.  Since we are in uncharted territory (QE first started in 2010), knowing how the market will react to future FED changes is anyone’s guess.  As such, being prepared for anything and playing defense should be a top priority.

Jan. 20, 2014

Obviously this post is meant tongue-in-cheek but there actually are those that watch (and invest accordingly) these things … The Super Bowl Indicator holds that any NFC team winning the Super Bowl is bullish for stocks. It’s worked 80% of the time since the Super Bowl began in 1967.  But if you take a close look at the S.B.I.’s performance, you’ll see the stock market LOVES the 49ers. In fact, win or lose, San Francisco has been in the Super Bowl in four of the five best years for the stock market since the big game between the NFC and AFC champs began in 1967. The Niners’ Super Bowl wins in 1985, 1989 and 1995 were followed by annual gains of 27.7%, 27.0% and 33.5%, respectively, for the Dow industrials. From 1967 to last year, only the Pittsburgh Steelers’ victory in 1975 delivered a bigger advance.

Even in 2013, when San Francisco lost to the Baltimore Ravens, the market boomed.

So S.B.I. believers don’t want just any old NFC team to triumph over the AFC champion in the Super Bowl. Under this thinking, it’s best for your portfolio to have the 49ers beat the Seattle Seahawks in Sunday’s NFC championship — and then win the big game itself on Feb. 2. Of course, the Super Bowl Indicator is a classic example of confusing correlation with cause and effect. MarketWatch’s Mark Hulbert took the whole faulty concept to the woodshed in a column last year. As he blasted “spurious correlations,” Hulbert pointed out that Bangladeshi butter production is an even better “indicator” for stocks. Perhaps the S.B.I. should be renamed the B.S.I.

Of the nine years when the  S.B.I. has failed, four involved Super Bowl appearances by the Denver Broncos — who play the New England Patriots on Sunday in the AFC Championship. So you may want to be wary of the Broncos — and also the Patriots. The best performance in years when the Pats won it all was a 3.1% gain in 2004. The worst was a 16.8% drop in 2002. And the Patriots’ loss in 2008 to the New York Giants was followed by Wall Street’s worst year since the Super Bowl began, a 33.8% slide in the Dow.

Seattle’s only Super Bowl appearance in 2006 was a loss to the Pittsburgh Steelers.  The Dow surged that year.  (Although the Seahawks are in the NFC, the Steelers have their roots in the old NFL, and for the purposes of the indicator are deemed to be an NFC team, meaning the indicator is deemed to have held that year.)

Overall, the prediction business is tough. Just ask all those Wall Street strategists who bet that the falling hemlines in last year’s spring collection indicated a bad year for stocks.

Nov. 25, 2013

Relocating in retirement is brought up often when we’re working with retirees, especially here in California, where the cost of living is much higher than the country average. The article below does a great job of breaking down things to consider from a taxation standpoint. Beyond your federal tax burden (which usually stays the same no matter where you live if you use the standard deduction) there are state, local, sales, property and inheritance tax variables also to wade through. So if you’re thinking about relocating in retirement -- in hopes of enjoying milder weather and lower expenses -- before you make a move, it pays to assess the overall tax burden of your future home. ---------------------------

No matter where you live, your federal taxes will be about the same if you take the standard deduction. But you'd be amazed at how much your state and local tax burden may vary from one location to another.

People planning to retire often use the presence or absence of a state income tax as a litmus test for a retirement destination. That's indeed one factor for retirees to consider. But higher sales and property taxes can more than offset the lack of a state income tax.

Seven states -- Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming -- have no state income tax. Two states -- New Hampshire and Tennessee -- tax only dividend and interest income that exceeds certain limits. But many of the remaining 41 states (and the District of Columbia) that impose an income tax offer generous incentives for retirees. If you qualify for the breaks, moving to one of these retiree-friendly areas could be cheaper – tax-wise -- than relocating to a state with no income tax.

Here are five other key tax factors to consider when comparing states as possible retirement destinations:

Taxes on retirement-plan distributions

Although most states that impose an income tax exempt at least a portion of pension income from taxation, they often treat public and private pensions differently. For instance, some states exclude all federal, military and in-state government pensions from taxation. Other states go even further, exempting all retirement income -- including distributions from IRAs and 401(k) plans.

Some states that tax pension income offer special breaks based on age or income. At the other end of the spectrum, several states are particularly tough on retirees, fully taxing most pensions and other retirement income.

Taxes on Social Security benefits

Depending on your income, you may be required to include up to 85% of your Social Security benefits in your taxable income when filing your federal return. But in recent years, many states have been moving away from taxing Social Security benefits. Fourteen states now tax Social Security benefits to some extent.

Sales taxes

Don't forget to include state and local sales taxes in your personal budget analysis. Some states exempt food and medicine; other states famously have no sales tax at all, while some will tax every dime you spend.

And keep in mind that the sales-tax pain doesn't always stop at the state level. Most states allow cities and counties to assess their own sales taxes.

Property taxes

Property taxes are a major cost factor, particularly for retirees living on a fixed income. The median property tax paid in the U.S. on the median U.S. home value of $185,200 is $1,917, according to the Tax Foundation.

Tax rates vary significantly from state to state and among cities in the same state. But many local jurisdictions offer property tax breaks to full-time residents, some based on age alone and others linked to income.

Check to see how the local jurisdiction generates property-tax bills. There are two key numbers to evaluate: the percentage of a home's assessed value that is subject to tax and the property tax rate. Note that, depending on the tax rate, a home taxed at 100% of its assessed value could have a lower tax bill than a property that is taxed at only 50% of its assessed value. For example, on a $100,000 property taxed at 100% of its assessed value with a 2% tax rate, the property-tax bill would be $2,000. If instead the property is taxed at 50% of its assessed value with a 5% tax rate, the tax bill would be $2,500.

Estate and inheritance taxes

In addition to the federal estate tax (only relevant to estates valued at $5.25 million or more in 2013), some states levy their own estate tax. Many of these taxes kick in at levels lower than the federal threshold. Wealthy retirees need to make sure their estate plans take into account both federal and state estate taxes, which can eat into the amount passed on to heirs.

In a handful of states, heirs have to pony up. States that levy an inheritance tax require heirs to pay taxes on inherited assets.