Rarefied Air

Scouring through 100’s of charts it becomes obvious investors have a clear idea on which companies they expect to benefit from the current political climate. One that immediately jumped out at me can be seen below in the chart of the Aerospace and Defense ETF, ITA. As you can it has broken out to new highs after consolidating for 6 months and using the 200 day moving average as a trampoline to propel higher. With RSI momentum unwinding during the consolidation, it appears to have a lot of room to move higher before investors need concern themselves with being overbought and expecting a pullback

The pattern’s (rectangle) target is still some $12 higher than where we closed yesterday. Keep in mind targets don’t mean a whole lot when stocks have entered rarefied air (new, all-time highs). As such, I expect ITA to likely ignore and blow right through it as long as this bull market has legs.

Muni Bombs

Regular readers should be comfortable knowing investment price patterns develop, repeat and understanding the reasons why. A great example of this can be seen in the US Muni bond ETF, MUB. Over the past 7 years, a head and shoulders topping pattern has formed 4 times. Of the first 3, only two actually played out to or beyond the pattern’s lower target. The middle one failed and reversed strongly higher (“from false breaks come big moves”) where it went on to make pattern #3. Interestingly, all of the first three formed their peak (head) when RSI momentum (the upper pane) entered and then exited the overbought region which is not the case in the current. Muni bond holders want to keep an eye on the present pattern and insure price holds at or above the neckline otherwise risk the possibility of much larger decline.

If you change the time frame on above chart to 5 years instead of 7 thereby removing the first pattern nearest the left edge of the chart and clean it up a bit something interesting appears … a  4+ year head and shoulders topping pattern.  

As you can see, it still has some room before it reaches its neckline and the pattern could trigger. Take a look at volume in the bottom pane. Notice how during the 2015 selloff from the head, you started to see big green bars as it broke below the neckline, an indication the big institutional buyers were stepping in. If I were a Muni bond holder right now I hope to see those big buyers step in once again as/if we approach those same levels. If not, I will be thanking the investment gods above I am not a holder of any Muni bonds as it could just be bombs away lower.

Funnymentals

Bull Market 
noun \ˈbu̇l ˈmär-kət\ 
Random market movements causing investors to mistake themselves as financial geniuses.

In spite of my continual poking fun at anyone putting too much confidence into fundamental only analysis, I do fully admit they should be a part of an investment process.  My problem with them is that they really only become obvious when looking in the rear-view mirror. They are horrible for making decisions on timing because once the information is known, the market has already reacted and it’s too late. In spite of that, I do find them useful and include them in my investment process as one element among many. They are of similar value that longer-term charts are. Directions and trends are more easily discernible and so they help to make short term decisions better but only when used with a weight-of-the-evidence approach. 

From a fundamental standpoint we know that, in theory, stock prices are directly correlated to corporate earnings growth. Stock prices move higher along with earnings and vice versa, Below is a chart of a 6 quarter look-back and 4 quarter look-ahead of the SP500 indexes earnings growth.

For the sake of argument if we take the estimated data at face value (don’t get me started on estimations and the ability to predict the future), the chart is telling us we will see a peak in earnings this quarter (Trump tax and policy changes) followed by a significant rollback to the long-term average. While I do believe the future growth numbers provided will be wrong, I am certain earnings will mean revert lower. Bottom line is the chart is telling an accurate tale. The when, how fast and how much will only be known in the future though. What equity investors need to determine is what impact will earnings mean reversion have on stock prices in the future knowing their strong correlation?

Seasonality 2x

It’s not the first time I have mentioned September being one of the year’s weakest months for stock returns. It should come as no surprise then that Septembers of the Presidential cycle are the weakest. What is interesting, is September in the second year has historically been the weakest month in the 4-year cycle.

It is theorized

• In years one and two of a presidential term, the President exits campaign mode and works hard to fulfill campaign promises before the next election begins. It is theorized that because of these circumstances surrounding the President's work, the first year after their election is the weakest of the presidential term, with the second year being not much better.

• This trend of initial economic weakness was thought to be true because campaign promises in the first half of the presidency are not typically aimed at strengthening the economy. Instead, political interests, such as tax law changes and social welfare issues tend to be highest priority.

• In years three and four of a Presidential term, it is thought that the President goes back into campaign mode and works hard to strengthen the economy in an effort to earn votes with economic stimulus, such as tax cuts and job creation. As such, the third year had often been the strongest of the four-year term and the fourth year, the second-strongest year of the term.

Seems like Trump may throw a monkey wrench in this theory as he seems to have gotten it backwards.  I have been on both sides of seasonality patterns and have found that other than the rare fat tail, a 1.43% average loss is well within normal acceptable market monthly wiggle. This is especially true when you look at the historical patterns that follow September’s weakness… A big rally. Market draw-downs are both normal and healthy so if September turns out to be one, it’s time to put on our big-boy pants and suck it up --- we’re in an uptrend.

Is an Intermediate Term Internet Top In Place?

By now it should be easier to recognize some of the more basic price patterns that investments can develop. Because the head and shoulders top reversal is frequently brought up most by those who are least qualified to talk about them (the media), making them more recognizable, I thought I would bring to light one that just came up on my radar screen.

As you can see in the Dow Jones Internet Index below, it has formed a symmetrical head and shoulders pattern with a well formed horizontal neckline. In the favor of the bulls we can see the head did not make a divergent high but the volume patterns are what bears would prefer to see. As is almost always the case, there is a case for both bulls and bears to make. On a bigger picture view we should be leaning bullish as we know from experience that most of these patterns fail. Why? Because stocks are in uptrends most of the time and these patterns are uptrend reversals. As such, from a probability standpoint it makes sense they do fail most of the time. Of course, there are always short term corrections and pullbacks giving any topping patterns an opportunity to play out. It’s important to mention since we are looking at a daily chart, I am not speaking of a “final” top, but rather an “intermediate” top where price eventually moves on to new highs.

With all this in mind this post is not intended to cause alarm or fear or a signal to sell but rather something to learn from. I intend to come back later and post a follow up after the final outcome of this pattern has played out. The two possibilities are 1) a completion move down to T1 or below; or 2) a failure confirmed by a move back above early August’s right shoulder high (before it has completed a move to T1).

On a side note, you will find head and shoulders bottom reversal patterns (inverse head and shoulders) have a much higher probability of meeting their target. Why? For the same reason why topping patterns fail most the time. Because stocks are moving higher over the long term and you are investing with the trend.