Predicting 2016, From a Behavioral Standpoint

The S&P 500 has had the worst start to a year in its history. Investors are worried about China, and the strength of the dollar. The first day of trading, in China, showed the first use of their circuit breaker system. This led to a global sell off of risky assets. Two days later, there circuit breaker system was used again! The market was only open about a half hour, before shutting down for the day again. On Friday the US had a exceptionally strong jobs report, but the trading day still ended up down around 1%. So, what is going on? Why are US investors selling their stock?

To understand why the market is selling, we need to look at the market behavior. We need to take a look at the market participants, and evaluate their reasons for selling.

The first thing you learn in your fundamental economics class is that in order for any theory to work, market participants are assumed to be rational. However, when you look at the stock market, you quickly realize that this assumption is about 50% false. Let us take a look at the rational side of things first.

The market has been on a tear since the Great Recession. It has been uncharacteristically good. If you bought in 2009, 2010, 2011, 2012, 2012, or even at the beginning of 2014, you likely saw some nice gains. So, you have some strong gains, in an uncharacteristically risk-less market. Now comes along 2015. The market does not move. There is the first correction in 3 years. First there was the Grexit, where everybody was uncertain about what would happen in Greece. Then there was the Chinese slowdown, where everybody was scared that a slowdown in China meant a slowdown in the global economy. On top of that, the bond market went into its first bear market in over 25 years. Commodities have plummeted, and oil just kept on falling. Earnings have been weaker and weaker. To top it all off, we had the first rise in interest rates in eight years. Even though all of this was thrown at investors the S&P held its ground. That is pretty remarkable. Now let's look at December 2015. Everybody is expecting this "Santa Clause Rally." Analysts everywhere, on every channel are predicting this rally to come, late into the year, but it never comes. Where does this leave investors?

With the memories of the Great Recession in the backs of their minds, they decide to take what they have gained. They are scattered, and jittery. They want to protect their gains, and make sure that they do not lose everything in a recession, or a big sell-off. With the recession in everybody's minds, they realize the risks of losses, and they remember that the stock market has its risks. The market will always go back down, so protect your gains and sell.

On the irrational side of things, people are actually wanting to buy stocks. They ignore evaluations, and believe the market is going to keep going up. This is entirely possible, but why would you want to risk it? The risk reward ratio has gone up significantly since 2015. You do not take the same risks for 3% growth, that you would with 14% growth. The stock market was not as risky in the previous years, not because the risk was not there. It was just less likely to occur. The Fed basically wanted to improve the economy by pushing up stock prices. With all the economic fundamentals going against the market, coupled with a negative year, it makes the likelihood of a downturn much more reasonable. At the very lease, investors should be rebalancing their portfolios to at least lower some risk.

That is right, it is irrational to believe the market will continue with its previous years strength. In prior years, the confidence of the stock market was strong. Interest rates were as close to zero as possible. The Fed was doing its best to propel the market up. All this has changed though. Interest rates have been raised, and the market is concerned that earnings are starting to slow. Sure you can miss a few percentage points of growth in your portfolio, but at what risk? Especially when you look at a typical portfolio. Even an average 60/40 portfolio, a 3 percent gain in the stock market only translates to a less than 1.5% increase in the portfolio. So instead of 60/40 portfolio, you would expect rational investors to lower stock exposure, and move to less risky assets.

With all of this, you would want to see a gradual step lower in the overall stock market. You should not see a huge drop, or panic selling (until maybe the end). There will be a gradual decrease in stock prices, and we have a well mannered bear market for a little while. At least until valuations decrease, and stocks become cheap again. When earnings show strength again, and global uncertainties start to go away again, people will gain their lost confidence back in the market, and move back into the more risky assets.

Disclaimer: At the time of publication the author is long RWM, DOG, SPH, PSQ. Inverse ETFs of the major US indexes.

What's Going on in The Stock Market

The stock market has rallied from it's August low, but can we expect it to keep going up from here? I don't think so. Let's take a look at the graphs.

First, we will take a look at the three major indexes.

All three indexes had a rounding top, a bearish sign, before the drop in August. None of the indexes have made new highs since their peaks in mid-July, this would imply weakness in the markets. When you look at the volume, you can see that there has been a lot more stocks changing hands, but there is little movement in either direction. That could tell you that the market is waiting. People are waiting to see if the bull will continue, or will the bear win the fight.We could think that the bulls are stronger, because the prices came back after the drop, but that may be a mistake as the comeback has weakened, and prices have failed to reach a new high.

Now let's take a look at the indicators. Looking at the MACD, you can see a bearish sign. as the MACD did not make a new peak, next to the previous peak, as price has. The RSI has that same issue, and shows a bearish sign as well. 

I believe that a bear is coming, and it will come in one of two ways. The price will continue to show weakness, and the overall trend will continue down. As for the other way, I think the price could get close to reaching its peak, forming a double top, before prices will drop again. 

Now we will take a look at the transportation average, which is used as a leading indicator in Dow theory. 

The transportation average is trending downwards, with indicators showing more downward pressure. There has been a rally that coincides with the rally that came after the August sell-off, but as you can see there is still weakness.

I believe the market is weak. It is hard to find a reason to buy stock, as earnings were weaker, and demand seems to be weakening as well. I think profit taking has occurred in the August drop, and now the current rally is a weak attempt to keep the bull going. Very few stocks are propelling these indexes higher. The Dow only has five or six stocks pushing it back up. Also, when you look at the industry leaders by market cap, only a few stocks are making new highs, the rest have been falling since before the index peaks, and a lot are in confirmed bear trends. The best strategy may be to hold cash and wait for a trend confirmation.

Stock Market Thoughts

If the stock market were to go into a bear market, we can look for key price levels that can help determine where the bottom is. We will look at the Dow Jones, S&P 500, and the NASDAQ Composite.

The S&P 500

There are two key levels to look at here. The higher one, is around 1,500. In the early 2000’s the dot com bubble peaked around there, and the bubble burst. During the housing bubble, the index made it to about the same level, and the bubble burst. However, since then we have gotten to a new peak around 2,100.

1,500 was a resistance level, meaning the price reached it then fell back down. After it passes through resistance you can begin to look at that level as a support level. So, that is why this is the first key price to look for.

The second level is the support level that was created after both of the bubbles both popped. That level is 700 – 750. This level is a strong support because both of the bubbles ended at this level. So, if the index falls through the 1,500 level, we would look for it to keep going to about 700-750.

The Dow

The Dow looks a little different. It does not have a key resistance level like the S&P 500 does. We can look at the previous peak before the housing crash for a key level that may be tested, and that is about 14,100. However, that level has not been tested yet, so the real level to look at is around 6500 – 6650. I think it is more likely to go down to this level, for reasons I will explain after we talk about the NASDAQ Composite.

NASDAQ Composite

The Nasdaq is actually a different ball game. It has actually just reached its peak from the dot com bubble this year. So, this means that there is a resistance around 5,000. The key level to look at here would be 1,300. That is the bottom of the dot com and housing bubble.

Price Conclusion

I believe that the lower levels of support are where we are headed. The reason is because that is where all three indexes have a support. They all have the same support level at the bottom of the bubbles. It is because all three agree at those levels that makes the support so strong, and a likely place for it to stop.

There are many reasons why this bear market can cause these prices, but here are a few key reasons:

•     China slow down
•          National economies across the globe are on the brink of recession
•          Commodities prices are falling: Oil, metals, food, etc.
•          The Fed

China

The Chinese economy is shifting from a manufacturing economy, to a services/consumption based economy. This has led to a slowdown in the Chinese economy, which means that international US companies are losing sales in China. China has tons of people, so companies were doing well there, so lower sales mean lower profits.

International

Around the world, economies are on the brink of recession. By definition a recession is two consecutive quarters of negative growth. This means that people are not spending money, like they should, in order to keep the economy afloat. Of course, less spending leads to lower profits and lower stock prices.

Commodities

Commodities are all falling, which is actually putting us at risk for deflation. Companies that sell commodities are losing lots of money as the prices fall. Mining companies and things of that nature will lose money because the prices are cheap. They lose money because the cost to mine does not change, but the price they can see at does.

This also can lead to deflation, as it becomes easier to buy more things with less money. This is a problem for stock prices because they act the same as buying a loaf of bread. They become more expensive or cheaper based on inflation rates. If everything goes on sale, so do wages and so do stocks.

The Fed

The problem with the Fed, is that they have built this economy on a false foundation. They have kept interest rates artificially low, which has spurred growth, but that’s the problem. They interacted into a natural process and have only prolonged the bubble. They have essentially expanded the economy, and fought against previous bear markets. If you look throughout history, you will notice that you cannot prevent a crash, you just prolong it and make it worse. I believe that is what the Fed has done.

The stock market has been pushed up because of low interest rates. The low interest rates have made bonds look like lackluster investments, and has made other investment vehicles look bad as well. Because of this, people have taken money out of those investments and put them into stocks; the more money in stocks, the higher the prices go.

Now, remember this is not natural. So, we can expect that in order for things to be natural, they need to take money out of stocks to put back into bonds and other investments. Once rates go back up, people will start looking for bonds and stuff. This will take money out of the market, which is why I think it will fall to the lower levels. The higher levels were the highest the market has ever been naturally, so I do not think falling to previous highs will be good enough for the market to bottom.

Check out my blog

Brandonrossta.blogspot.com

Making a Case for a Bear Market, pt. 2

In part 1, we looked at fundamental reasons why the stock market can become a bear. Here, we will look at technical reasons. We will look at the Dow Jones Industrial Average and its relation to the transportation sector of the economy.

Background
The Dow Jones Industrial Average (DJI) and the transportation average (TRAN) should be correlated. This is from the Dow theory. The Dow theory states that a strong economy would be shown through the TRAN and the DJI. This is because the industrials need to get their products to places where they can be sold. If transportation companies are being used, then companies are shipping products to places where they are sold. In theory, if the TRAN were to go bear before the DJI, then it represents less sales, and less profits.

DJI

Here you can see the DJI peaked in mid-June and has been down since.

TRAN

The Transportation average began to fall in mid-March, about three months before DJI began its descent. You would expect DJI to follow. 

However, the TRAN is made up of different types of shipping methods. We can take a look at individual sectors and see what is happening, and what it implies.

DJUSTK

This is the trucking sector. It has a bearish pattern, a double top and it has fallen around 17.5%. The trucking sector will give tell you about domestic shipping. It will tell you about shipping from factories or ports. The lowering price implicates the outlook of the trucking sector will fall, which means products are not going to be shipped.

DJUSRR

The railroad sector has fallen at a very rapid rate. This is correlated with domestic shipping as well. The sector has fallen about 35%, starting in March.

DJUSAF

The delivery services has fallen about 17% from peak to trough. The falling prices in this sector imply that people are not shipping goods, or ordering goods to be shipped. This is more correlated with consumers, not so much industries.

DJUSMT

This is the marine transport index, and this has fallen 48% since mid-October. This index will tell you about imports and exports internationally. With this index you can see that global production has slowed.

DJUSAR

The graph here does not look like much has happened, but the index has actually fallen about 26%. This is actually counter-intuitive to what you would be expecting. With falling gas prices, airlines should be generating more profits. However, we can read this as people are choosing not to fly as much anymore. Which would mean people are starting to save money. When people decide to save, the economy gets weaker. Less spending means less GDP.

Conclusion

As you can see, the transportation sector tells a different story of the economy than the DJI does. Imports and exports have fallen, showing that global producers are not selling as many products internationally. The domestic shipping industries are not transporting as many products within the US, which signals a slowdown in the domestic economy. 

A global slowdown in shipping can signal a global economy slowdown. As you read stock charts, it is important to look for these types of connections. Technical analysis assumes that the market discounts all available information. This means that when a sector falls, it can have other implications, rather than just the transports are going down. Making these connections will allow you to read into the economy. Rather than waiting every quarter to run the fundamentals of each company, you can look at sector price action, and gauge things for yourself, before the fundamentals come out. 

Making a Case for a Bear Market, pt. 1

Alright, so the market did some crazy things this last week, but it had a strong couple of days Wednesday and Thursday. However, I am not too sure we are out of the woods yet, so let's look at some reasons why.

China
The Chinese economy is in a transitional phase right now. They are moving from a manufacturing economy to an economy based on services and consumption. This should and will, cause a shake up in the world's economies. This means that all those things you used to get that said "Made in China," will no longer be made in China. So, what does that mean?
A manufacturing economy means that most people produce goods, while a consumption economy means most people sell goods. China became such a strong economy because they had cheap labor. In fact, they kept their labor cheap by controlling their currency. China is still a communist country, so they would control their currency in order to make their exports cheap, so people would keep using their labor to manufacture products then ship them to other countries.
Now that they are moving to an economy that models the US, their labor has gone up. Since labor has gone up, companies that have been using their labor are looking to move to other poorer countries, such as Cambodia or Laos. That way they can spend less per product, and generate more profit. Now, before companies have a chance to move, they need to pay for the more expensive labor, which will drive down profits, which should drive down stock prices.
The other problem with China, is that their economy is not doing too hot; they are spending less. This means that lots of companies that have made a lot of sales from China, are not going to have such strong numbers. This leads to less profits, and lower stock prices.
The reason for the slowing economy is probably most attributed to uncertainty. As the transition from a manufacturing based economy to a consumption based one, jobs and government action become uncertain. People can lose their jobs, or the government could do something that hurts the economy, so the people become savers, and spend less and less. As before, less spending means less profits and lower stock prices.

The Fed
The Fed is still not clear about when to raise rates, and some Fed officials are even saying we should begin easing again. I think that would be a terrible idea, but I also believe it to be highly unlikely. The problem is that the economy is running in emergency mode, at the moment. It is supposed to try and get the economy in the right direction, but I think it will eventually cause problems, especially if it is held out longer. Lower risk means bad investments, and if too many bad investments occur, eventually a bubble will pop.
However, if they turn off the emergency burners, they will cause some volatility in the market, because nobody knows what is really supposed to happen after rates lift off. At least they do not know what will happen in the stock/financial markets. This can all be a reason for a bear market. People may begin to sell with a rate hike and a slowing Chinese economy, and these two things will not be fixed in a quarter or two. I think we are looking at a bear that will last at least a year.

What Happens to Stocks Now?

The market had a selloff these last couple of days, and the indices have dropped around 4%, so what can we expect to happen? Well first we can take a look at a few reasons why the market has finally given up on the lower supports.
First there is China. All the signs are pointing to a slowing economy in China. The stock market is plummeting, manufacturing is slowing. Commodity prices are slumping, and the Chinese government is doing everything in its power to prop the economy up. Second, there is the rest of the world. The rest of the world's economies are slumping as well. Interest rates are low everywhere, and the economies just aren't picking up. Third, the strong dollar is lowering international profits, and making US exports more expensive, drawing down demand for US products. Lastly, interest rates are looking to rise soon, so it may be smart to exit some stocks now, take as much profit as possible, and have cash ready to enter the bond market.
Fundamentally what does all this mean? Well, the US economy is going rather strong, compared to the rest of the world. Most international companies are taking hits because of all the reasons mentioned above. So, what you can look for are companies that are more closely tied to the US economy. Look for companies that are not affected too much by the dollar, and that do not have many international ties. Those are the companies I would expect to take smaller hits in this downturn. However, most stocks will probably take some sort of hit. When a downturn in the broad market occurs, people get scared and will exit their positions. So you will want to look at the technicals of the stock and wait for a clear sign that the price won't continue to fall.
Now lets take a look at the technicals of the market as a whole. We'll take a look at the S&P 500, the Dow, the Nasdaq Composite and the Russell 2000.

S&P 500

The S&P traveled sideways and ended the range with a symmetrical triangle and a subsequent drop. Normally, a symmetrical triangle is a continuation pattern of a trend. In fact, by definition, there is supposed to be a clear trend before the triangle forms in order for it to be considered this pattern. However, this was just to perfect of a setup to not pay attention to, and a lot of insight can be made from its formation. 

The blue lines are where the supports are. These are the levels where we would expect the price to fight a little before bouncing back up, or continuing the fall. So the price is right around a support at the moment, so we need to watch to see what the price will do. I think that the price will fall through this level and head towards the 1810 mark. 

The Dow

From this screen shot, you can see that the Dow has broken through a few supports and still has some room to keep going down before the next one. I think the index will keep falling into the 1600 area, before the price starts to fight the bears. This is partly because the same formations exist on the S&P 500, and both indexes have a support there.

Nasdaq Composite

The Nasdaq Composite does not  have many supports to, well, support it. If the price falls passed the 4550 level, were looking at a drop towards 4000. The Nasdaq Composite has diverged from the other two indices from the beginning of the year. If all the indices were to align again, we would be looking at a fall to around the 4200 mark.

Russell 2000

The Russell 2000 is a small cap index, that is very different from the other three indices. This one barely traded above it's two year range, and has now fallen back into it. Unfortunately we cannot see the volume for this index, but it almost looks like the RUT has topped out with a head and shoulders pattern. The head and shoulders is one of the most recognizable pattern, where there are three peaks. Two peaks are roughly the same height, the shoulders, and a middle taller peak, the head. This almost always leads to a reversal in trend, and it looks like it is doing that here. The RUT looks like it will fall to 1090, and once it gets there it will probably show some support. However, from there it could keep going down, or bounce back up, 

The Russell 2000 is full of small cap stocks, and these are the ones that we would expect to take less of a hit. However, after looking at the technicals, it does not look like they will be spared the selloff.
Conclusion
The stock market has finally done something exciting this year. The amount of volume that has been generated shows people trying to take their profits before price falls more. We can hope this will only be a correction, and not a full blown bear. However, as prices fall, it makes these companies cheap again. So now it is time to watch, wait for a bottom, and buy the climb back up.

Disclaimer: (http://http//brandonrossta.blogspot.com/2015/07/disclaimer.html)

Why a Stock Market Correction is Due

The last six years has been one of the longest bull runs in the history of the stock market. This alone marks that a correction should occur, but let's take a look why.

When the housing bubble burst, the stock market crashed. People were losing jobs and equity in there homes, so they sold their stock. They wanted to save their money. The Federal Reserved realized this, so they began a program called Quantitative Easing (QE). They did three rounds of QE that were meant to make cash cheaper, and to spur investment. The idea was to keep interest rates low, and make money cheap. This should increase investments because it is cheaper to borrow from the bank, so loans are made and things are bought. See, what most people do not realize is that in order for the economy to be "good", it requires people to buy stuff. Every individual is part of the economy, and if everybody wants to save, the economy is not going to get better.

Now people have cash, but where do they put it? Stocks? Bonds? Venture capital? Remember, interest rates are low, so bonds are not the answer. That leaves stocks and venture investments. Because of this, you can see how stock prices have gone up, and why there is all these startups. People put there money somewhere, because the opportunity cost of keeping their cash in a savings account is high. People want to put their money in stocks, because most people do not have the cash to fund a startup. This raises prices because the demand for stock goes up.

Now, the Fed knew this would happen, its why they did it. When people make good investments, they feel a wealth effect. They feel they have made more money, and they spend more. They have those stocks to sell if they need to. That was the Fed's plan the whole time; prop up stock prices, create a wealth effect, increase spending. So what is the problem then? The economy is getting stronger. More people are getting jobs.

The problem is that this economy has been built upon artificial interest rates. The cheaper money has spurred more investment, but it has also spurred more risk. Investors have cheaper money, so they can take more risk when they make their investments. This will lead to bad investments, and when these investments fail, it will hurt the economy. The other problem is that when people feel this wealth effect, they technically do not have the cash in hand in case of an emergency. They still have to sell the stock to actually realize any profits. The savings they are relying on, are at risk. All it will take is something like a stronger US Dollar, or falling oil prices to make profit margins fall and force stock prices to fall. This will lower the wealth people have, and start to cause some worry. What can happen here is panic selling. Stock prices fall to a certain level, and everybody decides to sell at the same time. People late to the party can see the "savings" they were relying on in the stock prices fall quickly, and lose a lot of money.

Another problem is interest rates will go up, and it will be better for the bond market. Since people have gone out of the bond market and moved their cash to stocks, they will sell stock to put back into bonds. This will create a higher supply in the stock market, and that will cause the market to fall.

Lastly, and the hardest one to grasp, is how much higher can the stock market really go? Demand causes the prices to go up, but what happens when people simply run out of money to put into stocks? Is it realistic for the market to keep going up? Do people want to risk more money to keep the prices going up? Or has demand reached supply?