Has the Market Topped?

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The S&P 500 (SPY) had a fantastic rally after dropping to start this year.  Just two weeks ago, many market longs indicated the bull market would continue and we would hit new highs. However, the market failed to move to new all-time highs. The market got very close to the mark, reaching the 2100 level, but has slumped in recent days and now remains in chop mode around the 2050 level.  While technical analysis is only ever part of the story, it does paint a worrying picture:


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Importantly, the market made a lower high, and continues to struggle at the same precisely the same level of resistance where corrections started in 2015. There is serious congestion at the 2100 level on the S&P and it appears to be establishing a Berlin Wall of technical resistance where sellers are very happy to take money off the table.


In a bull market, it is unusual for the S&P 500 not to make frequent new highs.  The last time the S&P 500 went this long (a year) without making a new high during a bull market was in the aftermath of the 1987 crash.  Therefore it is quite possible that the next bear market has already begun.


There are several other reasons to support this thesis supported by recent data from earnings, China, and the US economy. Focus in risk management is crucial at this time.


Rough Earnings Season


For stock market bulls, it must be a relief that the earnings season is almost over. While expectations were set so low that companies have been able to (just barely) beat them on average, the overall picture is still grim. The Financial Times reports that:


“[T]here is the fact that the current picture for both the top and the bottom lines is, in absolute terms, very bad. Both revenues and profits are falling, and normally this only happens when an economy is entering a recession. Globally, the profits of MSCI World companies are down 4 per cent from their peak in 2014, and back to where they were five years ago.


In the US, according to Thomson Reuters, earnings are coming in at 5.2 per cent down on the first quarter of last year. This compares with forecasts of a 7.1 per cent fall when the quarter ended, but is still terrible by any sensible estimation. Meanwhile in Europe, the companies in the Stoxx 600 are seen registering an earnings decline of 18 per cent.”


There are a few important takeaways. One, the earnings problem is a global phenomenon. The slowdown in earnings is happening everywhere; it isn’t just a result of currency fluctuations taking from one economy to give to another. The fact of the matter is that everyone is struggling simultaneously.


And no, it’s not all energy’s fault. Six of the other S&P sectors show revenue declines in addition to energy. Utilities at -7% revenue growth and technology at -6% revenue growth are other notable losers.


The basic but trusty PE ratio has just two factors: price and earnings. As the Financial Times notes, globally, earnings are back to where they were five years ago. Unless earnings make a notable turnaround to the upside in coming quarters, it wouldn’t be surprising for stock prices to follow earnings back on down. It’s very risky to invest on the idea of permanent multiple expansion.


China: Pressure Is Mounting


The flow of negative news stories out of China has abated recently. While Chinese stocks haven’t put in a strong performance compared to other emerging markets, they are clinging to 15% gains off the winter lows. Out of sight, out of mind; the West has grown complacent regarding the tenuous Chinese economic situation.


For seven straight months, Chinese PMI slumped. March and April broke the down-streak by posting fractional gains. However, these appear to be based on aggressive lending rather than any structural improvements.


According to Cantor Fitzgerald’s research chief, China has seen aggregate financing hit a record high, reaching 10% of GDP in Q1. This tremendous flow of money only just barely lifted manufacturing back to a steady state. The new debt has gone both to promote commodity production and speculation in commodity futures contracts. The volume in futures markets for goods such as steel has exploded, without there being any clear sign of end demand for these input goods.


China appears to be trying to paper over a mounting economic problem. Concerns about social unrest are building; the government is working diligently to avoid the appearance of a broader crisis. However, much of the government’s efforts at stimulus appear to be creating artificial demand for commodities and infrastructure spending.


This is likely to reverse itself fairly quickly. Some goods, such as oil, are already running into trouble. US producers are using the uplift in prices to start increasing production and lock-in hedging activity.


China played a large role in triggering both the August 2015 and January sell-offs. It appears that little is fixed there. The Chinese government’s actions are likely to trigger more volatility in the near future.


Slowing US Economy


Most signs are pointing to a mounting dip in US economic performance to start 2016.


Retail sales have been very slow to start the year. There’s been a growing streak of flat or negative sales numbers. On the jobs front, the latest ADP report showed just 156,000 jobs created in April, far below the 195,000 estimate.


Between January and March, the economy grew at just 0.5%, a sluggish rate that clocks in well below recent quarters. JP Morgan Chase economists warn that the economy may have “slipped into ‘stall speed’, that is, growth so weak that the economy loses enough momentum and slides into recession.”


Adding to the weak data, US worker productivity continues to decline. Following a sharp 1.7% decline in the figure in Q4 of 2015, productivity dropped another 1% in Q1 of 2016. Workers put in 1.5% more hours, but the pace of their output only grew by 0.4%. This sort of discrepancy will steadily chip away at the unusually high level of corporate profits the economy is experiencing at present.


Risk Management is Now Crucial


As a reminder, in a bull market the stock market continues to find new highs and we wake up feeling good about our investments.  If we’re making money, there’s nothing to worry about; carry on. In a bear market it’s very different.  When the market stops going up, people get nervous, and then stocks tumble.  In these types of markets risk management is crucial. If we preserve our wealth in rough markets we are massively ahead of the game.


It’s worth considering that Carden Capital’s free Smart Hedge market timing algorithm remains out of the market. Stocks have begun to slide over the past week, supporting the idea of remaining cautious. China, poor earnings, and slowing US economic performance all give credence to the idea that a serious correction could be starting.


Therefore it’s time to consider protecting portfolios rather than speculating on further gains.  If you’re looking for an investment approach that offers downside protection while retaining upside, it is a good time to consider the Carden Capital Smart Wealth portfolios. With the stock market still near all-time highs, and with mounting signs of trouble arising, focus on risk management is crucial.


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