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A Stock Market Breather Before A Big-Time Bullish Breakout? Not Bloody Likely

It is unsettling to deal with the probability that we are closer to a bearish decline in stocks than a bullish reboot. However, if one prepares for inevitable depreciation in overvalued asset prices, buying low becomes less intimidating. At the current moment, far too many folks are being led astray by talking points they hear on CNBC and Bloomberg. History and probability do not favor the idea that stock markets will magically grind higher. It is unsettling to deal with the probability that we are closer to a bearish decline in stocks than a bullish reboot. Investment account values will wane. Household net worth will diminish. And when stock prices near their lowest ebb, the typical investor will decide that buying is impractical. However, if one prepares for inevitable depreciation in overvalued asset prices, buying low becomes less intimidating. For example, in spite of the exceptionally poor rap that trend-following techniques receive from the mainstream financial media, a decision to “stand down” when the 50-day crossed below the 200-day in the previous stock bear provided a remarkably desirable return OF capital. A subsequent decision to embrace risk when the 50-day crossed above the 200-day provided a remarkably desirable entry point for a return ON capital. Selling the S&P 500 near 1500 (a.k.a. “selling high”) and purchasing it again near 900 (a.k.a. “buying low”) helped one successfully transition from capital preservation to capital appreciation. At the current moment, far too many folks are being led astray by talking points they hear on CNBC and Bloomberg. For instance, popular shows regularly trot out analysts who insist that that market is “grinding higher.” First of all, which market is grinding higher? The Dow Industrials, Dow Transports, S&P 500, S&P 400, Russell 2000 and New York Stock Exchange (NYSE) Composite are all lower than they were one year ago. (Note: Ironically enough, the Fed’s last asset purchase actually occurred on 12/18/2014, making 12/17/2015 the end of a full trading year.) It follows that the only significant U.S. index that has made genuine progress since the end of the Federal Reserve’s quantitative easing (QE3) is the NASDAQ . Even there, progress is less impressive when one weights the components of the NASDAQ equally, rather than rely on the super-sized weightings of Facebook (NASDAQ: FB ), Amazon (NASDAQ: AMZN ), Netflix (NASDAQ: NFLX ) and Alphabet (NASDAQ: GOOG ). This is evident in the deterioration of the First Trust NASDAQ-100 Equal Weight Index ETF (NASDAQ: QQEW ):the PowerShares QQQ Trust ETF (NASDAQ: QQQ ) price ratio. Why is the lack of meaningful progress in so many U.S. stock barometers – the Dow Industrials, Dow Transports, S&P 500, S&P 400, Russell 2000, NYSE Composite – being overlooked? The most common answer that I am hearing is the prospect of a “breather.” A proverbial “pause” for U.S. stocks in the middle of a bullish cycle. The problems with the “breather” belief are numerous. For one thing, where consolidation has occurred during previous “pauses,” the number of advancing stocks on the exchanges relative to the the number of declining issues usually move higher. Consider the euro-zone crisis in the summertime of 2011 – the last time stocks experienced anything close to a sharp correction. The NYSE Advance/Decline Line (A/D) offered ample signs of a healthier stock market with a series of “higher lows” and “higher highs.” In essence, the number of advancers began to eviscerate the number of decliners. If one is inclined to believe that the current stock bull is merely catching its breath for a second wind, shouldn’t we see the same kind of improving breadth here in 2015? Like we did in 2011? Yet, over the past year, more stocks in the US have been declining than advancing for the first time since 2009. Moreover, the NYSE A/D Line is not currently demonstrating the kind of resilience that previous bullish rallies demonstrated. A second shot across the “breather” bow is the earnings environment. Combine the strong dollar, low commodity prices, higher borrowing costs, and we’re about to see our third consecutive quarterly decline in S&P 500 earnings. That has not occurred since the systemic financial collapse. What’s more, the profitability concerns are wreaking havoc on traditional valuations; that is, you cannot see a 14% decline in year-over-year earnings , as well as a third consecutive quarter of earnings deterioration, and anticipate anything other than expensive stocks becoming even pricier. A third dilemma for the “breather” believers? The rest of the world’s stock markets are trading near the levels they were trading when the S&P 500 hit 1867 back in August. Or worse. Many of the world markets are trading at even lower prices than the August lows for the S&P 500 . How about the world’s 4th largest economy in the United Kingdom? The i Shares MSCI United Kingdom ETF (NYSEARCA: EWU ) is far beneath its 200-day moving average and hardly shows any indication that it is ready to rally back to new 52 -week highs. Of course, history only rhymes, it does not repeat. There’s no way to know what will transpire with any certainty. Yet history and probability do not favor the idea that stock markets will magically grind higher. (They haven’t for the last year.) History and probability do not favor a bullish breakout to new records when manufacturing is contracting, earnings and sales are declining, and global economic hardships are increasing. Here is one final item to digest. Several years ago, the U.S. Department of Transportation’s Bureau of Transportation Statistics produced a study that showed how its transportation index “…led slowdowns in the economy by an average of four to five months.” Is there anything in the activity of a similar index – the longest running stock index in U.S. history, the Dow Jones Transportation Index – that suggests U.S. stocks are gearing up for a breakout above all-time highs? Does a 17.25% price drop show that stocks are grinding higher or lower? Keep a little cash on hand. Not only will it help you sleep better at night, but it will give you the confidence to buy good stuff lower down the road. D isclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

5 Must-See Economic Charts Show Why Stocks May Stumble In 2016

On your mark. Get set. Terrible. How do we know the economy is slowing down rather than picking up? The treasury yield curve is flattening. Key credit spreads are widening. The manufacturing segment is contracting. Labor market conditions are moderating. And the consumer is spending less. Everyone has a guilty pleasure or three. Mine? I am addicted to Seth MacFarlane’s “Family Guy.” I cannot get enough of outrageously random references on everything from a pizza place’s version of a salad to writers plying their trade at Starbucks. Underneath it all are characters whose comments are outlandish and whose behaviors are impetuous or harebrained. This morning, a particular exchange in a Family Guy episode is stuck in my head. Peter Griffin is blackmailing his father-in-law about an extra-marital affair. As part of the extortion, Peter requires the father-in-law to produce a list of exceptional catch-phrases. (Peter wants his own catch-phrase attributable to him.) One of the catch-phrases that he admires is as inane as it is nonsensical. “On your mark. Get set. Terrible.” Why is this scene playing on a loop in my head right now? Perhaps it has to do with the Federal Reserve’s imminent directional shift with respect to borrowing costs. Or maybe it has to do with the current state of the economy. Or even more likely, the catch-phrase aptly describes what is likely to happen to risk assets when the Fed is hiking overnight lending rates into a decelerating economy. How do we know the economy is slowing down rather than picking up? The treasury yield curve is flattening. Key credit spreads are widening. The manufacturing segment is contracting. Labor market conditions are moderating. And the consumer is spending less. Let me start with the all-important yield curve. A steepening curve is indicative of a healthier economic backdrop whereas a flattening curve is indicative of weakness in an economy. Granted, a flattening curve by itself is not a death blow for an expansion. On the other hand, the less the difference between long maturities (e.g. 25 years, 30 years, etc.) and short maturities (e.g., 1 year, 2 years, 3 years, etc.), the less confidence the financial world has in the well-being of an expansion. Right now? Investors have less confidence in the well-being of the current expansion than they did when the Fed put plans in motion for its awe-inspiring QE3 stimulus back in 2012. Beyond the yield curve’s warning about the economy as well as riskier assets like stocks, we have the widening of 10-year treasuries and comparable corporate bonds. For example, six months ago, the Composite Corporate Bond Rate (CCBR) was at 3.85% and the 10-year Treasury was at 2.4%. Today, the spread has widened with the CCBR at 4.32% and the 10-year treasury at 2.22%. The jump in this credit spread from 1.45% to 2.10% – 65 basis points – is significant for just 6 months. There’s more. One can investigate the risk preferences of investors by comparing the lowest end of the investment grade corporate bond (Baa) spectrum as it compares with a comparable 10-year treasury. Not only has the spread moved nearly 100 basis points in the last year – from 2.2 percent to 3.2 percent – but the same move from 2% to above 3% in this spread preceded the last two recessions. Still not persuaded? Let’s take a look at one of the most consistent economic forecasting tools: The Institute For Supply Management’s Purchasing Managers’ Index (PMI). Economists tend to interpret PMI in two ways – on a single reading as well as over a time horizon. In essence, a percentage over 50 expresses manufacturing health and a percentage under 50 expresses a manufacturing recession. On an absolute basis, November PMI came in at 49.8. We are already in pretty bad shape. More troubling, however, is the persistent downtrend over the last 12 months. Keep in mind, the same type of downtrend preceded the real estate inspired Great Recession. What’s more, when the Fed acted to stimulate the U.S. economy in 2009 as well as 2012, PMI expanded handsomely. Based on what the manufacturing sector is telling us, does it make sense that the Fed is hell-bent on hiking overnight lending rates now? Wouldn’t it have been more “opportune” to do so immediately after QE3 ended in 2014? From my vantage point, the timing of the Fed’s directional shift is on the wrong side of history. Contraction in the manufacturing segment, the flattening of the treasury curve and the widening of credit spreads are signs of economic deceleration. Is it wishful thinking to place all of our hopes in the service sector basket? Probably not. Take a look at the state of retail sales. The last time that year-over-year retail sales looked this anemic, the Federal Reserve shocked and awed the country with its boldest ever stimulus program. In complete contrast, the Fed is gearing up to set a course for gradual tightening. If risk assets like stocks are going to power ahead to new 52-week record highs, they’re going to need that course to be as gradual as a snail crossing a 5-lane highway. (And the snail better hope it does not get crushed by a car as it attempts to cross!) Still not convinced that the economy is on shaky ground? Still think the Fed is invincible with respect to its policy wisdom? Then take a look at the Fed’s own Labor Market Conditions Index (LMCI). The model incorporates labor market conditions across 19 underlying indicators. Just this month, November’s reading came in at a less-than-promising 0.5. That was revised down from 2.2 in October. Equally troubling, there have been 12 negative revisions with only 6 positive revisions over the last year and a half. When the LMCI drops below zero, it is meant to be a warning to economists that labor market conditions are contracting. The current reading of 0.5, then, doesn’t exactly promote warm and fuzzy feelings with regard to claims that labor market is healthy. What’s more, each of the last five recessions were preceded by an LMCI reading below zero. With the current reading of 0.5, is the Fed is genuinely confident about the well-being of the labor market? Is the chatter about “nearing full employment” more of a smoke screen to distract others from discussing the Labor Market Conditions Index (LMCI) in greater detail? Why are voting members of the Fed’s Open Market Committee (FOMC) downplaying the fact that the percentage of working-aged individuals (25-54) in the labor force continues to evaporate? Millions of working-aged Americans (25-54) are not counted as part of the headline unemployment rate such that prospects for the prime working-aged demographic (25-54) haven’t been this grim since the early 1980s. The economy is fragile. If the economy were humming along, the treasury yield curve would be steepening, not flattening; if the backdrop were rosy, key credit spreads would be coming together, not widening. If the economy were firing on all cylinders, manufacturers would be growing their businesses, not making less stuff; households would be spending more each year, not increasing their savings and holding back on holiday purchases. Additionally, the percentage of working-aged individuals in the labor force (25-54) would be growing, not disappearing; labor market conditions via the LMCI would be vibrant, not wobbly. Now, if someone wants to make a case that the economy’s shakiness is irrelevant to the near-term or intermediate-term direction of stock prices, he/she might be able to argue it. However, history suggests otherwise. For one thing, a contraction in earnings (a.k.a. “earnings recession”) is already in effect. Earnings contraction typically portends weaker economic output as well as inferior total returns in the stock market. In fact, corporate earnings on the S&P 500 have declined 14% year-over-year – from $106 to $91. Even the Wall Street Journal/Birinyi Associates Forward P/E Ratio of 17.4 – a ratio that is 25% higher than the 35-year average Forward P/E of 13 – would require 33% earnings growth over the coming 12 months. Is this economy going to witness an industrial/energy revival as well as extraordinary demand for U.S exports to support 33% earnings growth over the next year? Not likely. Stocks will only be moving from overvalued to insanely overvalued. Second, there’s a remarkably strong link between profit margins and recessions. Not that long ago, Jonathan Glionna at Barclays’ noted the relationship between shrinking profit margins and recessions for the last seven business cycles, going back to 1973. He wrote: The results are not encouraging for the economy or the stock market. In every period except one, a 0.6% decline in margins in 12 months coincided with a recession. Already, profit margins have declined 60 basis points. Will stocks and the U.S. economy be more like 1985, then? Or will they be more like 1973-1974, 1981-1982, 1987, 1990, 2000-2002 and 2007-2009? For my moderate clients, I am maintaining an asset allocation that is less “risky” than normal. Whereas it might be appropriate for a moderate client to have 70% equity exposure across all stock types (e.g., large, small, foreign, emerging, etc.), we have 60% primarily dedicated to the large company space. Some of the ETFs that we own include the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), the iShares Russell 1000 Growth ETF (NYSEARCA: IWF ) and the Technology Select Sector SPDR ETF (NYSEARCA: XLK ). Similarly, it might typically be appropriate for a moderate client to own 30% across all income assets (e.g., investment grade bonds, convertibles, higher-yield, master limited partnerships, short maturity, long maturity, etc.). However, we have 25% primarily dedicated to investment grade bonds with intermediate maturities. Some of the ETFs that we own include the SPDR Nuveen Barclays Municipal Bond ETF (NYSEARCA: TFI ), the iShares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ) and iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ). The remaining 15%? Cash and cash equivalents. In addition, if the economy worsens and market internals degenerate and stock valuations become obscene, I would make a tactical decision to raise cash levels. There’s only one way to acquire assets at lower prices. You’ve got to have the cash on hand to take advantage when the world seems to be falling apart. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Flatter Yield Curve, Narrow Stock Leadership Forewarn Extreme Risk Takers

Summary How confident should diversified investors be that U.S. stocks can power ahead without the extraordinary stimulus of quantitative easing (QE) and zero percent interest rate policy? Not too confident. Some folks are glad to see seven years of extraordinary accommodation come to an end. Understanding late-stage bull market phenomena help tactical asset allocators monitor changes in risk-taking. Here are two gauges of “risk off” behavior that I am watching. How confident should diversified investors be that U.S. stocks can power ahead without the extraordinary stimulus of quantitative easing (QE) and zero percent interest rate policy (ZIRP)? Not too confident. Stocks that trade on the New York Stock Exchange are down roughly 7.0% from their May highs and down nearly 3.5% since the last QE asset purchase by the Federal Reserve occurred on December 18, 2014. Some folks are glad to see seven years of extraordinary accommodation come to an end. Consider Andrew Huszar. He is the former Fed official who managed the acquisition of $1 trillion in mortgage-backed debt, then subsequently condemned the endeavor in 2013. Huszar told CNBC, “[QE] pushed up financial asset prices pretty dramatically. A lot of that is the Fed pushing the market’s paper value way above it’s true value.” Is he wrong? Probably not. Metrics with the strongest correlation to subsequent 10-year returns – Tobin’s Q Ratio, P/E10, market-cap-to-GDP, price-to-sales – all suggest that current valuation levels are at extremes not seen since 2000 . Worse yet, if previous cycle extremes are any indication, one should be prepared for a 40%-50% bearish decline for popular benchmarks like the S&P 500. The typical argument against overvaluation – the “this time is different” argument – involves the assumption that unprecedented lows for interest rates render traditional valuation methodologies insignificant. There are at least two problems with this notion. First of all, for rates to stay this low well into the future, it would likely correspond to a feeble U.S. economy as well as anemic corporate revenue. (Corporate sales per share have already declined for three consecutive quarters.) It follows that a deteriorating fundamental backdrop would offset borrowing costs that remain low on a historical basis. The second trouble with pointing to low interest rates to dismiss overvalued equities? It ignores the directional shift from emergency level QE stimulus to zero percent policy alone to the highly anticipated quarter point tightening. Again, a diversified basket of equally-weighted stocks is down nearly 3.5% since the last QE asset purchase. (Review the NYSE chart above.) As always, overvaluation doesn’t matter until it does; exceptionally overpriced can become ludicrously overpriced for several years. On the other hand, understanding late-stage bull market phenomena help tactical asset allocators monitor changes in risk-taking. Here are two gauges of “risk off” behavior that I am watching: 1. Flattening Of The Yield Curve When spreads between longer and shorter treasury bond maturities rise, the yield curve steepens. Investors are less inclined to purchase long-dated treasury debt because they have faith in the strengthening of the economy. In contrast, when spreads fall, the treasury yield curve flattens. Investors demand the perceived safety of longer maturities because they are concerned that economic conditions are deteriorating. Now consider the current “risk off” behavior. One year ago, the spread between 10-years and 2-years chimed in at 1.8. Today it is roughly 1.3. The 2-year treasury bond yields have soared on the prospect of the Fed’s imminent rate hike, yet the 10-year yield has barely budged because investors are expressing concern about the potential for Fed policy error. Take a look at what transpired in the middle of 2012. The Federal Reserve met rapidly falling spreads head on, jolting “risk on” investing behavior via open-ended quantitative easing stimulus (QE3). Right now? Investors are exhibiting the kind of “risk off” preferences that transpired back in mid-2012. Yet the Fed is not gearing up to provide additional liquidity. On the contrary. Fed committee members seem resigned to raising borrowing costs, if ever so slightly. The narrowing between 30-year maturities and 2-years demonstrates a similar “risk off” pattern. The spread is even lower than when the Fed shocked and awed the investing world with QE3. The declining spreads and the flattening of the yield curve are a sign of risk aversion – one that, historically, has worked its way into stocks. If the current pattern of yield curve flattening continues, equity prices of popular benchmarks are likely to fall. 2. Narrowing of Stock Breadth According to Bespoke Research, the top 1% of Russell 3,000 stocks (30 largest) are up roughly 6.6% YTD. That is the top 1%. The other 99%? The remaining 99% of Russell 3,000 stocks have averaged a decline of -3.0% YTD. Others have identified the lack of participation using the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). The top 20 components have gained 59% while the other 480 components are collectively down 3.0% YTD. The result for the market-cap weighted ETF? A 3% gain. Historically, narrow breadth rarely bodes well for the intermediate- to longer-term well-being of market-cap weighted funds. A better picture of what is actually happening to risk preferences is evident in equal-weighted proxies like the Guggenheim Russell 1000 Equal Weight ETF (NYSEARCA: EWRI ). We can see that, much like the NYSE itself, EWRI is still close to 7% below its May high; EWRI is still trading at a lower price than when the Fed exited QE for good with its final mortgage-backed bond purchase on 12/18/2014. Similar to stock valuations, weak breadth may not matter until it does. Thin leadership where a few stocks carry the entire load can become even thinner leadership. Historically, however, the top 1% or the top 5% tend to buckle. That’s why it is sensible to ask one’s self, is it likely that the other 95% or the other 99% will join the top 1% or top 5% at extremely overvalued price levels? Or is it more likely that profit-taking on stocks like Facebook (NASDAQ: FB ), Amazon (NASDAQ: AMZN ) and Netflix (NASDAQ: NFLX ) will result in a take-down of the heralded S&P 500? For the majority of my moderate growth and income clients, I maintain a 60% stock (mostly large-cap domestic), 25% bond (mostly investment grade) and 15% cash/cash equivalent mix . This contrasts with a more typical “risk on” allocation of 65%-70% stock (e.g. large, small, foreign, etc.) 30%-35% bond (e.g. investment grade, convertible, high yield, foreign bond, etc.). Top stock ETF holdings include the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) , the Technology Select Sector SPDR ETF (NYSEARCA: XLK ) and the iShares Core S&P 500 ETF (NYSEARCA: IVV ). Top bond holdings include the Vanguard Total Bond Market ETF (NYSEARCA: BND ) as well as the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) . D isclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.