Model Portfolio Update
I reduced the allocation to equities in the model portfolio from 50% to 20% in the third week of June 2013 and continue to run with that asset mix today. 20% of proceeds were invested in 5+ Year Eurozone government bonds and 10% in cash. The current asset mix remains at 20% equities / 50% bonds / 20% gold / 10% cash. Given that stocks remain overvalued (the price/earnings multiple on the S&P 500 is 19 times based on 2012 net reported earnings), investor sentiment remains overly bullish, we are 4.5 years into the current equity bull market (compared to 3.8 years for the long term average) and a number of my technical indicators are tipping into bearish mode, I continue to recommend a defensive position for now.
Equity Market Update
Stock market tops are a process. After breaking 1,400 for the first time in July 1999, it took the S&P 500 another 15 months to hammer out a major top before plunging in October 2000. The second major bull market peak in recent times began to take shape in 2007. The S&P started to wobble at 1,450 in February 2007. Then, in October 2007, US equities experienced a sharp -20% correction from 1,576 to 1,257 in five months. The relief rally lasted all of two months before the wheels came off. All in all, coincidentally, it again took 15 months for the US stock market to complete the topping process before collapsing in 2008.
This time around, top-calling is a little trickier. The Fed has begun to talk about tapering their massive monthly purchases of treasuries and mortgage backed securities. However, talk is cheap. Mr. Bernanke has an unlimited monetary arsenal at his disposal and could resume his QE project at the drop of a hat if economic data start to soften again. More QE could mean ever higher stock prices. At some point though in the not too distant future - we could be there already - continued Fed intervention will be perceived by investors as the problem rather than the solution. Stock prices will stop going up Federal Reserve announcements of additional money printing. Then they will start going down and that will be a sight to behold. The tide has started to turn in my opinion, which means that the next 12 months could prove quite challenging for stock markets.
Let's examine the stock market's technical setup for clues that the four year uptrend may be waning.
This week, for the first time in over a year, my technical trend indicator has tipped over into the red, testing support at the long term moving average. Investors should take note of this early warning signal that the uptrend in the stock market is deteriorating.
We can also see some initial signs of an overall weakening in this equity bull market by examining the Advance / Decline Line of all NYSE traded stocks. The A/D Line graphically displays the relationship between the number of stocks in rising trends versus the number of stocks in declining trends. In a healthy bull market, you should expect to see the majority of stocks in rising bullish trends. However, late in every bull market, the number of stocks participating in each rally falls until such a time that the trend peaks and reverses. For example, in 2007, we witnessed a negative divergence in the A/D Line for months prior to the stock market peak as fewer and fewer stocks participated in the rising trend. We are starting to see the same behaviour today.
In addition to the initial signs of technical deterioration we see in the stock market, investor optimism has also reached a rather bullish extreme. Taken together, excessive bullish sentiment and initial signs of a technical breakdown in the stock market should provide food for thought for those with a bullish outlook. Last time we reached a similar low level of investor bearishness was just prior to the stock market correction in May 2011; before that was just before the wheels came off in 2008. Buyers beware.
Here is a longer term view of the same chart. There is still room for bearish sentiment to decline further (and stock prices to continue to rise), but a correction to reset sentiment is not far off.
Like clockwork, and coincident with the low levels of bearish sentiment graphically shown above, investors are back in confident mood and returning to the stock market in their droves, with many going on margin (borrowing) to do so. Margin debt peaked at close to 2.8% of nominal US GDP in 2000 and again in 2007 as the S&P 500 was making a multi-year top in each instance. Margin debt levels are surging higher again and I fear the same result for stock prices in the months and years ahead.
Evidence is building that the current stock market rally is running into trouble. Stocks remain overvalued, investor sentiment remains overly bullish, and a number of my technical indicators are tipping into bearish mode. It is therefore prudent to continue to hold a defensive position for now as recommended in the model portfolio.
Bond Market Update
Long-term interest rates are rising across the world. US 10 year yields have risen 100 basis points from 1.76% to 2.76% in the past 8 months, despite the Federal Reserve printing $680 billion during that time to buy US government bonds. The bond market is signalling its discontent with Federal reserve policy of unlimited money printing. Rising interest rates will be the trend of the future, so investors that buy bonds should only do so for tactical reasons and always invest at the short end of the yield curve.
Gold Market Update
After a 2 year correction, the gold bull is back. The gold correction lasted from the peak in September 2011 of $1,921 to a trough in June 2013 of $1,180, a steep decline of -39%. Now, I expect gold to make up for lost time and challenge the all time highs over the next 6-12 months. During the last gold bull market of the 1970's, gold corrected in price from $200 to $100, a -50% decline before surging higher to a peak of $850 in 1980 as inflation ran wild. This time round, following the $1,180 low in June, gold has already recovered $240 to reach $1,420. If I am right about gold, we should see a strong move higher over the next 3-5 years as the bubble builds momentum.
Despite gold's recent 20% rally off the June lows, investor sentiment relating to the sector remains in the doldrums. Investors have thrown in the towel and have been very slow to return despite the recent turnaround in performance. This behaviour is exactly what is required to drive the gold bull market higher over the medium-term. As you can see from the next chart, the popular Rydex Funds are showing no signs of investment inflows into their precious metals funds. We have a long way to go before fund inflows return to the levels of 2010 and 2011.
The gold mining stocks, after getting taken to the woodshed earlier this year, are also making a comeback. While gold has rallied +20% in 6 weeks, the gold miners as measured by GDX, have already tacked on +39% over the same period. It is too early to get excited yet, but the prospects are definitely looking better. It's always darkest before the dawn. Hold your gold position and add on weakness. The next three years are going to be very profitable for precious metal investors.
To learn more about the full range of investment services available at Secure Investments, please contact Brian Delaney by email at firstname.lastname@example.org.