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Dan Calandro - Sunday, August 23, 2015

Stocks took a beating last week as all major stock market indexes (the Dow, S&P 500, and 15-51 Indicator) lost 6%. Stock market strength via the 15-51 Indicator is the only index still in positive territory for the year. It’s up 2% year-to-date even after this most recent correction. The Dow and S&P have lost 8% and 2%, respectively, so far this year.

Yields have also fallen by a sizeable amount in the past week, ending 7% lower. And even though gold added 4% in the last five trading days, it’s still down 2% for the year. Below is the ugly chart of year-to-date activity.

 

The Dow Jones Average hit its all-time high on May 19 of this year (18,312), and since then has dropped 1,853 points, or 10.1%. Some people define a 10% move as a “correction” and a 20% fall as a “Bear Market.” I find these arbitrary definitions not only confusing, but silly.

Corrections are simply a price condition that can happen at any time, in either direction (up or down), for any reason, and in any denomination – 5%, 10%, 20%, or 30%, etc. For instance, the S&P 500 moved 6% this week. That’s a correction – even though the S&P is down only 7.5% from its all-time high (2,131 reached on May 21, 2015). Anyone saying anything different is just being silly.

Bull and Bear Markets are much different than simple price corrections – they are market conditions. Bear Markets are when stock prices lead the market (a.k.a. the economy) downward. Bull Markets are when stock prices lead the economy higher. See the difference? Bear Markets relate downward stock prices to a receding economy, and Bull Markets tie upward prices to an expanding economy.

To better illustrate the difference between corrections and Market conditions we’ll use the run-up to the last major correction to make the point clear. Below is a chart that starts at year-end 2005 (the heat of the housing-boom) and extends to the essential bottom of the last major correction, February 2009. Three critical points are highlighted along the Dow’s trend-line during that time: the market’s top (indicated by a red square), a 13% downward correction from the top (signified by a red diamond), and a further 7% corrective move commencing a Bear Market (signified by a red circle). See below.

 

As you can see, the 13% downward move signified by the red diamond is clearly a negative price correction. And though it easily could have been called a Bear Market based on its trajectory (the Dow’s trend looked destined to lead the economy lower) confirmation of the Bear Market didn’t arrive until July 2008 (the red circle). That’s when the Dow crossed under the GDP trend-line. At the commencement of the Bear Market the Dow Average was coincidentally down 20% – but as you can see, prices continued to correct another 23% before reaching bottom. The whole move was a “correction” to the downside. It began in October 2007 and didn’t end until February 2009.

A Bear Market lasts for as long as the stock market averages underperform economic output as measured by the long-term GDP trend-line. In other words, the Bear Market doesn’t end until stocks start to consistently lead the economy higher (a.k.a. a Bull Market). This transition, from one type of market to another, is never an even process.  In fact, the stock market was littered with up and down corrections from the time the Bear Market arrived (July 2008) until it finally ended (around June 2013). See below.

Downward corrections do not always make Bear Markets just as upward corrections do not always make Bull Markets. For instance, it would be foolish to ascertain that the market move from March 2009 (the market bottom) to July 2010 (the first yellow diamond after the market bottom) was a Bull Market simply because stocks advanced from 6,148 to 10,772. At that point stocks were still 4,000 points off their high and well below the long-term trend-line of Nominal GDP. (The DJIA is a nominal trend-line.)

The yellow circle all the way to the right of the chart above is where the new Bull Market commenced (June 2013) – which is the point at which stocks began to consistently lead the economy (GDP) higher.

So why do I go through such great pains to make this point clear?

Because it is important to understand what happened last week. It was a simple price correction – and a minor one at that. Sure, six percent is a big move for a five-day trading week. No doubt about it. But it’s important to keep it in perspective. Last week’s 6% move was a minute event in the grand scheme of things. In fact, the Dow’s 10% correction is just as miniscule, a proverbial blip on the radar screen.

Consider that “the market” is still valued higher than the peaks of the tech and housing booms in Real terms – and the modern economy is nowhere as robust as they were. (This is explained more thoroughly in my new piece, SURVIVING THE NEXT CRASH, which can be downloaded for free on my homepage.) And, ironically, the Dow is currently trading at the same exact multiple as it traded to Nominal GDP in October 2007, just before the last major corrective cycle began. (How’s that for an eerie coincidence?)

The chart below drives this point home by bringing the above trend-line up to date. It’s a 10-year look from year-end 2005 to present day, August 21, 2015. This timeframe puts last week’s move into proper context. See below.

Last week’s 6% drop looks like no big deal in the chart above – and that’s an accurate assessment. And while last week’s move was an insignificant amount in the big picture, it was still a major warning signal. A move of that size in such a short amount of time is the equivalent to a quick, sharp chest pain. It should seize attention.

And the reason it should capture attention is because stocks should really be trading close to “fair value” – that’s 2,000 points from where the Dow stands today after the 6% correction – which would represent a 20% correction from its recent top. But that 20% move would not automatically present a Bear Market because stocks would be trading at fair value and above Nominal GDP’s long-term trend-line.

To be sure, however, a 20% correction can certainly indicate that a Bear Market is on the way. Recall the major issues facing the global economy. Growth has been consistently weak and uneven at all corners: China is in a shambles. Europe is a disaster. The Middle East is at constant war. Emerging markets are at high risk. And the fragile U.S. economy is producing frail growth and statistics that have been inflated by trillions of dollars of newly printed money via QE that has produced an abysmal ROI and amassed the largest amount of national debt ever recorded in world history.

That said, it is totally reasonable to expect stocks to continue downward and for a Bear Market to ensue. In fact, current market indicators and dynamics are acknowledging this threat.

Take oil, for instance. It is down below $40 per barrel for the first time since the heat of the Great Recession. The drop in oil is reflective of lower global demand and the unwillingness of producers to curb supply. Let us also not forget that terror organization ISIS uses oil proceeds to fund their war effort, as does global antagonist, Russia. These threats provide extra incentive to keep oil wells pumping and prices low. Add to this the specter of Iranian oil supplies flowing into world markets that were freed by the new nuclear agreement – and $30 per barrel seems almost impossible not to materialize.

Lower oil prices are a double-edged sword. While the economy likes the revenue savings to spread around other market sectors, and therefore provide economic benefit, the current dynamic is different. In this instance, lower oil prices indicate soft demand and economic weakness. In other words, consumers aren’t spreading savings from energy products to other sectors of the economy. This is corroborated by what’s happening in China.

China’s manufacturing base is shrinking and growth is slowing substantially, and in a surprise move last week, they abruptly devalued their currency in hopes to reverse their downward spiral. In other words, China made this move because internal economics are going south and global demand is weak. A devaluation of their currency, in theory, would make Chinese products cheaper and thus increase demand and growth.

But there’s a problem with that thinking. First, most world governments are also devaluing their currencies at the same time. This minimizes the potency of the Chinese move. And second, many Chinese suppliers are raising their prices in the face of their government’s currency devaluation, which also produces headwinds to the Chinese currency move. 

Again, currency games like this and QE cannot fix Market problems.

Perhaps that is the reason global stock markets are selling off and U.S. bond yields have dropped so dramatically. Remember, yields decrease when bond demand increases. The recent drop in yields (along with lower stocks prices) indicates a skittish investor populous migrating from risk to safety. Gold’s recent reversal corroborates that dynamic. See below.

The first market rattle of the last major correction occurred in February of 2007 – eight months before the market topped, and eighteen months before the correction began its severe decline.

Major market corrections like that take time to metastasize, which luckily gives investors plenty of time to act before it’s too late – that is, if investors are listening to what the markets are saying.

Last week was just the beginning – and the worst is yet to come.

Spread the word, and stay tuned…

 

The road to financial independence.™

 

What's Wrong with the Dow--and How to Fix It

Dan Calandro - Friday, August 07, 2015

The Dow Average has been anything but average recently. In fact, the S&P 500 has consistently outperformed it over the last one, two, five, and ten-year periods. That makes the Dow Jones Industrial Average a below-average portfolio.

What’s the problem?

Perhaps the greatest benefit of a small portfolio is its ability to turnaround quickly and provide rapid growth after corrections. As such, one would expect the Dow 30 to have greatly outperformed the 500 stocks of the S&P since the bottom of the last correction (March 2009). But that hasn’t happen. See below. 

During this six-plus-year period the S&P outperformed the Dow by 23 percentage points (189% versus 165%), or 4% per year. That’s absurd.

A 500 stock index should never consistently outperform a 30 stock portfolio. Never. Instead, the Dow’s performance should have been somewhere between the S&P 500 and the 15-51 Indicator (see below.)

The Dow, right now, should be somewhere over 21,000. Not only can it not get there, but it also can’t beat the S&P 500. Why?

The DJIA has structural issues, and more specifically, suffers from poor stock selection.  Think of this…

Of the Dow’s 30 components only 12 have outpaced the S&P 500 over the last year – and one-third of those are financial stocks (Goldman Sachs, Visa, Travelers Insurance Group, and JP Morgan Chase). In fact, the Dow currently has five financial stocks, which ranks that industry 4th in priority order. But because the financial industry accounts for the majority of the Dow’s gains, such an allocation signifies that the financial industry contributes 1/3 of all economic growth in America. That isn’t even close to being accurate indication.

The Dow’s highest ranked industry is technology, with 7 stocks that amount to approximately 23% of the entire Dow portfolio – and 5 of those seven stocks have underperformed the S&P by huge amounts (IBM, United Technologies, Microsoft, Intel, and Cisco Systems). As stated in my book, technology is about the future – and much of those five Dow tech-stocks are about the past. This industry clearly needs some updating.

In the Dow’s second ranked industry, consumer services, half of its components have consistently underperformed the S&P 500 (McDonalds, Wal-Mart, and Verizon) – as did 4 of the six consumer staples stocks (Coke, Johnson & Johnson, Procter & Gamble, and Merck). Needless to say, these industries also need some tender-loving care.

This is not to mention that all of the Dow’s energy and basic stocks have also failed to meet the S&P’s performance (ExxonMobil and Chevron, Caterpillar and DuPont, respectively.)

The Dow has become a pitiful collection of mediocrity, and the proverbial cherry on top is General Electric, the only original Dow component still remaining in the portfolio, which hasn’t sniffed a reasonable return since Jeff Immelt took office. He is clearly no Jack Welch.

Add them all up and a stunning 18 out of 30 stocks, or 60%, of the Dow’s components have underperformed an easy-to-beat S&P 500 index.

That’s an embarrassment.

It’s time for the people managing the Dow to make some drastic changes. It’s time to eliminate the redundancies and upgrade the portfolio’s brands and components. It’s time to put nostalgia aside and finally say goodbye to stalwart names like IBM and General Electric. Yes, they’ve been there for a long time. But who cares. Investment is a performance business – and the S&P 500 is kicking the Dow’s behind. (Again, there’s no good reason for a 500 stock index to consistently outperform a 30 stock portfolio.)

The main objective of LOSE YOUR BROKER NOT YOUR MONEY is to teach investors the art of portfolio construction and how to build a superior one. If investors understand the concepts of construction there is no portfolio on earth that they can’t fix and/or outperform. To demonstrate this I will use the techniques outlined in my book to make adjustments to the DJIA, creating in essence, my version of what the Dow should look like today.

Knowing that the Dow needs to upgrade itself to better reflect the modern day market, two technology moves are obvious – IBM and Cisco have to go. IBM will be replaced with a computer company for the modern era, Google (GOOGL), which will really bolster the personal computing segment (recall that Apple was added to the Dow earlier this year.) In addition, the Google move will make it easy to replace Cisco Systems with the multi-faceted Cummins Inc. (CMI), which would help diversify this industry by GDP spending class. 

In the consumer service industry, McDonalds, Wal-Mart, and Verizon, will be replaced by companies that better reflect the changing patterns of American spenders: Panera (PNRA), Costco (COST), and amazon.com (amzn) will be added.

Consumer staple Coke will be eliminated in favor of Church & Dwight (CHD) and superior pharmaceutical developer Gilead (GILD) will replace Merck.

The financial industry is a place that the Dow can upgrade by getting smaller. For instance, with Visa and Goldman Sachs in the portfolio there’s no reason to suffer with the poor long-term performance of American Express.  And as suggested earlier, the Dow currently has too many financial stocks. As a result Amex will be eliminated and not replaced.

In the industrial industry GE is out and Ford Motor Company is in, and with the extra slot created by eliminating Amex in the financial industry, conglomerate Parker-Hannifin (PH) will be added to expand this industry’s offering.

The choices the Dow’s managers have made for the energy industry is one of their most perplexing. I appreciate the wisdom of an integrated oil and gas company for the portfolio – but two of them? Having both ExxonMobil and Chevron is the epitome of redundancy. That duplication is eliminated in my version of the Dow Jones Average where Chevron gives way to Piedmont Natural Gas (PNY).

Those adjustments change 1/3 of the Dow’s components, 10 in all, and would upgrade and modernize the portfolio. And since the changes made preserved market allocations, my version of the Dow Average would remain a "market portfolio." The portfolio’s movements will prove that should it move in a "market-like" way.

Once again, the purpose of these changes is to elevate the Dow’s performance trend to where it should be – somewhere between the S&P 500 and the 15-51 Indicator.

The chart below shows my version of the Dow Jones Industrial Average placed among the other major market indexes (the current DJIA, S&P 500, and 15-51 Indicator). See below.

The changes made almost double the Dow’s output since the last market bottom in ’09 (294% versus 189%), and places the value right where it belongs – between the S&P 500 and the 15-51 Indicator – while continuing to move in a "market-like" way.

Building and/or fixing portfolios to achieve desired results is quite easy to do using the techniques of my award winning method.

 

Until next time...   

 

 The road to financial independence.


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