Get Your Bucket Ready For A Correction

Summary

  • Markets are approaching overbought, and are already overvalued, this means we are likely to see a correction soon.
  • A confluence of factors are coming together to suggest the correction begins in the next week or two.
  • We have no idea what the Fed will put into stopping a correction. Stocks could correct 10-20%, a lot more or somewhere in between.
  • There are still a few values out there to nibble on, most opportunities come on correlated corrections which means we will have a short period when we do a lot.
  • The “buy zone” for QQQ.

Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” 

– Warren Buffett

In Friday’s webinar I described why a correction could start in the next week or two. I covered a range of scenarios from a small retracement to the “Armageddon scenario.” 

While “the Fed” liquidity gets most of the kudos for the strong summer rebound rally, it’s really the Millennial traders who have been the marginal buyers that have driven prices. I believe a combination of the Federal Reserve avoiding more QE except in a dire emergency and Millennial traders flipping the option switch from buying calls to buying puts is a key dynamic to watch.

If there is a correlated correction in stocks, then we have to go from slowly putting holdings into thimbles to getting a big rain bucket and filling our portfolios up fairly quickly. 

I expect that there is a roughly two-week period coming when we can go from overweight cash to mostly or fully invested again in our “Barbell” investment strategy. As cash falls in value long-term, it is important for us to be mostly invested, most of the time, in assets that appreciate with secular growth themes and inflationary policy, i.e. the two ends of the barbell. 

Investment Barbell

What Does The Stock Market Care About?

Things the stock market has not cared about yet:

  • election related volatility.
  • a second wave of Covid-19 that has started.
  • the High Wage Layoffs that I covered recently.
  • broad economic numbers indicating a flattening economic recovery.
  • really bad trade numbers.
  • a potential downward revision of earnings expectations.

Keeping an eye on earnings which start this week I think will be very important. If companies are not as upbeat as they were mid-year, I think that could put a negative spin on stocks pretty abruptly. 

Why would there be a negative spin on earnings? Well, other than the depression, let’s take a look at a few of the early earnings so far: 

  • Carnival Corp (CCL) missed by 67% on no pick-up in cruise business. This could have been expected, but this market didn’t. The stock barely moved.
  • Dominos Pizza (DPZ) missed by 10% and that actually left a mark. Why? A pizza pick-up and delivery business should be hitting grand slams right now you would think.
  • Paychex (PAYX) which you would think is a good barometer of small business beat by 4¢ and is only down 40% on earnings year-over-year now. They guided a bit higher and saw a couple percent increase after earnings, despite this: 
    • Total revenue decreased 6% to $932.2 million.
    • Operating income decreased 19% to $284.0 million. Adjusted operating income(1) decreased 10% to $315.2 million.
    • Net income decreased 20% to $211.6 million. Adjusted net income(1) decreased 11% to $228.0 million.
    • Diluted earnings per share decreased 19% to $0.59 per share. Adjusted diluted earnings per share(1) decreased 11% to $0.63 per share.

The Carnival earnings shouldn’t be a surprise. Dominos should be a warning that even for $5 to $10 pizzas folks are short on cash. Paychex you would think should have been down because a quarter of small businesses are kaput and its earnings are crushed, but instead it went up a bit and is only 8 bucks below an all-time high.

Maybe earnings will be “the thing” that changes the bullish narrative to bearish. We know that popular new narratives are essentially tailored to fit price action.

Wouldn’t it be nice if somebody gave you the next narrative ahead of time? Like they figured something out and just didn’t fit a story into the flashing red and green numbers.

Let me try to give you the next narrative. These forward P/E charts from Yardeni should scream at you. If they don’t, lean closer to your screen.

Yeah, yeah, I know, tell me all about low interest rates mean P/E should be higher. Price to earnings ratios should probably be 5-10% higher than historical averages if we believe interest rates are lower forever.

What If Rates Rise A Bit?

Of course, my other response to the low interest rates equals higher multiples argument is this: rates will only be near zero until someone smart decides that the trickle down plus monetary largess approach that we have been taking isn’t working and tries something else. Helicopter money (or Modern Monetary Theory) and fiscal stimulus anybody? Bueller? Bueller? Biden?

For what it’s worth, several investment banks and institutional investors just warned about higher rates, very similar to what I’ve been talking about in webinars the past few months.

One of my core points has been that whenever it is the markets accept Biden as the likely winner in November, the dollar would firm and rates would rise a bit at the long-end. This will put a chill in stocks short run (just as higher cap gains and income tax rates for the 1% and corps will). 

But why do I and Wall Street believe that Biden is better for economic growth? Well, just as the Fed Presidents are crying out for growth oriented fiscal stimulus, that’s just what Biden is promising.

Put another way, the Trump tax cuts created massive deficits, for a short-term economic jolt that sacrificed intermediate term economic growth. With so much liquidity in the system now though, it is time to direct our resources towards building big things, like a new energy system, bridges, roads, communications infrastructure, maybe modern schools, etc…

In the past couple weeks, the long-end of the yield curve has firmed up a bit: 

Rates Rising 30 year

Morgan Stanley (MS) was among those noting the repricing of bonds.

I have also warned that inflation could rise a bit, possibly even a bout of stagflation in quadrant 4 of this model: 

Blackstone is anticipating higher inflation that markets expect. I’m there with them, hence the inflation protection side of our Barbell strategy. 

My thoughts are that with all the liquidity in the system, under a Biden Presidency with a Democrat Senate (I see both as likely), much of that money will get redirected to productive ends versus gaming the financial markets. Ultimately, as employment rises, velocity of money will start to recover. I believe this is especially true with the Millennials at the front end of taking the reins on the economy from the Boomers.

Notice the alligator jaws. What do we know about alligator jaws? They always close.

What The Market Is Really Saying

I presented an earlier version of this chart in the webinar above and in chat. I can make this very simple. I do not think that the stock market is saying a breakout through resistance is going to happen this year. I think it is more likely we have a Q4 correction that potentially lasts into 2021 for all the reasons described above. 

There are of course many different scenarios for how far down the stock market can go. Anywhere in the yellow box makes sense to me. A break to new lows would signal the Armageddon scenario I described in ‘To The Moon’ Vs. ‘Coronavirus Crash II’ Vs. ‘Armageddon’.

The most likely scenario to me is that we see the S&P 500 drop down around 2700. That would take the SPDR S&P 500 ETF (SPY) and Vanguard 500 (VOO) both down a shade over 20%, or a mini-bear market from Friday’s close and recent highs. 

A decline to about 2700 would be around the 200 week moving average for the S&P 500 which is a level breached longer than a few days. There are other multiple key support levels near 2700. It’s a structural area of support. It is almost down to where I think fair value is for the S&P 500. It is also where I think the Fed would get a bit nervous and potentially put a few dollars of QE into the system. 

Downward momentum could certainly send stocks lower than about 2700 though. The next levels are down are tests of the March lows. If the Millennial traders are borrowing to short and buying puts the market could move very quickly lower before the Fed could offset them. I don’t think that dislocation would last long, days probably, but it is a possibility.

The Armageddon scenario I think only plays out under one circumstance: a Trump win with the Senate remaining Republican as that would signal more trade problems, fiscal stimulus issues and the Fed compelled to “help” even more eventually leading to a weak dollar crisis.

What And When To Buy

If a bucket filling situation happens, we will look to our Plug & Play portfolio models to use our cash on. We will our to our buy zones as our guides for scaling in.

We will also check basic technical factors for overbought and oversold conditions, as well as, downward momentum. We do not want to buy into a market with downward momentum. We need to see that breaking.

MACD will yield major clues as to when downward momentum is breaking. (Make sure to read Bonnie Gortler’s Moving Average Convergence Trading Method (MACD) Made Simple. She worked with the creator of MACD for 3 decades and wrote this piece at my request.)

In a volatile market, the easiest thing to buy are ETFs as it reduces the number of trades you have to try to make in a condensed time period when the most important thing is getting your asset allocation right sized. 

I will be focused on buying our top ETFs per this quarters Plug & Play models. The Invesco QQQ (QQQ), which I consider the best large cap index begins to look attractive at around 240, however, we are really looking a bit lower.

at TradingView

Set your alerts just above the first spot you would consider buying. For QQQ I would set my alert at $240 even though I don’t intend to buy there unless the markets give me a reason to. The same for all of our other Plug & Play ETFs. 

While we might buy a few of our Plug & Play stocks, we don’t want to get too busy with multiple scaling in tasks. I think focusing on ETFs is the thing to do. You can always trim ETF positions as you build out the stock side of your portfolio. 

What if there is no correlated correction in Q4? Stick to filling thimbles when you can do so with controlled risk. Keep looking for the gold and certain resource stocks in Plug & Play, because even with the dollar firming, there is still a devaluation coming, it’s just a question of magnitude depending on who wins in November. Reread this if necessary: 

Gold Can Reach Extremes In Perfect Monetary Storm

Tomorrow I post our list of GTC limit orders for ETFs and Stocks to buy on a correction. These will be paid members only pieces.

If you do not have a membership, sign up today using code “Smart50” to get 50% off your first year of any membership.

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