I Saw the Signs

Words From Withers

A monthly market snapshot for discerning investors

April 2016

"I saw the signs, I opened up my eyes I saw the signs" - Ace of Base

If you've been following my rants and raves (or "newsletter," for the technical types), you'll know that I've been eagerly waiting for this most recent market rally. It's not "Little Joey on Christmas Eve" type of waiting, though - I've been most excited about this rally not for what value it brings, but for what it can tell us.

No matter how crazy the market gets, I've learned the hard way that the signs will always appear that can give you an edge moving forward. I think this rally is the perfect event for studying what might come next. Let's dive in.

Timothy C Withers

Firm Principal, CLU,ChFC, MBA

The Signs: What Do They Mean?

Fundamentals

Looking down from 30,000 feet, we can't look at our economy and claim it close to perfect. GDP is forecasted for a weak first quarter and the S and P earnings are projected to be down again year over year.

Get out your binoculars and take a closer look, though. The Dollar's massive strength, which for so long has been a painful prickle in the sides of certain multinationals, has started turning lower and even broken below its 200-day moving average.

That's not all. Bond yields are moving down, too, meaning we're starting to get weird alignment as bond values and stock prices begin to appreciate together. As of today, the ten-year treasury generates around 1.9% annually as compared to 3% in 2014. Not great, but hey - I'm not complaining when some overseas rates (did someone say Japan?) are actually

negative over a ten year stretch. In short, this means our bonds will likely continue to draw in international money.

Take things one step further, though, and we notice something interesting: these lower rates tend to make alternative investments - like stocks - a lot more attractive. These days, you won't even break a sweat buying a nice little dividend-paying stock with a good-looking balance sheet and a 3% yield.

And, the thing is, I'm not surprised. These signs make sense in the context of everything we've seen: we've come a long way since mid-February and this stubborn market continues to refuse to dip.

So What About Oil?

As usual, Mr. Oil demands a seat at the table. Lower oil prices seem to have played a large role in how the market's reacted as of late and continue to pull it lower. I think the connection lies in some unprofitable oil companies - lower oil prices, lower profits. The scarce funds of these companies dramatically affect their ability to repay bank loans, etc., an especially dire situation for the notoriously debt-saddled oil companies. This debt-heavy structure helps returns when oil prices are strong (or even stable) but when oil takes a harsh fall like it has over the past couple of years, people (oil workers and bankers alike) begin to sweat.

Recently, though, we've seen a curious uptick in oil prices. Why is that?

Many are quick to whip out their Econ 101 textbooks and reference the supply/demand balance, but frankly I think a big piece of it is simply the lower dollar. Sure, supply and demand play their role here, but it's the combo with the lower dollar that's bringing oil bubbling back towards the top. Regardless, the key takeaway is that higher oil prices will take some of the sting out of those aforementioned sticky problems with oil loans.

A Major Sign: The Meeting at Doha

Just a week ago this past Sunday, the collective wisdom of many oil-producing nations came together in hushed (okay, not so hushed) tones to discuss a potential cut in production or even a freeze. The hope, of course, was that these folks could reach an agreement and such a cut or freeze could help boost oil prices.

I'm sure you'll join me in my wry lack of surprise upon discovering that they couldn't even agree on what brand of coffee to serve. As has been much the case in so many other meetings, the Saudis, Iran, and Iraq seem hardly able to admit they all live on the same planet, much less consider a mutually beneficial deal.

Monday, as it often does, followed Sunday, and with it came a slew of oil and stock prices that looked to be heading lower. And lower they went - that is, for an hour or so. In fact, oil prices quickly stabilized and many oil company stocks closed on a high yesterday.

Confused? I think we're seeing a sign of reduced fear in the environment concerning oil companies and the banks involved. In spite of it all, people are poking their heads out of their caves and contributing to the rally of both oil and financial stocks. Yep, spring is here, and I like what I see.

Spring means there's always the chance of a thunderstorm, but its signs like this that give me the cautious belief that we're now moving towards better growth. If we see oil prices get to $40 or $50, you can bet we'll start seeing more earnings from this sector.

Earnings and Such

As we enter earnings season, analyst projections seem to point only to more dismal news to come. That said, I'm feeling that the expectations are so dour that the surprises will be to the upside. Companies, historically, do a far better job managing their businesses than analysts tend to estimate.

Unconvinced? Here's another telltale sign that analysts are playing things overly conservative: this recent pile of "valuation downgrades." These downgrades usually occur when analysts believe a company has reached its fair value given its current metrics. The problem is, though, they often underestimate the rate of change in top line growth. If you smell an opportunity here, you're dead on - for the right companies, this situation often provides prime buying prospects.

Now, you're going to hear some jibber-jabber from doomsayers proclaiming the price earnings multiples are too high, but hold up - we need to look at the specific environment. If you hold the belief that we're in a pocket where earnings can accelerate, then you can look at buying higher P/E ratios.

Quick example: Let's look at two P/E ratios for the S and P 500, say, 17.36 times earnings and 70.91 times earnings. Which do you buy? Conventional wisdom says the one with the lower P/E, of course.

Remember, though, that 17.36 was the S and P P/E just before the market downturn in 2008. 70.91, on the other hand, was the approximate P/E of the S and P near the market bottom in 2009 right before it shot back up.

P/E ratios are worthless without context. Don't get caught up by anyone advising you buy some cheap P/E; that's not helpful to you as an investor. What you should really be asking yourself is, "Where are earnings headed?"

Technical

Last month, I hypothesized that things could develop in one of two ways after the recent rally: either we'd drop lower, or we might gather strength and grind sideways for a bit towards even higher market averages.

Buckle up: I think we're starting to see that sideways grind. Here's a picture of the S and P 500 as of now:

So, what's the sign?

I've been looking closely at the Advance Decline line for some time now. Ari Ward mentioned a similar focus on CNBC the other night as well. (I maintain that I was watching this trend before he was, but as he managed to get himself on TV first I'll give him the credit.)

The Advance Decline line is simply the ratio of advancing stocks (those moving higher in price) to the declining stocks (those moving lower in price.) In a healthy market, that line should be trending up.

Take a close look here: our A/D line looks to be breaking out towards higher levels.

So, What Are We Doing?

As usual, for those doing strategic allocation, sit tight - your best bet is a waiting game right now.

For us tactical managers, though, it's time to start moving gradually back into the market. At this point I have approximately 65% invested according to my models and I'm building on our strongest positions as we review the earnings report this season.

In this environment, you'll find a lot different narratives in play at once. Some "stock stories" revolve around oversold stocks that rebound quickly. Other stocks are predicted to have strong growth, and, voilà - they do.

As avid story listeners, we're biased towards focusing on those companies where their narrative predicts high growth simply based on fundamental and operational strengths.

These "hero" stories that rebound quickly do make good bedtime reading, but they're often over-told and therefore oversold. I take positions on some of them, but I prefer opportunities where we can consider simple levers to evaluate their prospects. For example, I've purchased some of the larger integrated oil companies with strong balance sheets. No fancy plotlines here, just a simple truth: as oil stabilizes and rises in price, these companies will prosper. And, even if there is a dragon or two lurking around the next bend, the financial strength of these companies will allow them to survive and grow down the road.

I can't say exactly where I'll be a month from now investment-wise, but I will tell you that I have 50 attractive stocks in my sights that I'm now evaluating from a fundamental perspective. And that, of course, I take as a good sign.

-Tim

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Disclosures:

S&P 500 An index of 500 stocks chosen for market size, liquidity, and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and it meant to reflect the risk/return characteristics of the large cap universe.

Dollar cost averaging does not assure a profit and does not protect against a loss in declining markets. This strategy involves continuous investing; you should consider your financial ability to continue purchases no matter how prices fluctuate.

"Asset allocation does not protect against loss of principal due to market fluctuations. It is a method used to help manage investment risk."

The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

Dow - The Dow Jones Industrial Average is a popular indicator of the stock market based on the average closing prices of 30 active U.S. stocks representative of the overall economy.

FactSet Earnings Insight February 6, 2016 edition was used for information contained in the Micro Section of this newsletter.

Rebalancing assets can have tax consequences. If you sell assets in a taxable account you may have to pay tax on any gain resulting from the sale. Please consult your tax tax advisor.

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The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. It is not guaranteed by NFP Advisor Services, LLC for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.

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MSW Financial | c.617-312-6256 | o.781-319-0098| tim@mswfp.com |www.mswfp.com