[Premium] Weekly Open Letter About The Current Market Environment

In this week's members-only letter we discuss the following topics:

• How Do We Manage Risk In US Stocks?
• Market Internals: When They Matter Most?
• The Bearish Sentiment In US Stocks Is Bullish
• What Is The Best Way To Profit From The Relative Strength In Transports?
• Which Mega-Cap Tech Stocks Do We Want To Own?
• Intermarket Analysis Points To Higher Oil Prices
• Waiting For Oversold/Overbought Readings in Bonds and Rates
• Railroad Stocks Over Airlines Stocks
• Which Currency Denomination Do We Want In Our Europe And Japan Longs

Jump to Advisors Corner Client Summary

October 27, 2016

Dear Members,

Stocks continue to have a consistent bid. There is no way around it. You have the closed minded community complaining about a stock market that goes no where. Meanwhile, stocks all over the world continue to breakout. More specifically new highs in Latin America, Brazil and Emerging Markets as a group relative to US Stocks. Even domestically, even though the S&P500 has not broken out to a new high yet, Technology and Financials continue to show their leadership as they break out to new highs. These are the 2 most important sectors in America. So who cares that Healthcare is making new multi-year lows relative to S&Ps and that Biotechs are a mess. Why is that our problem? We don't want to buy that group anyway, so we're not worried about it.

Money continues to flow out of equity mutual funds and ETFs at an alarming rate. Meanwhile, they are piling into bond mutual funds and ETFs. This creates an environment poised for reallocation. So when you ask, where is the money to buy stocks going to come from? I think see further selling out of bonds and continued buying of stocks, both US and internationally. This has been the thesis since late June and I see no reason to change that tune.

Further sentiment analysis also suggests this similar poor positioning and potential for reallocation into year end. The National Association of Active Investment Managers (NAAIM) is down to 67.3, which is back below the pre "Brexit" lows. I would argue there is plenty of cash sitting on the sidelines ready to be allocated. In addition, Investors Intelligence shows that there are only 43% bulls, the fewest amount since June. Also, the CNN Money Fear/Greed Index has been crashing the past few months and is currently at the most fearful levels for 2016. And finally, if you're into small sample sizes (I am not), the AAII polls shows the lowest bull to bear ratio since early June. Although I don't like this tiny sample size for a poll, when taken within the context of the rest of the sentiment data, it makes perfect sense and in aggregate is all another feather in the hat for the stock market bulls.

With respect to market internals, I want to make this point once again because I've been getting some emails from you guys asking about it. If you recall, one of the reasons that I had been structurally bearish into January this year was because with every new low in the S&P500, the list of stocks on the NYSE hitting new lows was expanding, essentially confirming the downtrend in price. By the time the February lows came for the S&P500, only half the amount of stocks on the NYSE were still making new lows, compared to the prior pivot low in January. This "internal" strength was part of the reason we got so bullish in late January/early February. The reason I have not brought up this statistic is because we are not making new highs in price. So to suggest that a deteriorating list of stocks on the NYSE making 52-week highs is a negative is simply not an apples to apples comparison. If/when the S&P500 breaks out to new highs, we want to see an expansion of individual stocks participating. If not, then we'll have to reevaluate the circumstances. Until then, this is not something that we're concerned with. So it's not that I don't care for this indicator, it's that I just don't care right now.

The strongest of the US indexes is Nasdaq100. This is likely due to its exposure to mega cap tech. So if we're above 4740 in $NDX we have to be long with a target up near 5200. I like all of these indexes long, including the S&P500, Dow Jones Industrial Average and Dow Jones Transportation Average if we're above the September lows. That is the line in the sand. If we're below those levels and momentum on the daily timeframes hits oversold conditions, then we will have to reevaluate the bullish thesis. But until then, I see little reason to be short equities as an asset class.

The one thing I see is the Russell2000 breaking the September lows. That is definitely warning sign number 1. What we want to see is a quick recovery back above those lows with momentum staying above oversold readings. If the Russell 2000 Small-cap index can accomplish this, it would suggest further risk appetite out there for stocks. If we start to see deep oversold conditions in $IWM, then it is likely that the S&P500 and other indexes have broken down as well. So this is what we want to look for in the coming weeks.

A big focus of mine since early July has been the relative strength out of Transportation stocks. We continue to see new highs in Transports relative to the S&P500. I am still expecting a breakout to new 2016 highs in the near future. Relative strength tends to lead absolute price and I think this one is no different. Now, within the transports space, airlines as a group look good, but it's the railroads that we prefer. Look at the Railroads vs Airlines Index still looking good and the trend is higher. Not only do we not want to fight that, but it is where we're looking to add exposure. $CSX is the best behaving name and I think we're heading up towards $38. In the airlines, the group has impressed me and $UAL looks the best of all of them. But I'm not ready to pile in just yet. I think it still needs a little bit of time.

If the Shippers $SEA can break out here, I think that would be incredibly bullish for stocks as an asset class. This bottomed out in January with transportation stocks and has been consolidating between converging trendlines throughout the entire year. An upside resolution would be super bullish the space, Transports as a group and, in my opinion, equities overall. We want to own $SEA if we're above $11.80 with a target above 13 which have been the 2016 highs.

Finally, the delivery companies, FedEx and UPS, look great. $FDX is one that I believe goes on to make new highs and we want to be long if we're above $169.50 and taking short-term profits above $183. Bigger picture, however, I believe we can get up towards $240. $UPS is a long if we're above $110 with a target above $120. I like the entire Transports space, and we want to be overweight the group or long a spread between Transports and the S&P500. This has been working and the sector rotation continues to suggest this outperformance is here to stay. If you're looking for a more market neutral position, I think this is it.

The sector I mention every week has been Technology. Not only are we breaking out of a 15-year base relative to the S&P500, but its largest components are breaking out to new all-time highs. Just to summarize the same theme: Microsoft $MSFT is a beast and I think heads to $75. Short-term, however, we want to take profits above $62.30. Google also broke out to all-time highs this week and we want to be long $GOOG if we're above $790 and taking profits near $870. Although not exactly Mega-Cap Technology, but more of an Internet name, $NFLX had been a favorite name of ours for some time and it hit our upside target this week. I think we're better off now staying away from $NFLX and moving on to other names within the Internet Sector.

Financials are also flirting with a new 52-week high. Regional Banks $KRE this week hit the highest levels since December as higher rates continue to keep a bid under the banks. JP Morgan $JPM, Goldman Sachs $GS and Wells Fargo $WFC have all been long positions for us and I think they keep ripping. The $44 level was the high in October 2008 before the collapse. This was also resistance in August 2013 before eventually breaking out to new all-time highs in 2014. This is therefore a long all day if we're above 44.50 with the next target above $50, but eventually I think we get back up towards $60.

Aerospace and Defense is another area that is hard to ignore. We want to be long the group via $ITA if it is above the September lows with target up above to new 52-week highs. Within that space, Boeing $BA is setting up nicely. I think it heads back to 158 so we want to be buyers of any sips into the mid to low 130s.

Two sectors that we want to continue to avoid are Healthcare and Consumer Discretionary. We are hitting new multi-year lows in Healthcare relative to the S&P500 and we've been completely broken in Discretionaries relative to S&Ps. So why would we bother with these sectors if we have Tech and Financials breaking out to new highs. I would consider this sector rotation out of former leaders and into new ones as a positive. This sort of sector rotation in characteristic of a bull market and should be welcomed. Within the Healthcare space, Biotechs have been a disaster and still are. Not our problem. Meanwhile, the Medical Devices which had been the best of that group, are now breaking down as well. In Discretionaries, Homebuilders are breaking down to new 6-month lows. So this is not an area we want to be focused on for now.

Outside of the U.S. there is just more strength everywhere. If you're just looking at U.S. stocks, you're not quite seeing the power of this bull market for stocks. European indexes and Japanese indexes are flirting with breakouts after building nice bases throughout 2016. Forget the fact that they might break out. The fact that they aren't crashing is almost good enough from a global risk appetite perspective. Think about it like that. By comparing these indexes priced in both local currency and US Dollars, we want to own Japan priced in USD through $EWJ but Europe priced in Euro through HEDJ. Notice the higher lows compared to lower lows when you look at the other currency.

With the strength we're seeing in the Euro Stoxx 50, German Dax, Belgim 20 and the French CAC, the weight of the evidence suggest higher prices for European stocks. The one thing that bothers me is Switzerland. We're seeing the Swiss SSMI break down to new multi-month lows. This is the one area that worries me, similar to the breakdown this week in the Russell2000 for US Stocks. Although each of these are just one negative for their specific country, we want see if more indexes follow along, or if these quickly recover to join the strength in the others.

The leadership continues to come from Emerging Markets. Remember these guys bottomed out in January, well before the U.S., Europe, Japan and other developed countries. We therefore want to keep turning to these guys for leadership. The ratio between Emerging Markets and the S&P500 (EEM/SPY) hit new 52-week highs this week. The ratio between Latin America and Emerging Markets (ILF/EEM) also hit new 52-week highs this week after a monster breakout this month. All of this suggests to me that there is plenty of risk appetite out there for stocks. We just need to look outside of the handful of US stocks that the media obsesses about. We're better than that!

The best way to take advantage of this right now, I believe, is in Freeport McMoRan. We want to be long $FCX if we're above $9.50 and take profits above $14. This is a major move in a very important bench mark for emerging markets, global growth stocks, etc. So if I'm wrong on Freeport, there will be a lot more things in that space outperforming and doing well. But to me, this is the cleanest trade today. Brazil (EWZ) and Latin America (ILF) have already had major moves. While I still like them, the risk/reward up here is clearly not as solid as it once was. Freeport still has the potential reward skewed very much in favor of the bulls, when compared with the risk.

Looking out in Asia, the Shanghai Composite could be about to explode higher. This one has essentially gone no where for all year and has been stuck in a tight range. If we're above 3120 and can remain above there, that would be extremely constructive for, not only China but, Asia and Emerging Markets as a group. We want to be long the China 25 Fund $FXI if we're above $36.80 with a target above $44.40. Also in that space, Taiwan continues to make new highs and I still think the Y9999 goes to 10,000 (see what I did there?). Phillipines are a long if $EPHE is above $36 with a target above $40.50. But Vietnam $VNM, on the other had, can be included in the underperfoming list with Healthcare and Switzerland. I see no reason to mess with any of those.

Finally, within the Emerging Market space, Latin America has certainly been the leader. I have not kept this a secret. Outside of Brazil and the Latin America ETF, I like Chile $ECH with a target of $45. I like Peru $EPU if it is above $38 with a target near $38. And although not in Latin America, but in a similar space, South Africa is a long if we're above $51. I think we see new 52-week highs in $EZA before year end.

In currencies, the US Dollar broke out the past couple of weeks and I think can see 100. But understand that all of this still comes within the context of a massive 2-year range that we're stuck in. I would be a seller of USD into 100 for now. Ultimately this can certainly prove to be a much larger uptrend and rally in Q1 next year, but let it prove that to us, particularly with price near a flat 200 day moving average. Why rush?. In the meantime, I would consider the Euro and USD Index consolidations on the weekly charts and think about their implications bigger picture. This short-term action could prove the beginning of something larger, but let's wait for it to play out.

Even with this US Dollar strength lately, the Emerging Market Currencies still look good. Mexican Peso, Brazilian Real, Russian Ruble and the Indian Rupee all look like they're ready to rip vs the US Dollar. That would be a positive for Emerging Market Stocks, not to mention energy and industrial stocks with exposure to global growth.

On the other side of the coin, the Chinese Yuan continues to get killed. Our upside targets in USDCNY has been and is still 680. We are quickly approaching those levels and I see little reason to be concerned with it. While it might make a sexy headline, for us it's nothing new and math suggests little or no correlations with any of the things we've discussed above. I've done the work. 1) this is not a new trend, far from it. And 2) So what? It's a weaker Yuan. So? If/When it start to matter, we'll consider it a factor in our work. But that day is not today.

A currency we have not mentioned in a while is Bitcoin since all of our upside targets were hit early in the Summer. After a healthy consolidation, Bitcoin is now resolving higher. We want to be long Bitcoin (priced in US Dollars) if we're above 615 and taking profits above 1075. Notice how this is not getting much attention from the media. That's a good thing. Let them worry about Elections. We'll worry about making money in the market.

Further Intermarket Analaysis in the currency markets suggests that our theme of Emerging Markets leading us higher is correct, at least for now. The basket of the BRICS Currencies (Brazil, Russia, India, China, South Africa) keeps making higher lows and higher highs and we still have higher upside targets. A more broadbased measure of Emeging Market Currencies is suggesting a similar trend and outcome. You can see the EM FX Equally-Weighted Index poised to resolve this consolidation higher.

In Commodities, the CRB Index still looks like a bottom to me. We continue to iron out this massive bottoming process and if you ask me why rates keep rising, I would argue it might have more to do with the counter-inflation trade than the economic growth story. This is a theme that I am not hearing anyone talk about, but one that price is suggesting is a very good possibility. I like that no one is talking about it. Historically this means I'm probably on to something. And although this is more of a theory conversation over beers with friends, and less about execution, it's still a notion worth thinking about when drawing up our more macro thesis. As money comes out of bonds, as it has been since June, it has gone into stocks and commodities. I believe this continues.

This week Crude Oil hit new 52-week highs when priced in both Euro and Canadian Dollars. So this strength in Energy is not a "US Dollar Story" like you might hear in the gossip channels. Crude is doing its thing in other currencies as well, even in the face of a stronger US Dollar. This is an Energy and Emerging Market Story and, in my opinion, has nothing to do with the US Dollar. Math suggests the same thing.

Meanwhile, the All Star Charts Oil Countries Index is breaking out of an 8-year downtrend. Remember this is an equally-weighted index of 4 countries' stock market indexes priced in local currency: Australia, Canada, Brazil and Russia. The double bottom in Saudi Arabia last month is making a similar argument that points us towards energy and energy stocks. All of this analysis collectively is what has me bullish energy and emerging market. The breakout in Latin America vs Emerging Markets (ILF/EEM) and the major bottom we see in the Australian Dollar all point to the same thing: Energy and commodities need to be bought.

Precious metals, however, are another story. After a nice consolidation of gains from July through September, the range resolved itself to the downside, not higher. That creates a bigger problem structurally. Momentum also hit oversold conditions across the board - Gold, Silver, Platinum and The equally-weighted Precious Metals Index are all in bearish ranges in Momentum, reemphasizing why we want to stay away. So in Gold, we still want to be sellers of any strength towards 1300 for now. There is no reason to be a buyer of any kind. I want to see the Commercial Hedgers covering some of their historically short position in metals. They've been covering a little bit over the past few weeks, which is a good thing, but not enough of a reason to get involved again just yet.

I think the tell here is the Junior Miners $GDXJ. I noticed that momentum did not get oversold on this sell-off. It did in the larger-cap $GDX, but put in a bullish divergence. So the ingredients for a gold rally are definitely there. Also, $GDXJ broke down early this month from a nice little topping pattern. The former support that broke is near $43.50. So if gold and silver are going to rally, then I would expect $GDXJ to prove it can stay above that $43.50 level. Then I would be on board. Also, I'd want the vehicle of choice to be $GDXJ as it would have proven to have the most relative strength out of that entire space. That's what I"m watching there.

Meanwhile, at the individual stock level, I don't see much to get excited about from the larger cap names like $ABX and $GG or $NEM. A couple of the smaller ones look pretty good. $IAG is a long if we're above $3.80 with a target near $5.80. Although this is a low priced stock, it is a $2Billion Market-cap. Also Pan American Silver $PAAS is one we want to own if we're above $17.20 with a target above $21.50.

In Agriculture, Sugar has been the big winner. I've liked it since last month and still do. I think we get over $26. Corn, longer-term also looks good. If you have a longer time horizon, I like Corn long if we're above the September 2014 lows. Staying above this would reiterate the double bottom that I believe we have in place. Soybeans also look good if we're above $983. We want to be long if we're above that with a target above 1100. Cocoa breaking the uptrend line from the December 2000 lows is a problem for that commodity and is still not one we want to mess with. Overall I like the Ag space. We want to be long $DBA if we're above $19.90 and take profits above $23 for now, although I do think it can go a lot higher than that.

Finally, in US Treasury Bonds, the 10-year Note Yield is holding above 1.73% and won't fall. Our upside targets in 10s and downside targets in US Treasury Bonds ($TLT and 30-year futures) were hit this month where we wanted to take profits. Remember that this all comes within the context of what I consider to be a much bigger trend of higher rates and lower bonds. Although tactically I'm not ready to pile into this trade again like we did since late June, but I'm getting ready. Longer-term holders are looking great. Tactically I think there is still too much opportunity cost, but a new entry point is coming. The longer we remain above 1.73% in 10-year yields, the better this looks.

Also, we have not seen overbought conditions in 10-year yields or 30-year yields. On the other side of the coin, we have not seen oversold conditions in Treasury Bonds, not the ETF or Futures. But I think they're coming. Seeing these overbought readings in rates and oversold readings in bonds would put an exclamation point on this bearish bonds thesis and would give me more of a reason to get involved tactically, rather than focusing more on the longer-term outlook. Just keep the 30-year bond chart in mind. This is the one that really has me the most structurally bearish bonds.

That's it for now! Please feel free to write with any comments or questions.

Cheers,

JC

Advisors Corner

Client Summary With Talking Points & Charts

October 27, 2016

• US Stocks are still in a strong uptrend being led by the 2 most important sectors in America - Financials & Technology.
  
• In terms of areas to stay away from, Healthcare still looks weak. We want to avoid Biotechnology, Pharma and Healthcare from any sort of relative strength standpoint. These are all either "underweights" or "no positions".
• Internationally, we want to be buying Latin America and South Africa. I think we rally into the new year and the vehicles to execute include $ILF $EWZ $EPU $ECH $EZA representing individual countries equities.
• Individual Stock Trade ideas include from the long side include: $CSX, $MSFT $GOOG $UAL
  

• The US 10-year Note Yield is holding above 1.73% and won't fall. Our upside targets in 10s and downside targets in US Treasury Bonds ($TLT and 30-year futures) were hit this month where we wanted to take profits. Remember that this all comes within the context of what I consider to be a much bigger trend of higher rates and lower bonds. Although tactically I'm not ready to pile into this trade again like we did since late June, I am getting ready. Longer-term holders are looking great. Tactically I think there is still too much opportunity cost, but a new entry point is coming. The longer we remain above 1.73% in 10-year yields, the better this looks moving forward, and worse it is for bonds.
  

• We are now entering the most bullish time of the year for US Stocks. This is the Dow Jones Industrial Average Seasonal Pattern in Blue going back to 1950
  

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