The letter below was composed last Friday. In it we discuss our growing concerns about the technical condition of the U.S. stock market. We also talk about some major changes we are making in the Mendocino, ORCA and Cape Lookout portfolios. 

The huge relief rally today almost caused me to cancel sending this letter out. Our base case is that markets are starting to show real signs of stress and could be in a topping process. But today's rally implies that central banks and politicians are still clearly in charge. Since we get new interference from governments and central banks weekly, the market could continue to go higher. But despite the rally today, the longer term technical picture was not changed. Therefore we think this letter is important for you to see and consider. 

So here goes....

Last week we wrote,

"A bounce may be a good opportunity to take profits on winners and sell losers. It may also be an opportunity to rotate portfolios into more defensive positions. Longer term charts of all major U.S. stock indexes are starting to roll over in what looks like major topping patterns.

We are starting to see some of the same technical sell signals that we saw at the market tops in 2000 and 2007. It is early in the development of these patterns but they are getting clearer on the monthly and weekly charts."

It didn't take long for us to get the anticipated bounce and we did sell into it.

We have actually been raising cash in our two tactical portfolios for some time now. They are ORCA and Mendocino. By this afternoon Mendocino accounts should be holding an average of 40% cash. ORCA accounts should be at about 47% cash. There are a couple of exceptions among ORCA account holders because they hold "legacy" positions that the clients do not want to sell.

If memory serves me correctly this is the highest allocation to cash for Mendocino since fall of 2007. ORCA did not exist at that time.

Mendocino is now down to a 43% allocation to U.S. stocks. ORCA is down to about 32%. These are also the lowest allocations to domestic stocks in a very long time.

Why are we getting so defensive at this time? Particularly when we have been writing nearly forever that it is extremely difficult to call market tops. I think that I have even called it a "fool's game". Yet we did it successfully in 2007 and we are now seeing a lot of the same technical indicators that appeared back then, as well as at the top in 2000.

We are the first to admit that technical analysis is not perfect and that there are many ways to apply it. Therefore we have spent a couple of decades studying various technical analysts with an eye toward identifying those that are more reliable than others. I have personally made technical analysis my core discipline.

At this time we are seeing some of our favorite analysts lining up in the bearish camp. Several are growing extremely bearish and feel that we are on the verge of a major sell-off like 2008-2009. John Murphy, Stockcharts.com, thinks we may be in store for a correction of 10-12% that should be followed by a push to new highs in U.S. stocks. He is using Elliott Wave Theory to derive this view of the market.

We are still not in the camp that a 2000-2002 or 2008-2009 50% +/- correction is in store. We have written many times since mid-2013 that our base case is that U.S. equities are probably in a new secular bull market that could last many years. But whether a major collapse is in store for us, or simply a garden variety correction, we set the odds at "high" that markets go lower before they go higher again.

We have told individual clients many times that if we ever saw the warning signs of another major market downturn that we would act on them. They are starting to appear and we are trying to respond.

Here is a version of a chart of the S&P 500 that has been circulating among analysts. This chart spans 1996 through present day. The first two vertical blue lines mark the beginning of the collapses of 2000-2002 and 2007-2009. The point of the chart is to show that several technical indicators are lining up just as they did on those two previous occasions.

Several of our favorite technical analysts are creeping into the camp that the market is about to roll over again and that it may retrench by up to 50%. That theory is represented by the red arrow on the right.

John Murphy's "Elliott Wave" projection is portrayed by the blue and white dotted lines. He thinks the market is in a bullish formation represented by 5 Elliott Waves. In this theory the market moves from its low to its ultimate high in 5 waves. Waves 1-3 and 5 are advancing waves. Waves 2 and 4 are corrective waves. Whether it makes sense to you or not, advances usually work that way for stock indexes and individual stocks alike.

John thinks we may be about to enter into corrective Wave 4 which could be a 10-12% correction. Elliott Wave theory also allows for the possibility that Wave 4 can simply be a sideways correction. The odds of that increase if Wave 2 was a steeply declining wave--which is was. Therefore Wave 4 may cause the market to trend sideways for a couple of months.

From our point of view it doesn't matter if we are about to get a 50% correction or a 10-12% correction, or a sideways correction. All signs are pointing to a correction. The odds are simply higher than they have been in quite some time and we are getting defensive in the models in which we are supposed to do that.

Fossil Fuel's are out

We have also removed all fossil fuel stocks from Mendocino and ORCA. This is a move we have been contemplating for quite some time. We have had numerous inquiries from clients over the years.

We didn't necessarily do this because we are zealous about not owning fossil fuel companies. There are still several in Dividend Diamonds. They are also held by the mutual funds and ETF's that populate Cape Lookout. We also own the bonds of fossil fuel companies in the fixed income accounts we manage.

But we are sensitive to what seems to be an expanding sentiment among some of our clients who do not want to own these companies.

Besides we think that solar power is finally achieving the technological level and pricing level to actually be a competitive alternative fuel. This has never been the case before.

We also wrote last week that we think health care, biotech and cyber security stocks are sectors to add to going forward.

When we do start adding stocks back to Mendocino and ORCA they will likely include ETF's like IShares Global Clean Energy Fund (ICLN), PureFunds ISE Cyber Security (HACK), Health Care Select SPDR (XLV), Guggenheim Solar (TAN) and ALPS Medical Breakthroughs (SBIO).

We are also in the process of creating an environmentally friendly (GREEN) version of Cape Lookout comprised exclusively of ETF's and mutual funds.

For all the comparisons to 2000 and 2008 this year feels more like 2011 to us. In that year the market started moving up in January but by July had lost all its gains. From July through September we experienced a lot of volatility and a significant correction. The last couple months of the year were strong for equities and the market finished up slightly on the year.

This year the S&P 500 remains up slightly, but the Dow Jones Industrial, Transportation and Utility Averages are all down on the year. All the major averages look poised to correct.

If they do we are sitting on a bunch of cash to put back to work at lower prices.

All the best,

 

Paul Krsek
MANAGING MEMBER & CHIEF INVESTMENT OFFICER  
5T Wealth Management
(707) 603-2672 Office
(707) 486-7333 Cell

Paul@5TWealth.com  

Disclosure and Disclaimer - Updated last on July 23, 2012 by Paul Krsek:
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