The Breadth of a Pullback

Senior Portfolio Manager James McFarland guest-hosts the 6/7/2019 edition of Stock Talk and discusses the recent market action and how it relates to Oak Harvest’s view going forward, and covers the concept of “Market Breadth.”

James: Good afternoon, everyone, This is James McFarland, Senior Portfolio Manager and Head of Trading for Oak Harvest Financial Group, and welcome to the June 7th edition of Stock Talk, Keeping You Connected To Your Money. Chris Parres is out of the office today, so I’m privileged to be able to join you all again and host today’s episode. Each week here on Stock Talk, we share with you our views on the market, what we see happening now, and what we see coming down the pipe for the economy and markets.

We also focus on education, sharing with you what we’ve learned about how the stock and bond markets work and what makes them tick. I’m recording this on June 7th, 2019 at 9:30 AM Central Time, and today we’re going to take a brief but focused look at what’s been going on in the market this week, focusing on one particular element, something that we believe is important but that you may not have heard a whole lot about if you’ve been relying on the financial media for updates as to what the market is doing.

We’ll also touch on how what’s happening this week ties into our view for the rest of the year and where we think things are headed, but before we really get going, there’s a little background material that may be good for you to take a look at. First, if you haven’t read our first-half outlook for 2019, I would strongly encourage you to go and give that a quick read. If you’ve read the piece, you’ll know that we expected a relatively strong first quarter followed by a pullback in the second quarter in the market.

Second, if you listened to the April 18th edition of Stock Talk, the last time I hosted the show, you may remember that I reiterated our view that stocks would pull back as we headed into the second quarter and that we would be looking to any such pullback as a buying opportunity. Both our first-half outlook and all prior episodes of Stock Talk are available at any time on the website at oakharvestfg.com.

If you’d like to hear what our view has been for 2019 so far, I do encourage you to go read the first-half outlook and maybe listen to a few older episodes of Stock Talk during your commute or your workout or whenever is convenient for you. With that said, let’s just jump into it. What has been going on in the markets? Well as we’ve been expecting, forecasting, and saying for some time, the early summer pullback is here.

The S&P 500 peaked and made a new all-time high on May 1st, 2019, and then went on to rapidly drop by about 7.5% to a low of 2,729 on June 3rd. As we’ve said, this was not a surprise for us. This has been on our radar since January, and also as we’ve said, we’ve been using this month-long pullback as a buying opportunity. As you may know, our standard investing process puts new money to work in the markets over a roughly four to six-month time frame.

We believe that this slower, measured approach gives us more flexibility and can help raise the odds of a better investing experience for our clients. Sometimes, when volatility hits, we accelerate the process, taking advantage of opportunities to buy the names, sectors, and areas of the market we like at relatively cheaper valuations. This month has been one of those times. This has been one of those times that irrational pricing situations develop in markets, and irrational pricing situations are something we like to take advantage of. We talked more about this in our piece, Volatility Equals Opportunity, which is available on the website under the investment management section.

In fact, there was only one element of this move down that came as a bit of a surprise to us, and that was the timing. We were expecting this move downwards more towards mid-June to July. Since it started earlier than we anticipated, we also expect it to finish earlier than we anticipate as well, and at this moment, we are more inclined to believe that this leg down may have concluded.

Recall the title of this week’s Monday market update from June 3rd entitled Kenny Loggin’s Market, This Is It. After we posted that, as of the time of recording right now, the S&P has risen by over 6%, bouncing hard off the Monday low and taking out most of the pullback that occurred throughout the month of May. What makes us think that we might have seen the backside of his pullback already? After all, even though just a few weeks ago, the media was calling for a stock market melt-up.

Over the last two weeks, it’s been nothing but doom and gloom for most commentators with plenty of dower outlooks and lots of rounds of the popular game, let’s call the next recession being played. Not to mention calls for higher volatility from here on out, even though historically, when the Fed eases, higher volatility typically doesn’t materialize and the Fed has indeed stated recently that they are open to a rate cut. How could so many voices, and loud voices at that, be wrong?

Well, of course, there are many factors we look at, and one of them relates to a key market concept called market breadth. Market breadth is a measure that compares the number of stocks in an index or on an exchange that are advancing in price or rising in price versus the number of stocks that are declining in price. If you have positive market breadth, it means there are more stocks in an index advancing in price than declining, and if you have negative market breadth, it means that more stocks in the index are declining in price than advancing.

Why is this important? Well, you have to remember that even though most folks will only ever say things like the S&P was up 3% or the dow is down 500 points, an index like the S&P 500 is actually made up of individual stocks and that just because an index price is rising or falling, that doesn’t mean that every stock or even a majority of the individual stocks that make up the index are rising or falling.

It is very possible and sometimes happens that a small number of stocks in the index have such large gains or losses or make up such a large part of the index that they can drag the index price higher or lower regardless of what most stocks in the index are doing. Let’s say, you have the S&P 500 up 1%, but a negative market breadth. What does that mean? It means that even though the index is up, the majority of the stocks that make up the index are actually down. Does that sound like a healthy market to you? Probably not.

If a minority of stocks are responsible for an up move, while a majority of stocks are declining, that can be an early warning that the market is not healthy and could be a sign of bearish action coming. If you were in a long-term bull trend and start seeing negative market breadth quite often, it could be a sign that the bull trend may be less likely to continue than it was before. Conversely, what if you have the S&P 500 down, say, 2% but positive market breadth?

In that case, you know that the down move in the index price is being driven by just a minority of names in the index. Because we have positive market breadth, we actually know that a majority of the stocks in the index are up. This can be a bullish signal and a sign that even though price may still be going down, the markets could be healthier than they appear or that a pullback or bear trend could be close to ending.

Market breadth can be a helpful gauge of the overall health of the market and can reveal more information than what price alone may be telling us. With that in mind, what are we seeing now? We’ve definitely seen the big tech names down, the FAANG tech names that have been leading the market for several years, but how about our market breath? Well, hold on to your hats. Market breadth is positive as of the time of recording.

If we were seeing negative market breadth, even in the face of an upward price move, we would have to consider a stronger possibility of further downside action. That might indicate that money had been leaving the stock market and flowing into bonds, and that’s what people do when they run, they run to bonds, but we’re not seeing that. Money hasn’t been flowing from stocks to bonds.

Managers have been selling these very liquid, high-growth FAANG type names that they can get out of easily and then rotating into areas that have already been down like value stocks, small caps, emerging markets, financials, and old-line tech names like semiconductor companies. This is all in line with what we’ve been calling for since January 2019, and this view has played significantly into how we positioned our equity portfolio and the actions we will continue to take over the next few weeks.

What we are seeing now and what we’ve been seeing is good for the market, for the economy, and for these sectors. To have an extended rally in the market, we need to see people buying more in different sectors and areas of the capital markets. It can’t just be Google, Apple, Facebook, and these ultra high tech growth names. That is just unsustainable over time. With very narrow or negative market breadth, the market would just peak and find itself unable to advance further, so yes, it hasn’t been fun what’s happened over the last month. It’s no fun at all to watch positions and holdings decline in value, but what we’re seeing now with price and market breadth heading up is right in line with our view and we reaffirm our positive outlook for the second half of the year. There are good opportunities ahead.

Also, what I’m talking about now is another example of just how important tuning out the noise is. If you’ve been watching the financial media, you probably haven’t heard much of anything about what I’ve been describing. Those aren’t the headlines, but those headlines, noise, noise, noise. In our view, it’s not what matters. We and you should focus on the fundamental factors that move markets and move stocks up and down, which are what I’ve been trying to describe today. Tune out the noise.

I do sometimes take a look around this industry and see what some advisors out there are doing with people’s money, and it does upset me. We, in this industry, are being trusted to be good stewards of your money, and that’s all we are, stewards. This is the money that you’ve worked hard for, but instead, I see a whole lot of emotionally driven investing, marketing, and frankly, in my view, poor decision-making that I believe could potentially be detrimental to individual investors and their families. It doesn’t matter how big or how famous the company is. There is little to no correlation between fame and the ability to be a good steward to a family’s wealth.

In my view, advisors and firms who prey on emotions, do their clients, the industry, and the public, a disservice. I’m going to throw in a shameless plug here, but if you haven’t heard, I’ve started up a new monthly podcast for Oak Harvest called The Investor Mindset. On each episode, I’ll be diving into topics that I believe can help investors have the right attitudes and behaviors to have more successful long-term investing experiences. If you haven’t, I would encourage you to listen to episodes one and two of The Investor Mindset, both are now available on our website, oakharvestfg.com.

Episode one is all about tuning out the noise, and episode two deals with learning how to avoid mistakes that emotions can drive you to, that could harm your portfolio and affect your financial future. We all have emotions and emotional responses, but there are concrete steps to take that may be able to help you keep your investment plan in the driver’s seat and not emotion. With all that said, we are sticking with our bullish outlook for the second half of the year. We do expect a more broad-based rally to continue into 2020. Are there risk factors still in play? Yes. Are there going to be bumps along the way? Yes.

As always, for any of you to be right, a lot of things have to fall into place. Key players like the fed and the president are in play. What they do can and will have impacts on the market. Right now, we are still confident in our positive outlook for the second half and do believe that we may be in one of the better opportunities to put new money to work this year. Even more importantly, regardless of what happens in the market, we remain firm in our overall diversified long-term investing approach, emphasizing relatively low turnover, diversification, reducing tax impacts, managing risk, and aligning our client’s portfolios to their specific objectives and overall financial plan.

That will bring us to the end of today’s edition of Stock Talk. Thank you so much for joining me. Chris Perras will be back in the hot seat next week with more to add on our view for the second half of 2019 and our view on more key factors that will impact the markets over the coming weeks and months. If you enjoyed the show, please share it with your friends and family or with anyone who may be feeling a little uncertain in the current market conditions.

If you have any questions or would like to find out if we can help you with your portfolio or help you make sure your financial plan has you on the right path, give us a call. Our number is 281-822-1350. For those on the fence, who’ve been wondering if now may be the right time for you to take that first step, give us a call and see if working with a company that is dedicated to using all of our skill and experience to help you achieve what you want to achieve with your money is right for you. Our phone number is 281-822-1350. All of our contact information is on our website, oakharvestfg.com, along with a lot of good articles, podcasts, and even radio shows, all available for you at your convenience. Once again, this has been James McFarland, this has been Stock Talk, have a wonderful weekend, and I’ll speak to you again soon.

Operator: The preceding content expresses the views of the speaker and is for informational purposes only. It is based on information believed to be reliable when created, but any cited data, statistics, and sources are not guaranteed. Content, ideas, and strategies discussed may not be right for your personal situation and should not be considered as personalized investment, tax, or legal advice, or an offer or solicitation to buy or sell securities. Investing involves the risk of loss, and past performance does not guarantee future results.