Analysis, Featured, Market Pulse,

Is it a Bull or Bubble?

The past two corrections have had investors crying recession, myself included. Technical analysts have made references to the 2008 Financial Crisis. The list of potential bubbles is long, and some of them could drop the market like it’s 2008. Bulls say the 2008 recession is still fresh enough in our minds to make us irrational about every correction, and that the market is going up from here.

It’s been a few months, and the market has indeed been in rally mode for quite a few weeks, coming out of a correction. The media is no longer talking about negative interest rates and recessions. In fact, yesterday Wall Street threw a birthday party for the “current” seven-year-long bull market. It’s one of the longest bull runs in history, and one of the least trusted. It’s time to look at the data again and decide if a recession is coming, or if the 2008 crisis has just left us gun-shy.

 

The American Economy

The fundamentals of the U.S. economy are sending mixed signals. Though it’s true that there is a potential underemployment problem in the United States, the unemployment rate is very low, and job growth is good. The automotive industry has surprised us with better sales than expected. The housing market is looking healthy. If Americans have the discretionary money to buy houses and cars, we can’t be doing too badly. To top that off, the volatility index (VIX) is back below 20, which indicates that the sentiment is much better. Investors are no longer afraid of losing their life savings in the market.

On the other hand, with the rest of the world struggling, the dollar has become extremely strong, which could severely hurt U.S. exports and therefore the GDP. The Chicago PMI (Purchasing Managers Index) is weaker than we would like, which indicates a contraction. The ISM (Institute of Supply Management) index is above expectations, but it is still showing a contractionary number for the fifth month in a row. That has not happened since 2009.

Another foreboding sign is the margin debt of NYSE investors. After reaching an all-time high in April 2015, margin debt has declined, but it is still more than $150 billion. When margin debt, or greed, gets especially high, any fundamental disturbance in the market could cause a furious selloff. Losing borrowed money causes much more panic than losing invested money. I found the below chart in a fascinating article by Doug Short from Advisor Perspectives, and it shows us that if we do have a recession on its way to wipe out the greed of investors, we have a long way to fall.

 

NYSE margin debt

NYSE investor credit and the Market – Margin Debt. Source: Doug Short – Advisor Perspectives

 

Technical Trouble for the Dow and the S&P 500

The main reason why market technicians have been calling recession is because of ominous chart patterns on all three major indexes.

The head and shoulders pattern appeared on both the S&P 500 and the Dow in January. Head and shoulders forms when the market or security rallies and falls and then rallies higher and falls to the same level as the low of before, breaking its upward momentum to the downside. It will then rise to another high that is lower than the high of the head and then fall back to the same support, or “neckline.” Statistically, there is a 70 percent chance that the price will plummet to a level at least equal to the distance between the head and the neckline.

 

SPY long term chart

 

 

DIA chart

 

But the market didn’t implode like it was supposed to. It rallied.

Since the market did not follow the mathematical expectation, we need to find out why that happened before we can say whether or not the chart pattern was a false alarm.

 

Weakness in Demand for Apple Products

One possible factor that could be to blame for the seemingly false head and shoulders pattern on the main indexes is the appearance of the same pattern on the chart of the largest, most widely held company in the United States: Apple ($AAPL). Fundamentally, we saw a weakness in the demand for iPhones, and Apple stock fell on the news. Apple followed statistics and dropped to its expected bottom of $93.00 after the chart pattern was observed by technicians.

A disturbance in the most loved stock on the planet coupled with a fundamentally iffy (at best) national economy and eroding global economy was likely enough to create enough panic to move the whole market. In fact, this move in Apple’s stock directly corresponds to the market-wide fall of all three indexes in January. Since then, the stock has consolidated and is back up over $100.

 

The Oil Bubble

Over the past few years, energy has become a booming part of U.S. GDP. Due to fracking innovations, the United States has become a net exporter of energy, and the oil rig count has soared.

 

US oil rig counts

US oil rig count – historical values. Y-Charts.

 

As a result, we now have a massive global oversupply that threatens the global economy. As the laws of economics require, the demand for oil cannot keep up with supply, so the price has dropped dramatically. Of course, neither the USA nor OPEC wants to give up market share, so oil remains overproduced, and the price remains low. There are only a few ways to fix the problem: cooperate to cut production, or start a war of attrition. Since it’s not likely that the USA and OPEC will cooperate, this oversupply problem will be long-lasting and systemic.

The U.S. energy bubble has popped. U.S. fracking companies and OPEC are in a race to the bottom price. Since energy is a large portion of the S&P 500, the oil collapse has been a drag on the whole stock market (and the whole global economy). The Spider Energy ETF (XLE) chart is horrifying. Not only has energy fallen hard since its all-time high in July of 2014, it has fallen below technical support after showing a bearish head and shoulders pattern on its way down.

 

XLE chart

 

Oil prices could be low for a very long time before oil “recovers,” and that won’t happen until we see a large number of bankruptcies of companies, and maybe even countries.

So what is behind the recent energy rally? Two words: short squeeze. It will not last! There is no fundamental reason why oil prices should be higher. This is an irrational, unsustainable bear market rally.

In 2015, investors began protecting their portfolios by investing in oil refiners instead of oil drillers. Companies like Valero ($VLO), Tesoro ($TSO), and Phillips 66 ($PSX) are more efficient when prices are low. However, at some point, the supply problem will affect even the refiners, especially as production drops.

The Federal Reserve has the power to further exacerbate the oil collapse by raising rates again. With the debt load high for most oil companies, it could be catastrophic if the Fed raises rates by even just 0.25 percent. The media keeps spouting that the U.S. market is moving in lockstep with oil prices, so a drop in oil could mean a drop in the overall market.

 

Technical Trouble for the NASDAQ

The NASDAQ is presenting a different troubling picture: the largest double-top in history. Double tops form a strong level of technical resistance that requires fundamental expansionary forces to break through. Without a fundamental reason to reach new highs, it’s likely that the price will fall and remain in the channel between that resistance line and support. Given the range, this is terrifying.

A peak a few months ago was in line with the NASDAQ in 2000 right before the tech bubble collapse, and if the economy doesn’t improve, the QQQ could fall all the way down to the weak support between 80 and 85 or even to the stronger support between 35 and 40.

 

NASDAQ double top

 

The Technology Sector

Let’s look at the tech industry in isolation. In 2000, tech stocks grew through acquisitions. Technology companies were not always within the realm of understanding of the average investor, and they sold for sky-high valuations. Tech stocks were RSI overbought for years. Tech stocks had the volatility and return of naked long calls and not stocks. It wasn’t unheard of to make 35 percent or more investing in tech funds in the 90s. When we look at the Spider Technology ETF (XLK) chart, we see no double top. A fundamental analysis reveals the same rosy conclusion.

 

Top 10 Holdings of the XLK (61.66% of Total Assets)

Weight (%) YTD (%) P/E Cash / Debt* Credit Rating Debt Financing* (%) Debt / Equity*
Apple (AAPL) 13.67 -3.22 10.84 1.87 AA- 45.21 0.82
Microsoft (MSFT) 10.30 -8.02 36.11 1.25 AAA 55.02 1.22
Facebook (FB) 6.15 1.02 81.77   29.65 9.33 0.10
AT&T (T) 5.76 10.81 16.12 0.46 BBB 46.53 0.87
Alphabet (GOOGL) 5.30 -8.38 30.21 13.71 AA 27.56 0.38
Alphabet (GOOG) 5.26 -8.40 29.46 13.71 AA 26.40 0.38
Verizon (VZ) 5.26 12.96 11.95 0.08 BBB 94.27     16.47
Visa (V) 3.57 -7.23 25.89 1.48 A+ 43.81 0.78
Cisco (CSCO) 3.37 -0.07 13.44 1.63 AA 52.13 1.09
Intel (INTC) 3.02 -10.19 13.28 2.02 AA 57.08 1.33
RED  if uninvestible number

* “Cash” is cash, cash equivalents, retained earnings and short-term investments. “Debt” is preferred stock, convertibles, long-term and current debt, other liabilities, and deferred long-term liability charges. “Equity” is common stock and capital surplus.

 

There is no tech bubble in 2016. Tech stocks’ valuations are more realistic. They are some of the best understood and most analyzed stocks in the world. Many of them are hoarding cash, and they have some of the best credit ratings in the market. Leadership at tech companies are more responsible than ever before. If there is a crisis looming, the tech stocks actually look like a defensive play. That is, if they don’t catch the cancer hiding inside the rest of the NASDAQ.

Biotechnology is a doozy. In addition to the industry being under attack by Presidential candidates, we see a very troubling sight. Like tech stocks during the bubble, the I-Shares NASDAQ Biotechnology Index (IBB) has been RSI overbought for years. Biotech companies are growing through acquisitions, and they have lofty valuations.

Out of the top 20 holdings of the IBB, half of them have P/E ratios above 20, making them pricey. Another six companies are not even profitable. A chartist would look at the shape of the IBB and compare it to the shape of tech stocks in 2000. We will probably find that Hillary Clinton will not have to lift a finger to get drug prices under control.

 

Top 15 Holdings of IIB (71% of Assets)

Weight (%) YTD (%) P/E Cash / Debt* Credit Rating Debt Financing* (%) Debt / Equity*
Celgene (CELG) 9.68 -12.55 53.93 0.75 A- 47.81 0.92
Biogen (BIIB) 9.53 -10.67 17.84 2.06 A 98.70 76.00
Amgen (AMGN) 9.29 -8.53 16.28 0.79 A 55.14 1.23
Gilead (GILD) 8.54 -12.24 7.46 1.34 A+ 94.06 15.83
Regeneron (REGN) 7.27 -24.88 73.88 1.45 29.65 0.42
Alexion (ALXN) 4.26 -20.53 226.71 0.58 36.17 0.57
Illumina (ILMN) 4.20 -18.10 52.14 1.30 BBB- 40.16 0.67
Mylan (MYL) 4.08 -14.70 27.06 0.33 BBB-   76.74 3.30
Vertex (VRTX) 3.49 -26.47 -38.72 -4.04     BBB 14.18 0.17
Biomarin (BMRN) 2.54 -16.53 -83.71 -0.49 BBB+ 21.48 0.27
Incyte (INCY) 2.51 -32.13 2443.00 -1.57 25.88 0.35
Endo Intn’l (ENDP) 1.72 -28.37 -5.69 -0.12 BB 58.84 1.43
Jazz (JAZZ) 1.37 -10.49 24.06 0.82   54.83 1.21
Shire (SHP.L) 1.36 -20.04 24.23 3.30 A- 28.31 0.39
Medivation (MDVN 1.08 -23.79 25.12 1.11 35.19 0.54
RED  if uninvestible number

* “Cash” is cash, cash equivalents, retained earnings and short-term investments. “Debt” is preferred stock, convertibles, long-term and current debt, other liabilities, and deferred long-term liability charges. “Equity” is common stock and capital surplus.

 

Debt levels of biotech stocks are not nauseating, but how do these companies make money if they don’t have debt? They raise the price of drugs. Yes, Hillary Clinton is right. Biotech bulls argue that it has taken these companies ten to fifteen years to turn a profit on their initial investments, and this is healthy expansion, not a bubble. However, let’s consider how these stocks trade. FDA approvals can send these stocks sailing. Failure to get FDA approval can drop them by 50% or even 75%. Like tech stocks in the 90s, biotech stocks trade with the volatility and return of naked long call options. Bubble alert.

Many biotechs are cutting R&D spending and moving into sales and marketing. It doesn’t matter if Hillary Clinton, Bernie Sanders, or Donald Trump wins the White House because they all want to stir things up in the pharma industry. Under Clinton or Sanders, drug prices could become capped, and that would be like jumping on the bubble. Capping profits would force them to have returns of normal equities. Investors won’t want to pay a high growth premium for normal or slow growth, so the stocks will sell off rapidly. Under Trump, the government would be able to negotiate with drug companies on price. Same effect, different semantics.

C-suite leadership of a portion of smaller biotech companies will be unable to manage capital if they suddenly have to be more concerned about budgets. Unprofitable companies will be forced to finance research with debt or new stock issues instead of profit from increasing prices. With stocks selling off, it might be impossible to issue new equity. A selloff could also cause credit agencies to issue junk ratings. Thus, troubled biotech companies might not be able to issue bonds either. This is when bankruptcies of drug companies will begin. If we adjust the table for a potential biotech selloff from capped drug pricing, the picture looks grim.

 

Projection of Top 15 Holdings of IIB (71% of Assets) if Bubble Pops (Worst Case Scenario)

YTD (%) P/E
Celgene (CELG) -60 to -65 20.00
Biogen (BIIB) -50 to -70 15.00
Amgen (AMGN) -25 to -40 15.00
Gilead (GILD) -30 to -40 10.00
Regeneron (REGN) 90 to -100 20.00
Alexion (ALXN) -80 to -90 -100.00
Illumina (ILMN) -90 to -100     20.00
Mylan (MYL) -25 to -50 20.00
Vertex (VRTX) -60 to -70 -25.00
Biomarin (BMRN) -70 to -80 -20.00
Incyte (INCY) -90 to -100     -100.00
Endo Intn’l (ENDP) -50 to -60 -4.00
Jazz (JAZZ) -30 to -40 20.00
Shire (SHP.L) -25 to -40 15.00
Medivation (MDVN -70 to -80 20.00
                                                                                     RED if potential bankruptcy

Note: This table does not factor in potential FDA approvals or mergers and acquisitions because those are the attributes that make biotech stocks so volatile like call options. We want to see what they will be worth when they trade as stocks.

 

The best way for an investor to hedge their portfolio against the biotech industry is to not invest in the biotech industry. It can take more than ten years for an investor to recoup losses if they invest at the top of a bubble. Just ask Microsoft ($MSFT) investors, who just broke even 15 years after the tech bubble (excluding dividends received).

If the worst case becomes reality, it could drop even the most reliable medical stocks like Johnson & Johnson ($JNJ).

 

Probability of a Financial Crisis

An oil collapse is probably not enough to cause a financial crisis in the United States, and as it turns out, neither is a biotech collapse in isolation. Most biotech companies of all sizes have low debt levels, but there could be up to a quarter of a trillion dollars’ worth of convertible preferred stock floating around. There is also between $5 billion and $20 billion worth of warrant investments that could become worthless if the bubble bursts.

The banks say that they are stronger than they were in 2008, and that is true fundamentally. For the most part, we know big banks’ exposure to the oil industry. For the larger banks, it is between $20 billion and $40 billion. To a firm worth several trillion dollars, that is enough to significantly sink the stock (particularly if you are Bank of America or JP Morgan Chase) but probably not enough to cause a financial crisis.

If there is a financial crisis, it will be thanks to the government. We don’t know what will happen if the U.S. enters a recession with emergency-low interest rates, especially if that recession directly affects our medicine and healthcare. What will the Federal Reserve do? What will the President (whoever they are) do? At her last announcement, Janet Yellen said she doesn’t even know if negative interest rates are legal. Will they be forced to bail out the drug companies or face Americans having issues getting their medicine? Would a medicine shortage be enough to cause a run on banks? It’s impossible to know.

 

How to Trade This Bear Market

There are ways to make money during a bear market depending on your risk tolerance level. The best advice I ever got is to keep a bit more cash on hand than I usually do in order to maintain flexibility.

Another valuable piece of advice is to never invest in a bear, but always trade a bear. Traders find success by looking for stocks that are overbought and then riding the short term recovery. Bear rallies can be magnificent because in addition to buying activity from traders, people begin to cover their short positions either because of fear of upside risk or because of margin calls. I watch the Relative Strength Index and buy equities when they drop below 30 RSI. Then I ride them up until they have captured me a predetermined percent return on my investment, and then I cash out and leave.

The number one best hedge against a recession is to ensure that you are maintaining a diversified portfolio. Weight it heavy on utilities, consumer staples, telecommunications, and national defense. Make your portfolio light on consumer discretionary, technology and medicine names. With this strategy, you will likely have a better return than people who only pick one sector. I recommend staying out of financial stocks during recessions, especially with the world slowly headed toward negative interest rates. Negative rates really hurt banks.

I also recommend staying out of small cap stocks during recessions. Small caps are much more volatile and can lose money much faster than the large cap stocks do. Pick large cap stocks that pay dividends because investors like that little bit of extra cash back when the economy is in a recession and cash is hard to find. Investors also tend to flock to dividend stocks as an alternative to bonds because the high yield bond market also tends to take a substantial hit during recessions.

Think about products and services that Americans buy when they do not have a lot of money. What do Americans eat during recessions? Where do they shop? What are the products they are forced to buy regardless of how many greenbacks they have in their wallet? Products like diapers, inexpensive food and toilet paper are examples. Invest companies that make those products.

Another golden opportunity is to invest in gold. Gold is already up big this year, but it will probably keep going. People living in countries with negative rates and deflation are flocking to gold instead of cash. Don’t worry – you don’t need a secret underground room for your gold bars. You can just buy into the GLD ETF.

If your investments are profitable this year, you could consider a technique called shorting against the box in order to protect your favorite positions. Shorting against the box is when you own long positions in stock but then simultaneously short sell shares of the same stock. Once you think the price is done falling, cover your shorts, and you’ve successfully protected yourself against the price fall. If the stock pays a dividend, you will still get the dividend for the long position, but you won’t receive a dividend for your short shares.

Keep in mind that shorting against the box only works if you are at break-even or profitable on your investment. If you do this when you are already losing money, you could end up adding to your losses. Also keep in mind that shorting equities involves maintaining margin debt with your broker. Margin requirements and additional tax considerations can be complicated, but this is a good technique if these risks are understood.

The riskiest but potentially most rewarding way to profit is to use the Inverse Leveraged Proshares Ultrashort Nasdaq Biotech ETF ($BIS), which buys swaps and derivatives to profit off a biotech collapse.  I’m wrong and biotech keeps rallying, derivatives will lose more money than a simple short position will lose, and your portfolio could suffer large losses. However, it will also make up to three times as much money if I am right. You can read the prospectus here.

If you want to use a similar fund (with proportional risk and return) as a bet against banks, you can look at the Direction Daily Financial Bear 3x ETF ($FAZ).

 

Conclusion

With the market sending mixed signals, there is a very good chance the bear market will continue into late 2016 or early 2017. It’s hard to judge as of yet whether this will remain a simple bear market, or if it will become a minor recession or another monster of a scar on the economy. However, the bull is over.

 

Disclosure: I have long positions in AAPL, V, VLO, and TSO.

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J Rae has been interested in finance since age eight when her grandfather, who started investing in the 40s, started coaching her. She has been an investor since 2006 and a trader since 2013 and focuses on a diversified portfolio of stocks and options. J Rae has almost completed an MBA in Financial Management.

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