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The broad Russell 3000 Index is one of many indices and funds presently forming potential "Cup-&-Handle" formations on the charts; is the pattern the next bullish catalyst for the market?

There are a lot of complex ways of analyzing the directional prospects for the stock market. Indeed, we ourselves have developed complex models that guide our decisions as to when and where to invest. However, in the near-term, sometimes the market's directional catalyst seems to come down to a simple chart formation. That may be the case right now -- and if the interpretation is correct, it may be more good news for the bulls.

The chart pattern in question is the "cup-&-handle", a potentially bullish setup currently present on the chart of a great number of indices and ETF's, including the broad-based Russell 3000 Index (RUA):

As we have described before in the past, the cup-&-handle pattern is generally a bullish one for prices and involves 2 parts:

The Cup: This phase includes an initial high on the left side of a chart followed by a relatively long, often-rounded retrenchment before a return to the initial high (e.g., September 2018 to April/May 2019 in the RUA).

The Handle: This phase involves a shorter, shallower dip in the stock and subsequent recovery to the prior highs (e.g., April/May 2019 to the present in the RUA).

The bullish idea is that after taking a long time for a stock to return to its initial high during the “cup” phase, the “handle” phase is much briefer and shallower. This theoretically indicates an increased eagerness on the part of investors to buy the stock since they did not allow it to pull back nearly as long or as deep as occurred in the cup phase. Regardless of the theory, the chart pattern has often been effective in forecasting an eventual breakout and advance above the former highs.

Over the past few days, the RUA has been attempting to break out above its all-time highs represented by the top of the cup-& handle. Furthermore, a great many other indices, domestically (e.g., the SPX, the DJIA, etc.) and abroad (e.g., EAFE, ACWI, Global Dow, India, etc.) as well as sectors and ETF's (e.g., the DRG, XLK, XLY, IGV, etc.) are forming, or breaking out of, similar patterns.

This collective setup across a large portion of the stock market may well serve as the overriding catalyst for the stock market in the near to intermediate-term -- and would appear to bode well for continued good news for stock bulls.

Want to know how we are playing this pattern -- and in which areas of the market? We invite you to check out The Lyons Share, a daily “all-access” pass to our research and investment moves. Given what should be an exciting, volatile and opportunistic forthcoming market climate, there has never been a better time to reap the benefits of our risk-managed approach. Thanks for reading!

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If you’re nervous about where the market is headed (after enduring two eyebrow-raising weeks of pronounced volatility) then guess what - you’re normal. Human nature is to fear losses, and memory of the 2008 bear market still lingers. Nobel Prize-winning psychologist Daniel Kahneman discovered that investors dislike losses roughly twice as much as they enjoy gains. Frankly, I think losses are despised even more than that.

It makes sense then that the current volatility has many questioning the sustainability of this bull market. The knee-jerk reaction is to sell stocks and ride-out volatility from the sidelines. But, I think that’s the wrong move and I still see this current volatility as a short-term market correction, not a bear market. To me, this market is looking more and more like 1998 than 2008.

4 Reasons I Think This Market is More Like 1998 than 2008

Many investors won’t remember this, but in 1998 the market took a steep dive from mid-July to mid-October, falling slightly more than 19% in total.

But in 1998, the market did what it classically does in a correction – it falls quickly and steeply, posts a mini-recovery mid-way through (kind of what we’re seeing now), and then it falls quickly again until the correction finds its bottom. From there though, the market powers through to a very swift recovery, which in 1998 meant climbing some 28% from mid-October to the end of the year. Investors that got spooked out of the market given that volatility would have been majorly whip-sawed. My advice: don’t be that investor.  

Indeed, I see a similar pattern forming today. I wouldn’t be surprised if the market continues bouncing higher after big down days, luring investors to believe the correction is over when in fact there is still more downside left. But that’s ok! We’re only about three weeks into this downside volatility, and corrections can last anywhere from a few weeks to a few months. Investors should brace for continued volatility, but not fear it. I still think fundamentals point to more secular upside from here, and this downside volatility should be short-lived with a quick recovery in the wings – just like 1998.

Here are four similarities I see between 1998 and today:

1) Late Stage Bull Market – 1998 was the eighth year of a ten year long bull market, and 2015 marks the 6th year of our current bull market. A lot of folks think this is too long to be in a bull market, but that’s a false thought – bull markets since the Great Depression have lasted an average of 8 or so years, meaning for this one to last two more years would be quite normal.

2) Concerns over Asian and Emerging Market Currencies – at present, many are worried that the strengthening dollar is going to doom Emerging Markets [EM], especially if you tack-on lost revenues due to falling commodities prices (since many EM countries are energy and mineral exporters). A strengthening dollar also hurts EM countries because their debt is almost universally denominated in dollars, meaning that a strong dollar equates to more costly interest payments. All very true. Interestingly though, the same scenario occurred in 1997, when global markets rattled over the Asian currency crisis. Countries like Thailand, Indonesia, and South Korea rapidly saw their currencies fizzle in value, and experts predicted a complete collapse in the global markets. But it didn’t happen. The stock market corrected then and there was a carry-over into 1998, but it wasn’t enough to send equities into a prolonged downturn. The China economy concern (and currency devaluation) of today shouldn’t either.

3) Interest Rate Hikes Looming – as it turns out, 1998 was the precursor to a series of interest rate hikes by the Federal Reserve – just like 2015 seems to be. From 1999 – 2000, the Fed raised interest rates six times from 4.75% to 6.50%, but the market also annualized 5% over the same period! For everyone that fears interest rate hikes by the Fed, all they need is a history lesson: stocks have done remarkably well during the past three rate hike cycles.

4) Optimism Building, but Not Fully Developed – there’s no quantitative evidence to support this, but my general feeling is that investors aren’t entirely comfortable with this bull market. In my view, there has to be some level of unjustified optimism about stocks in order for me to believe they are overpriced. And I just don’t see that today. In my opinion, stocks thrive on skepticism – they love to climb that ‘wall of worry.’ And that wall very much exists today, especially now.

Bottom Line for Investors

Many are tempted to think that this market’s volatility is somehow unprecedented, and the media are quick to spin the downside. But that is simply the wrong way to think. The market has endured steep quick declines in the past (1998, 2011) and recovered briskly at a moment’s notice. I think the same applies to the current scenario, and that investors should hold their breath a bit and remain patient. Downside volatility is scary, but often times it’s just temporary. I think it is this time too.

Free Download - Zacks Market Outlook - September 2015

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

The popular wisdom that bear markets occur at expensive valuations is unsubstantiated fiction. The truth is bear markets occur all the time. The chart below shows all declines from the high water mark of the S&P 500 Index back to 1900. In the U.S., there were 14 bear markets with declines of 20% or greater and many more pullbacks of at least 10%.

The chart below plots the distribution of monthly observations of PE ratios on the S&P 500 Index in blue. The red numbers above each PE range indicate the number of times a bear market START occurred in the PE range. Of the 14 bear markets, 11 have commenced at PE levels BELOW the current PE valuation of 20.6x.

From 1928 to 2014, stocks earned 4.6% per year more than 10 Year U.S. treasury bonds — 9.6% vs. 5.0%. In finance-speak, this is called the risk premium that stocks earn over bonds.

Academics have tried to explain why the risk premium in stocks exists — they carry more risk, the returns are more erratic and equity owners are at the bottom of the capital structure for repayment. No one really knows the answer. It probably comes down to the fact that equity holders require a higher return on their capital than debt-holders.

Because interest rates around the globe are currently so low (and negative in some cases), many investors have come to the conclusion that stock returns should also be lower in the future. In theory, this makes sense because the long-term returns on bonds will certainly be lower than average based on the current yields. The risk premium is far from stable over time, but it’s reasonable to assume that lower interest rates should lead to lower equity returns.

Turning theory into reality can be tricky when you add in the human element of the markets. Let’s test this one out to see if it holds water. I looked back at the starting 10 year treasury yield at the beginning of each year going back to 1928. Next I calculated the subsequent 3, 5, and 10 year annual returns on the S&P 500 and separated each by their initial interest rate level. Here are the results showing the average annual returns for the S&P 500:

Starting with the highest yields at the top and working your way down it appears that the risk premium theory holds. As the starting interest rate deceases the future stock market returns also fall. That is, until you move under the 3% level. At that point average annual returns jump back up again.

I’m not sure exactly why this is the case, but my guess is that most of these low rate periods came after economic crises, so the low yields came about because Fed lowered rates. The returns are above average because they likely came after sharp stock market sell-offs. So even though it doesn’t make sense from a risk premium perspective, it makes sense from a common sense perspective that low interest rates would lead to higher returns based on the timing of those low rates.

The 10 year yield started out in 2015 at just above 2.1%. Does that mean investors should expect similar above average performance going forward? If it were only that easy. Market averages are never quite as clean as they appear. You always have to consider the range of outcomes that caused the averages you’re looking at. Here are the minimum and maximum annual returns for the averages from above:

By far the narrowest ranges have come from the highest interest rate environments. It’s counterintuitive to invest in stocks when bonds yields are double digits, which is exactly why the returns have been higher from those starting yields. Investors gave up on stocks when interest rates were so high, which pushed down valuations and increased future stock returns.

You can see that once the interest rates were closer to average levels the range of returns were fairly wide for nearly every period, although they do narrow as the time horizon is extended. So while low interest rate environments have led to above average returns in the past, there are always going to be outliers and a wide range of possible outcomes.

As with most historical data, there are scenarios that can work for both bullish and bearish arguments. Stocks have already given investors strong gains from the extended period of low interest rates since the financial crisis, but based on historical performance stocks don’t have to be doomed simply because of low interest rates.

Further Reading: What the Risk Premium Can Tell Us About Future Returns

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This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.

Long-term government bonds have been on an absolute tear this year. The 20+ Year Treaury ETF (TLT) is up almost 20% on the year as interest rates have continued to drop.

Over the long-term stocks are supposed to earn a risk premium over bonds because of the way they’re structured and the risk involved in each type of security. This has been the case historically, as stocks have earned a 5-6% premium over high quality bonds going back a hundred years or so.

But that relationship has been tested over the life of this bond bull market that saw double digit interest rates fall over the past 30+ years, boosting the performance of long-term bonds. The incredible performance in bonds has transformed the risk premium over this period.

These are the risk premiums over 10, 20 and 30 year time frames based on the annual returns for the total U.S. stock market (represented by the CRSP Total Market Index) and 20 Year Treasuries going back to 1926:

Any time the line goes below zero that means bonds have outperformed stocks over that period of time. It’s rare, but not out of the question, especially when double digit starting interest rates are combined with an ending date that falls close to a severe financial crisis. Anything is possible.

The further out you extend the time horizon, the more consistent the advantage of owning stocks over bonds becomes, but even the thirty year risk premium is all over the place depending on the start and end dates.

This data goes through year-end 2013, when the risk premiums for stocks over long-term bonds in the most recent 10, 20 and 30 year periods were 1.5%, 2.4% and 1.8%, respectively. These were all well below the long-term averages of 4.8%, 5.6% and 5.9% for each of the designated time frames.

It would be easy look at this data and say that stocks aren’t worth the risk, but I think that misses the point. This is really more about the unbelievable bond bull market than anything. Long-term bonds are up almost 9.5% a year over the past 30 years, an amazing run of performance (stocks are at 11.2% annually).

Eventually the bond bull market that began in the early 1980s is going to come to an end and long-term bonds will get crushed (and good luck figuring out when that happens), but sometimes it’s worthwhile to step back and appreciate a bull market of this magnitude. It’s been an amazing run for bonds.

It’s also makes sense to look back at the historical data to see what happens when bonds aren’t in a near-continuous falling interest rate environment. For the 50 years from 1932 to 1981, long-term treasury bonds returned 2.95% per year, which was almost a full percent below the inflation rate of 3.8%. The tail-end of this period saw rapidly rising inflation and interest rates, but it’s worth noting that the risk premium hasn’t always been quite so narrow (stocks were up 10.5% per year in that time).

I don’t know exactly what’s going to happen, but simple math based on the current level of interest rates leads me to believe that these risk premiums will be much wider in the future over longer time frames than they’ve been in the recent past.

This doesn’t even mean that stock returns have to be as high as they’ve been in the past. But it looks like a high probability bet that the spread between the returns on stocks and bonds should be wider in the future than it has been for the past three decades or so.

This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.

Many investors have been hoping for a “healthy” correction to put money to work at lower prices, but corrections never feel healthy when they finally hit.

It always feels like this is the big one when losses start to pile up. We start hearing comparisons to the prior peaks in 2000 and 2007 along with some scary stories about the 1987 crash.

Investors are now conditioned to expect binary outcomes in the markets. It’s either a top and we’re heading for a crash or it’s a bottom and markets are going straight up. Either of these scenarios is always a possibility, but rarely are the markets at an inflection point. There’s usually more of an ebb and flow than most investors realize.

In his terrific video called How the Economic Machine Works, Ray Dalio explains how the credit cycle works in general terms. Dalio offers an example using a simplified version of the relationship between credit growth and growth in the economy and how it fluctuates around productivity growth:

When the good times start to roll we see too much debt in the system and things can get out of control, which is exactly what happened leading up to the great financial crisis. Following the euphoric build-up, there's a readjustment period where we undershoot potential productivity in the economy (sound familiar?).

Within this long-term secular cycle are much shorter cyclical periods:

With two huge market declines in a the same decade, investors are constantly on edge waiting for the next crash. The scars are still fresh. But we're more likely to see cyclical, not secular, market drops for the simple fact that they happen more often.

Let’s assume the S&P 500 ends up falling 10% or more, something that hasn't happened since 2011. I don’t know if this will happen, but it’s not out of the realm of possibilities. Does this mean we’re heading for another 50% crash? Maybe, but probably not. That magnitude of loss is fairly rare historically.

I looked at the S&P 500 data going back to 1950 and found that there have been nearly 30 instances when stocks fell by 10% or more, roughly once every two years (go back to 1928 and it happens around once a year).

In that time stocks have only fallen 30% or more five times. It happens, but it’s rare. That’s one out of every thirteen years. Here are the rest of the stats on the double digit losses:

You can see the average double digit loss lasted almost 8 months and led to a bear market. The huge losses are the exception, not the rule. Two-thirds of the time, when the market falls by double digits, it's down by less than 20%. About half the time it’s down less than 15%.

These numbers don’t make you feel any better when you see the value of your portfolio drop, but it’s puts things into perspective. There are no rules set in stone in the financial markets and there’s no playbook that tells you ahead of time that this type of market will only lead to a 10-12% decline but that one will lead to a 30%+ crash.

Of course, these aren't actual odds. It's just what's happened historically. Anything can happen. There are always outlier events that could strike and upset market dynamics to cause a crash. No one really knows.

But you can't plan on a stock market crash every single time stocks fall. Sometimes stocks go down without an enormous crash. Were it not for the occasional correction or bear market stocks wouldn't offer a risk premium over bonds and cash.

Plan on seeing stocks fall plenty of times over your lifetime, including the occasional crash.

This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.

Active mutual funds continue to lag the market this year. The chart above from BMO Capital Markets, couresty of MarketWatch, shows the percentage of active stock managers that are outperforming the market over the past six years or so.

This is nothing new, but there are some risks for investors in active funds to consider that can result from this underperformance. Brian Belski, the chief investment strategist at BMO, had this to say about the implications of these numbers:

"We believe fund managers being too inactive and defensive with their portfolio positioning this year is largely responsible for this. However, given the level of underperformance, fund managers will likely have an added incentive to position portfolios more aggressively between now and year-end to play “catch-up” – something we believe will be a strong positive for market performance."

Ignoring the market implications (why would the market go up just because portfolio managers shift their stock holdings around?), this brings up a risk that few investors consider when making fund selections – career risk.

Whether right or wrong, if you underperform the market for an extended period of time, it will be much harder to attract new investors and keep current investors from selling out of the fund. Lower assets means lower fees which all compounds into more and more pressure on the manager to bring returns back up to stop the bleeding.

The risk for investors in underperforming funds is exactly what Belski outlines here, which is that portfolio managers take more risk to try to make up for their underperformance. Once a manager becomes fixated on short-term relative performance, risks can become magnified. Instead of performing rational analysis, they turn into speculators. They speculate on what other investors are going to do and try to get their first. They’re trying to forecast what the other forecasters are forecasting.

In essence, when you play the short-term relative performance game, you have to be able to guess the psychology of other people…not an easy task.

Obviously, this isn’t an optimal way to run a portfolio. This is why it’s so important for investors to understand what they are getting themselves into with any fund offering. A few points to consider when you’re involved with an underperforming fund or strategy:

Does the portfolio manager/firm have a disciplined process? A deep understanding of the fund and strategy is always important, but this is especially true when a period of poor performance hits. You must consider whether the manager will stick to their knitting or change course and go a new direction. Style drift is acceptable when it’s been sold as part of the strategy, but that’s rarely the case. More often than not style drift is a huge red flag for an underperforming fund.

Do you have the correct expectations for fund performance? Being out of favor isn’t that surprising. Nothing outperforms forever. Just as markets are cyclical, so too are strategies and investment styles. These things go in and out of style. It all depends on how willing you are to wait for things to turn around, which may or may not happen.

Do you have a plan for an underperforming fund? There’s no easy answer to the question of when to cut your losses in an underperforming fund. Investors always preach process, process, process until a bad outcome hits. At that point, process goes out the window and emotions take over. Emotions are the enemy of buy and sell decisions.

Playing catch-up to the market isn’t a great position to be in from a fund manager’s perspective. But adding risk for the sole purpose of getting even is not the solution.

Remember, trying harder doesn’t lead to better returns in the market.