Buy The Dip Sentiment Gives Way To Preservation Of Capital

The intransigence continues in Washington, and it has kept stock market buyers at bay until they get the go signal from Congress. This has left the sellers in control as investor sentiment has temporarily shifted from a buy-the-dip mentality to protect-your-gains and preservation-of-capital.

Tuesday’s extreme weakness hit momentum stocks the hardest, followed by a succession of the lowest-quality names. For example, last week I noted that the NASDAQ Internet Index (QNET) has been incredibly strong this year, but many of those names led to the downside on Tuesday. Still, many investors eagerly await the imminent Twitter IPO.

This has been a symptom of the junk rally and overall outperformance of lower quality stocks that has persisted during much of this year. I am talking about companies with weak analyst ratings, poor earnings quality, and aggressive accounting practices. As a result, many fundamentals-based quantitative models that have a general GARP and quality theme have underperformed much of the year.

We have seen it this year in some of Sabrient’s models, including our Earnings Quality Rank (EQR), which is a pure accounting-based risk assessment signal that Sabrient developed together with subsidiary Gradient Analytics, a forensic accounting research firm. Although Sabrient’s top-ranked (highest quality) stocks have performed well (including our renowned Baker’s Dozen portfolio that has more than doubled the return of the S&P 500 again this year), we also have seen many of the bottom-ranked (lowest quality) stocks perform even better as speculators have bid them up -- causing underperformance in tails-oriented long/short strategies. This has been particularly significant in the Energy, Consumer Non-cyclical, Financial, and Technology sectors (with the notable exception of Telecom). One glaring example is Tesla Motors (TSLA).

However, there are signs that this “upside down” performance is beginning to reverse. Mean reversion always happens eventually, and the “mean” is for higher quality stocks to outperform lower quality. Lack of fear breeds speculation and “irrational exuberance,” and bulls have remained unbowed during a constant barrage of worrisome external events, but perhaps the latest scares concerning fallout from QE tapering, Syria, government shutdown, and debt default are leading investors back toward rationality. At least one can hope.

Of course, all human activity is dictated by self-interest. Even charitable actions are performed out of a sense of duty, honor, or compassion, each of which makes us feel better about ourselves. And the same is true of our elected officials in Washington, who are driven mostly by their political futures and pleasing their constituents rather than compromising with “the other side” for short-term expediency and the greater good. In fact, compromising is a good way to lose the next election, so that definitely is not acting in one’s self-interest.

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As for the federal government shutdown, we all should take this as an opportunity to reflect on what services we truly need from our federal government. In the private sector, mass layoffs and/or cuts in pay or benefits occur frequently, even in the largest firms. But it almost never happens in the public sector, particularly at the federal level. In the private sector, we have to justify our existence (i.e., market value) at all times. Not so in the public sector.

As for the debt ceiling, if it’s supposed to be “automatically” increased as needed, then why do we have one at all? Imagine if your credit card automatically raised your credit limit whenever you approach it. It might sound good, but in effect, it is no credit limit at all. If our federal government isn’t going to take it seriously, we might as well do away with the concept of a debt ceiling altogether. Why perpetuate the charade?

Ultimately, resolving this situation comes down to the President and his ability to lead. Rather than standing firm with his party on this and refusing discussion, he must seek a way to placate those who are simply exercising their Constitutional powers. The founding fathers never intended a pure democracy, where the minority is forced to completely knuckle-under to majority rule. Instead, minority interests have tools at their disposal. In this case, it’s known as “legislation by appropriation,” and it has been exercised routinely by both parties through the years. Indeed, on Wednesday it appears the President is finally taking some steps toward fostering discussion.

This does not mean that he must defund his landmark healthcare program. There is no denying the fact that the Affordable Care Act is the law of the land. But it became so in a hasty power play by the dominant majority, and now a vocal minority has found a way to be heard, as the Constitution allows. Understandably, the Tea Party Republicans want to negotiate while they still hold their bargaining chips -- not after giving them up as the President has insisted. President Obama is going to have to accommodate their demands in some way, however small, or else the fallout will forever be a major blemish on his legacy and his alone. When you consider their respective self-interests, the Tea Party Republicans quite simply have much less to lose (and perhaps a lot to gain) from a protracted government shutdown and debt default than does the President.

Liz Ann Sonders of Charles Schwab has opined that the timing of a protracted shutdown would prove especially costly, as she believes the economy is now poised to move into the next phase of its recovery. She has seen signs of an imminent acceleration in capital expenditures among businesses rather than continuing to use their earnings for stock buybacks and dividend increases. In particular, she thinks the manufacturing sector has just about exhausted its ability to cut costs and implement productivity gains, so spending on new plant, equipment, and personnel is required for earnings growth to continue.

In any case, Bill Gross of PIMCO thinks interest rates likely will remain low longer than the market or most anyone else expects. A near-zero fed funds rate and some measure of quant easing is likely here to stay for the foreseeable future. It would be like trying to take away an entitlement that a large segment of the population has grown accustomed to and dependent upon -- it’s very difficult to do and rarely happens.

The SPY chart: The SPDR S&P 500 Trust (SPY) closed Wednesday at 165.60, which is just below the important 50-day simple moving average. I have drawn an uptrend line of support connecting the various lows since last November’s V-bottom, but this week’s continued weakness has pushed SPY below it. Oscillators like RSI, MACD, and Slow Stochastic are all oversold, but they are not yet at extremes and could go lower. We got a little intraday recovery on Wednesday. But if failure of support at the 100-day SMA is confirmed on Thursday-Friday, next support comes in at 165 and then 160, which also happens to coincide with the critical 200-day SMA. However, if and when bulls get the green flag to resume their rally, I doubt there will be much hesitation at any prior resistance levels above.