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Portfolio Update

Volatility and the Market Cycle

By Elliott H. Gue, on Feb. 17, 2018

Last week’s dramatic selloff, one of the sharpest in market history, saw the S&P 500 re-test its 200-day moving average on Friday afternoon. The 200-day MA held that test, with the market rebounding to close higher for the day and above it’s open price. In addition, the big intraday spike in the Chicago Board Options Exchange S&P 500 Volatility Index (VIX) on Feb. 6 signaled the sort of panic that usually marks a low for the market.

Corrections during bull markets often find a trough near the 200-day, though some pullbacks break below this key technical level for a period of a few days before rebounding. Accordingly, we suspect that the S&P 500 has already seen the low of this move, though it’s possible that the market will re-test or slightly undercut last Friday’s lows over the next week or two.

Another positive sign is that we’re beginning to see some breadth divergences. In particular, 258 stocks on the New York Stock Exchange (NYSE) set new 52-week lows last Wednesday, just as the market found a low and rebounded into Thursday. On Friday, the S&P 500 broke below its Wednesday low by about 2.3 percent, but the number of NYSE stocks hitting new 52-week lows on Friday shrank to 222.

These technical indicators mark the first, tentative signal that the selling pressure has started to abate; we’ll look for further confirmation that the tide has turned in favor of the bulls over the next five to 10 trading days.

In particular, we’ll monitor the number of NYSE-listed stocks making new lows to continue to decline. We’ll also look for some sessions where 80 to 90 percent more of the trading volume tilts in favor of advancing issues. Friday’s rally came in just below this threshold.

On average, the S&P 500 suffers pullbacks of 5 percent or more three times annually and corrections of around 10 percent once per year. Investors should remember that the frequency and severity of corrections tend to increase in a bull market’s final 12 to 24 months. 

When the last two major bull markets wound down in 2000 and 2007, corrections that occurred in the final 24 months of the bull market averaged about 50 trading days from the peak prior to the pullback to the point when the market logged a new all-time high.

This historical yardstick suggests that the market will trade to new all-time highs before summer.

We can’t underline this point enough, so we’ll also put it in bold: We regard the recent decline as a correction, not the start of a bear market.

If the Jan. 26 high marks the top for this bull market, it will be unique in US financial history.

Ten of the past 12 US bear markets—peak-to-trough declines of 20 percent or more—have occurred in the context of a US recession. None of our indicators suggest the US economy is at elevated risk of recession over the next six to 12 months. In fact, the US and global economies continue to show signs of accelerating growth.

Over the weekend, we also reviewed the chart of the S&P 500 in 1966 and 1987, the only two bear markets that weren’t accompanied by a recession. These two market tops share some similarities and may be instructive for the current cycle.

The market peaked in February 1966 and declined about 22 percent to a trough in October 1966.  However, before that peak, the S&P 500 suffered a 9.6 percent selloff in summer 1965. Of note, the 1963 to 1965 rally lasted 538 days without a 5 percent pullback; the June 2016 to January 2018 up-cycle lasted for 578 days. These two moves rank among the three longest, uninterrupted rallies in US history.

If the 1965 to 1966 experience were to hold this cycle, the S&P 500 will enjoy one more bull run to a new top later this year.

In 1987, the bull market ended with a series of violent pullbacks, including an 8 percent selloff in summer 1986, a short-lived 10.3 percent plunge in September of the same year and a 9.3 percent correction in spring 1987. The subsequent market ended in October with the infamous 1987 market crash.

Bottom Line: The S&P 500 historically has not soared to an all-time high only to descend immediately into a bear market. Historically, market tops are marked by at least one correction of 5 percent or more in the 12 to 18 months before the bull market peaks. Several of these foreshocks are the norm. We regard the recent pullback as one of those foreshocks, underscoring our view that this bull market has entered its latter stages.

If history is any guide, the period of ultra-low volatility experienced in 2017 has ended, setting the stage for a more jagged performance in 2018. Variations in performance between different sectors will also increase.

However, despite the increased volatility, gains in the final 12 months of a bull market have averaged about 25 percent since 1937.

Investors should continue to regard any weakness as a buying opportunity for the names in the Wealth Builders Portfolio, but we’ll also look for signs of a possible bull market top over the remainder of 2018. Lowe’s Companies (NYSE: LOW), for example, looks particularly attractive after the recent pullback.

Portfolio News

EnLink Midstream LLC (NYSE: ENLC) won’t officially report earnings until Feb. 20, but the general partner and EnLink Midstream Partners LP (NYSE: ENLK) released 2018 guidance and hosted a conference call earlier this month.

Management disclosed that EnLink Midstream Partners’ operating cash flow came in above guidance and called for 2018 EBITDA (earnings before interest, taxes, depreciation and amortization) to increase by 15 percent relative to midpoint of its target range for this year. Nevertheless, distribution coverage is expected to range between 1 and 1.1 times, likely reflecting the preferred units that the partnership sold in mid-September 2017 and equity issuance to fund $650 million in capital expenditures.

The executive team indicated that this momentum to continue into 2018, Devon Energy Corp (NYSE: DVN) and other customers transition to development mode in central Oklahoma’s STACK play, driving volume growth of 30 to 40 percent. Some of these natural gas liquids will flow to EnLink Midstream Partners’ Cajun-Sibon system in Louisiana, which should operate near full capacity for the year and could be due for an expansion.

Throughput growth will also continue in the Permian Basin, though ongoing declines in the Barnett Shale will become more of a problem when Devon Energy’s minimum volume commitments expire at the end of 2018. Against this backdrop, A simplification transaction that puts EnLink Midstream Partners on a sustainable path would make sense, though management has asserted that such a move isn’t imminent.

Devon Energy owns a roughly 60 percent equity interest in EnLink Midstream LLC, suggesting that EnLink Midstream could buy in the MLP and enact a stealth distribution cut to improve its ability to fund growth projects internally. EnLink Midstream LLC also raised its dividend by 5 percent, while EnLink Midstream Partners has kept its payout flat. EnLink Midstream LLC continues to rate a buy up to $19 for aggressive investors.

Elliott H. Gue founded and edits Energy & Income Advisor and Deep Dive Investing.

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