Over the past two weeks, I have become a net seller into this weak stock market rally. I talked extensively about it in our last webinar: https://youtu.be/_11AvJl3m_M

While I do not believe what is coming is “the big one” as far as market corrections is concerned, I do think it can mimic significantly what happened in February, but for different reasons.

For those who would actively try to navigate an uncertain stock market, raising cash levels by trimming winners and outright selling losers is a move to make now. Investors who would rather stay a bit more fully invested, and control risk with fewer moving parts, can rely on a smart asset allocation to offset a potential correction. 

Running Into, Rather Than Over, A Wall Of Worry

The stock market is often described as having a wall of worry that the market climbs. I agree, and all the evidence demonstrates over long periods of time,  that more often than not, that what worries the market usually helps support the stock market in the intermediate term.

Sometimes, however, the stock market runs into a host of worries that are more substantial than the daily or weekly angst. Right now, there are four things that worry me that could come into alignment in coming months. If some or all of these worries weigh at the same time, or about the same time, or sequentially in a short enough period, then we could see a correction similar to what happened in February. 

Back in January, I warned members and clients that volatility was set to surge and that would trigger a stock market correction. I saw the signs of what happened in quantitative and technical clues, with the knowledge that the “sell volatility” trade was unsustainably structured. Rationality was set to catch up with the stock market I surmised. 

The trade we made then was to sell into strength the last few weeks of 2017 and early 2018, and us proceeds to buy puts on the SPDR S&P 500 ETF (SPY), as well as, buy calls on the iPath S&P 500 VIX Short-term Futures ETN (VXX). Here is what I said on January 19th, 2018: 

“So, here’s where I am at. I am going to buy a few calls on the iPath S&P 500 VIX ST Futures ETN (VXX) to start a long position on volatility. Remember, this is a high risk move. We can’t own VXX for longer than a month or so on options and the actual vehicle is basically a day trading security. So, this is very speculative. However, when it works, it works big usually.

First, understand how dangerous this move is:

That’s not the sort of chart you want to see long-term.

Here’s 3 years:

Still pretty bad, but you can see where the pops were. Proportionately, we will be looking for similar. Here’s the 1-year VXX.

There really has been no volatility in the markets, despite the volatility in our heads, the past year. So the question I ask is this: are we ripe for a return of volatility? I think the answer is: maybe.

And that last word, “maybe” is where we are at again. We are maybe at a point where markets are poised to correct. Now, understand what I am saying. I am not saying a correction will occur. Nobody, absolutely nobody, can make that prediction with any certainty. However, we can handicap the probability and that probability seems much higher to me today than it has in a while. 

As we continued that trade we took profits as volatility rose: 

“If you have been following along on these iPath S&P 500 VIX ST Futures ETN (VXX), then you know that we are doing pretty well as of today. Last week I bought back the puts I had sold for about a 30% one week return. Today, I am selling the February VXX $27 calls. I got $2.75, which is about where it is now…

… If you close everything today, you’ll have made some money. I decided to only close the $27 calls because I’m trying to hit the jackpot on the $32 calls since they are free. These little trades are low risk because they are little, not because the underlying transactions are low risk, they’re not, they’re high risk. If I’m going to take high risk, I want a chance to hit the jackpot. I can sell puts on stocks and buy stocks to make low double digit gains. That’s not my goal with VXX options. The goal is to make a 100% or more. I’m not there yet, so I’m holding the $32 calls for now, heck, they’re free at this point. If I could play the lottery for free, why would I ever stop?”  

I ultimately closed the $32 calls for slightly over a 100% gain, others held on and reported gains well over 200%. Why did this work? First, it was understanding the structure of the market. Second, it was taking an educated gamble with a small amount of money and riding a trend while it was strong.

This sort of trade rarely works. That is why I rarely try it. Right now, I see a structural problem with the markets again and a four catalysts, already alluded to and which I’ll discuss below, that could cause a similar correction. 

Fewer Dip Buyers Is A Big Deal

Business Insider published a chart from Citigroup analyst Matt King. He pointed out in a note that “the wall of money driving markets has stopped.” He published this chart to demonstrate that the “dip buyers” (my term) are disappearing. 

These marginal buyers are disappearing for two reasons. First, easy money is less easy. As I discussed in the video, less QE (quantitative easing) cash is flowing to primary banks which means less money is finding its way into the stock market. Simply put, there’s less money originating from central banks to buy stocks. 

There is also the fact that there is less Chinese money flowing into U.S. assets. We saw this trend last year and it is manifesting this year as well. 

According to CNBC, in the first half of 2018, Chinese FDI into North Americadropped over 90%. In addition, Chinese firms have been divesting form North American firms, mostly U.S. at the rate of $9.6 billion so far this year. This is all on top of the tightening of currency movement under Xi Jinping. 

So, the short answer to why the market is becoming vulnerable is less central bank money and less Chinese money. 

The question some might ask is why hasn’t the stock market dropped already then, rather than chopping along? I think the answer is fairly straightforward. As I discussed in The Buyback Bubble Will End Badly, we are seeing corporations provide enough stock demand to hold equities up. 

There’s two problems with that, one obvious, the other hidden in plain site. First off, the buybacks are at a record high on the tax breaks corporations just received, particularly for companies that repatriated money. 

The second problem is more of a harbinger, a warning actually. Corporate executives are selling stock at a pace not seen in years. As provided by CNN: “Insiders dumped $8.4 billion of their shares in May and $9.2 billion in June, according to an analysis of regulatory filings by TrimTabs Investment Research.”  

So, insider executives are using the proceeds from one off tax breaks to buy back company stock while selling their stock into those buybacks. 

If that doesn’t wake you up, I don’t know what will. Old mobsters called things like that “a racket.”  Let me make this very clear, there is a group of executives who are not only selling out their companies, but are selling out investors and America too, all to get filthy rich, and it is filthy. 

Four Factors To Watch 

I have discussed four factors which are very concerning to me. Paired with a weakening structure in the stock market, we need to very wary. 

Here are the four things that concern me outlined: 

Federal Reserve: Fed Chair Powell’s insistence to raise interest rates belies a complete lack of understanding of the “slow growth forever” world I have described before. Minneapolis Fed President Neel Kashkari gets it, but he doesn’t have a vote right now. He has said we’re at the neutral interest rate right now and should not be raising. I agree. If Powell doesn’t pause the rise in interest rates he will be one of the culprits in bringing about a recession. 

A Real Trade War: We have discussed the escalation of trade tensions before. The past two weeks have shaken my belief in positive surprises. Something that has not been discussed much is that our sanctions on Iran are keeping Europe from investing in Iran, but at the same time, Russia has just committed $50 billion to Iranian oil and gas development. So, we have basically blocked our allies, while enabling a “foe” to investment in Iran. What if Europe decides not to play nice with us on trade. What if they decide it is time to push a bully back? 

An Oil Shock: This is the thing that could do the most damage short-term. Iran has threatened to block the Strait of Hormuz if it’s oil trade is hurt by U.S. sanctions. To my way of thinking, that probably means mining the Strait and disrupting oil shipments for a month or two. That is a big deal. China could preempt this if they ignore U.S. sanctions and give Iran an outlet for oil sales.

A Massive Shift In Political Sentiment

This November’s elections could have a dramatic impact on policy and market confidence. If the Democrats take the Congress or force gridlock, the Republicans could become very scared and turn on President Trump. The outcomes are completely unknown. 

Mind you, I am not advocating here (though I have a preference on the elections), I am analyzing. Markets hate uncertainty and I think we are going to get a dose of it in spades come November because a blue wave is likely coming. 

Investment Conclusion

Very simply, I am a net seller of stocks for only the 5th time in a decade. I have raised cash levels to nearly 40% in most accounts.

If you own the SPDR S&P 500 ETF (SPY) that is an easy sell right now to reduce your stock allocation. Similar large cap funds are worth selling as well. 

In this Friday’s webinar I will cover some stocks to sell. I will also offer over a dozen to sell in articles next week. There are literally hundreds of stocks that can be sold outright or at least trimmed in asset allocations right now.

Members of Margin of Safety Investing will receive two trades after Friday’s webinar for hedging mounting risks in the market. I recommend making those trades Friday afternoon.