Last week I wrote:

"I want to discuss the current status of the market and the potential impact to portfolio allocations.  As shown in the chart below, the market has held onto its critical moving average since December, 2012 when the Fed initiated its latest liquidity intervention program (QE3)."

"Importantly, I have noted when the markets have reached short-term oversold conditions (yellow highlights). For investors, it is always important NOT to PANIC SELL market declines and utilizing some form of technical analysis can help avoid doing so."

Furthermore, I laid out some basic portfolio management guidelines to be followed stating:

"There is NO WAY currently to tell if this is just another in the long series of 'dips' that we have seen since the onset of QE3, or if this is the beginning of a more severe decline. However, there are two points that need to be addressed:

1. The market, while currently oversold, has not retraced back to its long-term moving average. Moving averages, as discussed in the past, act like gravity and pulls on prices. While it is not required that the markets retrace all the way back to the moving average, it is a healthier entry point when they do.

2. The oversold condition suggests that the markets market “bounce” on Friday will likely last into next week. This bounce SHOULD be used to rebalance portfolios by taken the following actions to reduce overall risk:

• Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.
• Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.
• Retain cash raised from sales for opportunities to purchase investments later at a better price.Investment Rule: Sell High, Buy Low

3. Review your overall allocation model and adjust weightings to realign it with your longer term goals.

These actions will help reduce the risk in the event that the current sell-off begins to mature into a bigger decline."

So, for now at least, the "bulls" remain in charge of the current rally that begin the Federal Reserve's market interventions in late 2012. The seemingly inexhaustible rise, despite rising geopolitical tensions, extremely cold weather and weak economic data, has defied logic and lulled market participants into an excessive state of complacency. In fact, the bulls continually argue that the "retail" investor has yet to jump into the markets that will keep the bull market alive.

The chart below suggests that they are already in. At 30% of total assets, households are committed to the markets at levels only seen near peaks of markets in 1968, 2000, and 2007.

Furthermore, the number of individual and professional investors that are bearish on the financial markets currently is at some of the lowest levels on records. The dearth of "bears" is a significant problem. With virtually everyone on the "buy" side of the market, there will be few people to eventually "sell to." The hidden danger is that with much of the daily trading volume run by computerized trading, a surge in selling could exacerbate price declines as computers "run wild" looking for vacant buyers.

The risk, of course, is that when the markets do begin a mean reverting process, the decline could be much sharper than most currently anticipate. However, no one knows exactly when that process will occur which is why we must read the "trail of bread crumbs" that the market leaves behind. 

Follow The Trail

One of those breadcrumbs, as I have been discussing lately, is that the leadership of the market has narrowed significantly. While the correction in the S&P 500 has been rather mild, the real correction has occurred in the mid, small and international equities as money has rotated into mega-large cap stocks for safety.

(The chart above shows each index on a performance basis relative to the S&P 500 since mid-August.)

This type of leader compression is historically seen near major market peaks. While this does not mean that the markets are going to sharply decline tomorrow, it does suggest that the risks of a more severe correction is rising.

Furthermore, as Walter Murphy noted recently:

"NYSE declining stocks exceeded winners by 5:1 while the up/down volume ratio was bearish by a more robust 11:2 margin.

In recent comments, we thought that last week’s breach of the 1978 double-bottom was a warning for lower lows. The importance of that breakdown was brought home today for at least four reasons.First, the S&P closed below what has been the dominant intermediate uptrend line from the November 2012 low. Second, the percentage of NYSE stocks below their 200-dma is below 45% for the 1st time since November 2012. Third, the decline has an impulsive look to it. Finally, intermediate to longer term Coppock oscillators are deteriorating for a majority of indexes and stocks."

With both the number of S&P 500 stocks above their 200 day moving average and on "bullish buy signals"deteriorating since mid-2013, the increasing divergence of prices from the underlying performance is cause for concern.

I have also noted that the market has broken below the accelerated bullish uptrend, and a normal 38.2% correction would pull the index towards 1750 currently. While such a decline currently seems beyond the grasp of reality, it would be a healthy 13% retracement from the peak. However, since such a correction has not been witnessed since 2012, it will feel far worse for most individuals who have become overly complacent during the market's accelerated advance.

As stated above, while the current selloff may be over short-term, the deterioration in market internals suggest that the correction is not yet complete. With the Federal Reserve extracting liquidity completely by the end of the month, market participants will be left with just momentum and fundamentals to drive markets higher from here.

The Math Of Forward Returns

I just wanted to make a quick note about what is meant by "based on current valuation levels; future returns will be much lower than in recent history."

That statement of "lower future returns" is often very misunderstood by individuals. At any point, future returns can be estimated based on the price paid today for an investment. Based on current valuations of near 27x earnings (using Shiller's CAPE), the future return of the market over the next decade will be in the neighborhood of 1.5%.

This DOES NOT mean that the average return of the market each year over the next decade will be 1.5% each year. What it does mean is that there will be a greater propensity of loss going forward during a rather volatile series of annual returns.  For example, the returns over the next decade might look something like: 5%, 6%, 8%, -35%, 15%, 18%, 8%,6%,-17%. While 8 out of 10 years note positive returns, the two drawdown years reduce the average rate of return to just 1.5% annually. Of course, as discussed previously, when declines in markets occur, investors generally "panic sell" near market lows and do not return until near the next market peak. Such emotionally driven behavior makes forward long-term returns substantially worse.

Plunging Oil Prices Hit Energy Stocks

The recent spike in the US Dollar has impacted many areas of the commodity complex but has been particularly nasty to oil prices. There are many issues weighing on oil prices currently from reduced demand due to globally weak economies, a reduction in driving miles, continued improvements in fuel efficiency and a rising supply/demand imbalance due to the explosion of domestic "fracking."

Recent estimates from of demand growth from OPEC, the U.S. Energy Information Administration (EIA) and the International Energy Agency (IEA) place demand growth at 900,000 to 1.05 million barrels a day in 2014, and rising to around 1.2 million to 1.3 million barrels a day in 2015. The problem is that supply growth is projected to surpass that demand by rising to 1.6 million barrels a day in 2014 and 1.3 million barrels a day in 2015. Most all of that supply growth will come from fracking in North Dakota’s Bakken, and the Permian Basin and Eagle Ford plays in Texas.The Dollar Spike And Market Corrections.

While fracking has been a boon to U.S. energy stocks the costs of drilling wells has been climbing, and the decline rate of production from fracking is extremely steep. This year independent oil producers will spend roughly $1.50 for every $1.00 of revenue they get back. Furthermore, it will take roughly 2,500 new wells a year just to sustain the output of 1 million barrels a day in the Bakken shale alone. (As a comparison Iraq can do the same with 60 wells)

If the confluence of the rising dollar and supply/demand imbalances push oil prices below $85/bbl the profitability of drilling new wells becomes much less attractive and existing revenue streams for producers will deplete fairly rapidly. The poses a significant risk to energy-related investments due the recent deviation in price performance from the underlying commodity.

As shown, the performance of energy stocks has historically been closely correlated with the performance of oil prices with the exception of the liquidity-driven asset inflations in 2007 and 2012-13.

Currently, energy-related investments are under pressure by falling energy prices and the rising dollar. As discussed above with reference to "portfolio management," energy is an area that is ripe for "pruning and weeding" on any bounce. There is much "hope" built into energy stocks currently but there is mounting evidence that fracking may not be the "nirvana" most are expecting.

U.S. Dollar Spikes And Historical Market Impacts

As I discussed recently, the implications to investors of a strongly rising U.S. dollar is important as it has a negative effect on stock market prices. One of the last remaining last remaining footholds of the "bulls" has been the strength in corporate profits.

"With valuations now expensive, interest rates set to rise and yield spreads narrowing as the Fed removes monetary liquidity, the risks to markets have risen substantially since the beginning of the year. This increase in risk, as the Federal Reserve extracts support from the markets and economy, is being reflected by the surge in the dollar as 'safety' is sought. This has occurred each time QE has been extracted, and the surge in the dollar has been historically associated with market corrections."

Sigmund Holmes recently penned similar thoughts:

"The dollar also rallied in the [2011] although it didn’t really get started until later in the correction in September and October. This time the dollar has had a major rally even before the official end of QE. The end of QE 2 also ushered in the Euro crisis and once again, albeit to a lesser degree, we are seeing problems in Europe. One final similarity is that the economic data going into the correction was fairly good as it is now. It was only after the correction and the onset of the European problems that US economic data started to deteriorate. One can’t help but think of George Soros’ theory of reflexivity whereby it is markets that move the economy rather than the other way around.

We’ll see if this continues to develop in a similar fashion to 2011. I have a sneaky suspicion that it may actually turn into a bigger correction. There are a lot of people in this market who really don’t want to own it and any hint of losses may be enough to send the hedge fund and mutual fund traders to the door in an effort to protect the old year end bonus."

The spike in the U.S. dollar is a drag on U.S. exports that comprise roughly 40% of domestic profits. Again, there is much "hope" built on sustained growth in U.S. profits as shown in the chart below. (Read: Analyzing Earnings Q2 2014)  

The reality is that the trend is historically unsustainable and eventually will lead to a mean-reverting event in asset prices as fantasy collides with reality. The loss of capital, when it occurs, will be much greater than most are currently capable of comprehending. Again, this why a disciplined process of "portfolio management" is necessary to protect capital against such catastrophic losses.

Final Note:  I heard an advisor say recently that major stock market declines only happen during recessions. While he is correct, here is something worth pondering:  "Did a recession cause the correction, or did the correction cause the recession?"