Smart Money Briefs January 12, 2016 By: Jerry E. Tuma, MS, CFP

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1 Page Special Report Smart Money Briefs January 12, 2016 By: Jerry E. Tuma, MS, CFP Start of the Bear As we enter 2016 it s readily apparent that all is not right with the world, at least as it pertains to the world s economic growth engine, China, and the U.S. stock market. It remains our belief that the stock market in the U.S. has now topped, and the loss of momentum has become increasingly apparent. Our favorite momentum indicator (shown on page 2) has historically proven to be a very accurate guide to understanding and identifying big picture moves in the stock market. While certainly no indicator is perfect, the monthly MACD is the closest thing to it, in my opinion, for long term results. As you can see, the market appears to have rolled over, and I believe it is just now entering a major bear market, which will likely last about 18 months and could easily take the S&P 500 down by 50%. Jerry E. Tuma, MS, CFP Topics: Start of the Bear Psychology of the Bear Since the U.S. economy is still growing, albeit in slow growth mode, the question naturally arises why such a bad bear market? The answer, again is because it s mostly all about China, as we pointed out in our 2016 Year in Preview ( in December. For more than a decade China has been the primary growth engine of the world and for the time being appears to have run off the tracks. Most of the other train cars (countries which supply China with goods, commodities, etc.) are now piling up behind them. Magnitude of the Bear While I think it is unlikely that China will experience a hard landing or true recession -- (by textbook definition -- two consecutive calendar quarters of negative GDP), China will likely drop to a 4% growth rate. This represents enormous change for both China and the rest of the world, as China has recently experienced many years of double digit growth. One thing is certain and that is that you never know ahead of time what bad stuff is going to hit the economy or markets once a major top is in place. But we do know that stocks are very expensive, overvalued and highly leveraged, and as we ve said, leverage bites on the way down. Recognizing that no indicator is perfect, in looking at the monthly MACD (page two) you re attempting to get a view from 30,000 foot altitude. In other words you re trying to get the picture of the entire cycle, both bull and bear. Changing the Way America Thinks About Investing. This chart shows the market going back to 1995, and you can clearly see 3 distinct waves; the bull market, followed by the bear, then the bull market followed by the bear. Now we ve seen another big run which began in early 2009 and appears to be rolling over. The MACD is what we refer to as a momentum indicator, in other words it is attempting to show (for both bull and bear markets) which direction the momentum of the market is moving.

2 Page 2 Monthly MACD With Bull and Bear Cycles On the chart we have marked with a vertical line highlighted in yellow approximately where the MACD indicator was in the previous two bear markets. Based upon the previous cycles it would appear that we have just now entered the bear and probably have 18 months +/- left to go. Note: The similarity of patterns in the previous bull and bear market cycles does not guarantee that anything will be the same in the future. This chart is designed to show potential risk in the market. To illustrate the MACD, assume that I am in a plane taking off down the runway, about to fly to Pennsylvania, (which I ll be doing later this month) with the airplane expected to cruise at 30,000 feet. Should the pilot suddenly pull back the throttle at 15,000 feet (giving the jet less fuel) two things will occur. First, the plane will continue to rise for a while, purely based on its momentum. But secondly unless the pilot pushes the throttle forward again, the plane will eventually roll over and begin to fall. I m using this analogy to illustrate how the MACD works. Most of the time (certainly not in all cases) the MACD will peak out first, prior to the market. In other words it often serves as a leading indicator of the stock market when looked at on a big picture basis. As you can clearly see from the chart in the previous two bull markets the MACD either peaked early or coincident with the market and you can also see that the indicator continued losing momentum for awhile even as the stock market stayed up. Just as an airplane will continue to rise for a while due to momentum, the market in 2015 has done likewise. But unless momentum moves back up the plane will eventually roll over and drop. So, in interpreting this, my view is that we have clearly seen a long term top in the U.S. market and our favorite momentum indicator, the monthly MACD, shows no sign of bottoming any time soon. Historically it is likely that the MACD will fall well below zero into the -100 target range, similar to the two previous bears. This tells us that this bear market, if indeed we are in one, has a long way to go.

3 Page 3 Psychology of the Bear Historically bear markets have typically had 3 distinct emotional or psychological phases. Phase I - Is generally referred to as the denial phase. At this point, at the beginning of the bear, stocks have been going up for a number of years and no one wants to believe that bad things are about to happen. We are emotionally in denial. According to behavioral economics, people tend to subconsciously screen out information which does not agree with their desired outcome. This is known as confirmation bias. In other words they unintentionally screen out bad news in the HOPE that it will all go away and everything will turn out just rosy. However, once a bear market has started, Phase I is nowhere near the bottom. I believe we have just entered Phase I of the current bear market. -20% Bottom -20% Bottom Where did the Bear Start?

4 Page 4 Phase II Is known as the recognition phase. At this point there is a sudden awakening to the fact that we are now in a bear market and that bad things are happening. Generally speaking, the media tends to hold to a formula that says that it s not an official bear market until the market has fallen by at least 20%. But in my opinion, this rule of thumb is ridiculous assuming that it is not a bear market until it drops 20%. If you will look at the two previous bears, you ll note that the top is circled, which is actually the beginning point of the bear, long before the media officially recognizes it. The recognition phase is normally marked by a deer in the headlights emotional reaction by investors. It s like oh no, this really is a bear market, now what!?? At this point investors are likely being told that the best thing to do is to hold on and ride out the storm. We know from Behavioral Economics that the average person hates loss somewhere between 2 and 2 ½ times more than they enjoy commensurate gains. There is a built in psychological buffer which people use to shield themselves from potential pain. But if it s a major bear market this won t work because it s about to get worse (Source: Why Smart People Make Big Money Mistakes, Gary Belsky & Thomas Gilovich; Simon & Schuster; 2000). In this phase, investors will be frightened, but they will also be afraid to sell because they might lock in their losses and thus they usually do nothing. From here you go into Phase III. Phase III is known as the capitulation phase. This is the phase where panic sets in as losses have continued stacking up for months or years and a sense of survival kicks in. Investors often reach an I can t take this anymore phase, essentially seeing their financial life flashing before their eyes. Thus many panic and bail out, usually at exactly the wrong time. While past performance is never any guarantee, these psychological patterns go back as far as we can tell throughout history and are now being well documented through Behavioral Economics research. Magnitude of the Bear Typically the magnitude of the bear market has more to do with the amount of leverage (or debt) in the stock market, plus how expensive or overvalued stocks are. How good or bad the economy is, frequently constitutes a secondary issue. How so? It is possible to have a severe economic downturn combined with a mild bear market for stocks if stocks are not highly overvalued or overleveraged. We experienced this exact scenario from as that period was the worst recession -- up until that point -- since the Great Depression, yet stocks only went down about 25%. The converse is also true, during the timeframe the economy experienced a very mild recession but stocks got clobbered with the S&P 500 down almost 50% and NASDAQ down almost 80%. While this might sound puzzling at first, it fits common sense. The issue is how expensive stocks are when the bear market starts and how highly leveraged (in debt) is the market at that time. So, if I m right in my assessment that the U.S. economy will experience a mild economic downturn that does NOT necessarily mean a mild bear market for stocks, as stocks are very expensive right now and margin debt sits at the highest level of all time (please refer back to 2016 Year in Preview special report at

5 Page 5 So, in summary I believe that Phase I of the bear has begun, but I also believe that the vast majority of people will not recognize this fact until the media proclaims it officially a bear market, which won t happen until the market has gone down some 20% from the 2015 high. If I m guessing, there is a good chance we ll get a bounce this spring due to IRA funding season with Phase II likely starting in the second half of The likelihood is high, in my opinion, that this will be a severe bear market for stocks in the U.S. and rest of the world, plus a severe recession in emerging markets, due to their debt bubble, which will likely take years to unwind (please see 2015 Year in Pictures and 2016 Year in Preview at As you can see in this newsletter, Jerry believes we have reached a market top. Today, many important indicators are flashing red. Perhaps last time your portfolio went down you promised yourself that you weren t going to ride it out next time. This may prove to be the best time to take us up on our complimentary review of your finances. Call to schedule an appointment. All technical analysis and resulting conclusions and observations are based upon historical chart formations and patterns. Therefore, observations are a function of each analyst s interpretation of the charts and also a function of mathematical probabilities. In effect, technical analysis is a study in probabilities. What happened x number of times in the past per a particular chart pattern does not mean it will always recur in the future. It logically follows that historical precedent does not guarantee future results. The Cornerstone Report is published by Cornerstone Financial Services, Inc., a Registered Investment Advisor. The opinions and statements made within this newsletter should not be construed, directly or indirectly, as an offer to buy or sell any securities mentioned herein. Principals and/or agents of Cornerstone Financial Services, Inc. may or may not have positions in any securities or investments mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Statements and opinions are based upon sources of information believed to be reliable; however, accuracy and completeness cannot be guaranteed. No assurance can be made that recommendations contained herein will be profitable or will be equal to past results. Past performance is no guarantee of future results.

6 Page 6 This newsletter is designed to provide general economic and market information and should not be construed to comprise individual or specific counsel concerning investment, tax or legal considerations. Material discussed herewith is meant for general illustration and/or informational purposes only, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. Please consult your financial advisor(s) for specific advice pertaining to any and all areas of financial planning. Please remember: Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (including the investments and/or investment strategies recommended or undertaken by Cornerstone Financial Services) will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Cornerstone Financial Services, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of Cornerstone s current written disclosure statement discussing our advisory services and fees is available for review upon request. A complete history of Cornerstone s market calls is available at the Cornerstone office upon request. All technical analysis and resulting conclusions and observations are based upon historical chart formations and patterns. Therefore, observations are a function of each analyst s interpretation of the charts and also a function of mathematical probabilities. In effect, technical analysis is a study in probabilities. What happened x number of times in the past per a particular chart pattern does not mean it will always recur in the future. It logically follows that historical precedent does not guarantee future results. *Global or international investing involves special risks, such as currency fluctuation, political instability, and different methods of accounting and different reporting requirements. *MACD is the difference between a security s 26-day and 12-day exponential moving averages. * The S&P 500 is an unmanaged index comprised of 500 widely-held securities considered to be representative of the stock market in general. You cannot directly invest in the S&P 500 index. * The NASDAQ Composite Index is an unmanaged, market-weighted index of all over-the-counter common stocks traded on the National Association of Securities Dealers Automated Quotation System. You cannot directly invest in the NASDAQ Composite index. * The Russell 2000 is an unmanaged index comprised of 2000 smaller company stocks and is generally used as a measure of small cap stock performance * The Dow Jones Equity REIT Index is a capitalization-weighted index composed of 114 US listed Equity real Estate Investment Trusts (REITs) comprising 95% of the equity REIT investable universe * Small Cap stocks may be less liquid and subject to greater price volatility than large cap stocks. * Sector investing may involve a greater degree of risk than investments with broader diversification. * Investing in securities involves risk including the loss of principal invested. Past performance is no guarantee of future results. based on adverse economic and regulatory changes. As a result, the values of real estate may fluctuate resulting in the value at sale being more or less than the original price paid

7 Page 7 * The price of commodities, such as gold, or oil is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility. In addition, investing in commodities often involve international investing in emerging markets, which involve significant risks. Please consider all of these risk factors before making a decision to invest in any product. * Investments in real estate have various risks including the possible lack of liquidity and devaluation For investment advice or portfolio review, call (800) There is no charge or obligation for initial consultation. Jerry Tuma, David McCord, and other representatives of Cornerstone Financial Services, Inc., (CFS), are registered representatives of and offer securities through Independent Financial Group, LLC., (IFG), a registered broker-dealer, member FINRA/SIPC. Advisory Services offered through Cornerstone Financial Services, Inc. (CFS), a Registered Investment Advisory firm. CFS and IFG are not affiliated entities. Cornerstone Financial Services, Inc Quorum Dr. Suite 785 Dallas, TX Jerry E. Tuma, MS, CFP, Senior Editor David McCord, CMT, Contributing Editor