Investors Wake Up As Volatility Pops

August 5th, 2014
in contributors

X-factor Report 04 August 2014

by Lance Roberts, Streetalk Live

For weeks, complacency has ruled. Despite geopolitical uprisings, weak economic data or continued reductions in monetary policy, nothing has "ruffled" investor's feathers, well, until this past week.

Follow up:

On Thursday, the culmination of events occurred that sent investors scurrying for cover and stocks falling in the biggest one-day drop in months. That decline also reversed all of the gains in July, which makes it only the second negative month of the year since January.

Of course, I have reiterated each week in the missive for weeks now that the markets were much extended, and complacency high, which should give you some concern. I have also repeatedly recommended pruning and weeding portfolios. From last week's 401k Plan Manager:

"Therefore, with the markets extremely extended at the moment this is a good time to rebalance portfolios back to target weights by selling laggards and trimming winners. This includes bond holdings that are now likely overweight from their outsized gains this year."

The chart below shows the volatility index (VIX), which is a measure of "fear" and "complacency" in the financial markets, as compared to the S&P 500. As you can see, spikes in volatility are primarily associated with declines in the market. The sharper the spike, the larger the related decline.


In the next chart, I have inverted the S&P 500 to show a little clearer picture of the close correlation between the two the two measures.


Importantly, volatility measures are a COINCIDENT indicator at best. In other words, volatility measures alone are not useful by themselves as a forward looking indicator of future market performance.

Even with the recent spike in volatility, the VIX is still confined at levels that have been associated with this current bull market advance since the beginning of 2013. With the Federal Reserve still pushing $25 billion in liquidity each month into the markets, the current advance could remain intact for a while longer.

However, from a risk management perspective, this is a good time to do a review of the technical indicators to judge the current risk/reward of either having money invested in the markets OR potentially adding to, or adding new, investments.

A Technical View

In the long run, it is fundamentals that drive returns. In other words, the price you pay today for a future stream of cash flows will determine your gain or loss over time. Pay too much and you lose.

However, in the short term, it is only price that matters. This is why I focus so heavily on technical analysis for shorter term "risk" management as price is simply a reflection of buyer and seller "psychology" in the present.

The good news is that, despite plenty of headwinds from geopolitical events, ongoing tapering of bond purchases by the Federal Reserve, which is reducing liquidity, and weak economic data the markets have not experienced a significant decline. After breaking out of the consolidation range earlier this year, the markets have pushed higher. As shown in the chart below, the current pullback brought the market back to the current, very short term, bullish uptrend. However, it would not be unreasonable to suggest that the market could retest support at 1880.


From a bullish perspective, such a pullback would allow the market to be oversold enough on a very short-term basis for a trading opportunity back to old highs.

One caveat here. With the Federal Reserve currently on the path of extracting liquidity from the markets, and threatening to begin raising interest rates next year, I suspect that we may have seen the top of the market for this year. As shown in the chart below, the high correlation between the expansion of the Fed's balance sheet and the markets supports this assumption.


However, with that being stated it is important to review the BUY/SELL indications that drive the longer term portfolio allocations.


While the market has been volatile this week, no "SELL" signal has been issued as of yet. HOWEVER, if the market fails to rally next week, it is HIGHLY probable that the initial "WARNING" signal will be triggered.

Also, the market is still closer to OVERBOUGHT levels, the top part of the chart, than OVERSOLD, which suggests that further weakness could develop. As I will discuss in the 401k plan manager, this continues to be an excellent opportunity to "prune and weed" the garden particularly as we head into two of the weakest months of the year historically speaking.

Internal Deterioration

The following charts which measure the internal "health" of the market are also suggesting an increased level of caution.

(NOTE:The term "increase the level of caution" does NOT mean go out and sell everything you own to buy gold. It simply means "pay attention" to your money and your "risk management" protocols. If you DO NOT HAVE risk management protocols in place, or your advisor, this is a problem you should immediately address.)

The chart below is the number of stocks on bullish buy signals. The deterioration of stocks on "buy" signals as the market is rising is called a "divergence." Such divergences typically do not end well.


The same goes for the number of net new highs in the market. Historically, divergences in net new highs have signaled a market that is closer to the end of the advance than the beginning.


The "canary in the coal mine" is the recent gross underperformance by the "momentum stocks" over the "last year. Most small capitalization stocks share a common attribute which are very low outstanding share floats. These stocks are excellent candidates for high-frequency trading programs that can capitalize on "low float stocks" to push prices significantly higher. That capability, combined with massive amounts of liquidity via the Fed, has pushed these stocks into the stratosphere. However, as shown in the chart below, these issues are now grossly underperforming the broader market. This is typical of a late stage market advance and something that should be paid attention to.


One other issue that I am watching is the current downturn in the biotechnology sector. This action, as shown below, was a precursor to broader market corrections. Currently, the correction in the biotechnology sector has accelerated against the S&P 500 index.


During the last five years, it has not mattered much where you invested your money. The great thing about highly correlated markets, as shown in the next chart, is that everyone is a "freak'in genius"when the tide is rising.

Market-Perf-Chart 7-080114

While it is clear that small-cap and mid-cap stocks have outperformed the S&P 500 over the last year, while international and emerging markets have lagged. However, what is important to notice is that the rise and fall of the various markets are highly correlated.

The dark side to highly correlated markets, when the eventual correction does come, is that it leaves investors with no place to hide.

The current levels of margin debt, bullish sentiment, and institutional activity are indicative of an extremely optimistic view of the market. The chart below shows the most levels of margin debt converted to investor positive/negative net worth. Currently, investors have the most negative net worth EVER recorded.


Again, none of the data analyzed so far explicitly states that investors should exit the markets. However, what is crucially important to remember is that margin debt "fuels" major market reversions as "margin calls" lead to increased selling pressure to meet required settlements.

Unfortunately, since margin debt is a function of portfolio collateral, when the collateral is reduced it requires more forced selling to meet margin requirements. If the market declines further, the problem becomes quickly exacerbated. This is one of the main reasons why the market reversions in 2001 and 2008 were so steep. The danger of high levels of margin debt, as we have currently, is that the right catalyst could ignite a selling panic.

No Change To Portfolio Models Yet

There are some very early indications that we need to pay much closer attention to our portfolios, HOWEVER; there are no violations as of yet on a technical basis that require immediate action.

With that said, it is also important to be aware that we are entering into the month of August which, as shown in the chart below, is one of the worst performing months of the year with a 50/50 chance of being a negative return month.


It is from that viewpoint that you should consider taking the following actions within portfolios as a "hedge" against further potential deterioration or disruption in the financial markets:

1) Positions with outsized gains for the year should be reduced to original portfolio weights.

(i.e. if the position was initially 5% of the portfolio when it was purchased but is now 7%, reduce back to 5%. Profit taking.)

2) Losing positions should immediately be sold in their entirety. If they underperformed while the markets were rising, they are likely to outperform during a decline. Underperforming positions are a drag on the portfolio. Set aside emotional biases and sell positions that are not working as planned.

3) Interest rates have fallen as anticipated this year. This has been a boon for bond-related investments. These positions are now likely overweight relative to their original position sizes. Rebalance back to portfolio weights as interest rates are due for a bounce that will provide another "buy" point in the near future.

4) Reduce weighting to "high yield" or "junk bonds." While the "chase for yield" has continued for quite some time, the risk of being invested in these areas is now extreme. Time to "take the money and run."

5) Cash raised from rebalancing should just be held pending the next buying opportunity.

"In investing, what is comfortable is rarely profitable." - Robert Arnott

"At times, you will have to step out of your comfort zone to realize significant gains. Know the boundaries of your comfort zone and practice stepping out of it in small doses. As much as you need to know the market, you need to know yourself too. Can you handle staying in when everyone else is jumping ship? Or getting out during the biggest rally of the century? There's no room for pride in this kind of self-analysis. The best investment strategy can turn into the worst if you do not have the stomach to see it through."

Have a great week.

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