Expected Rally and Model Reductions

August 18th, 2014
in contributors

X-factor Report 18 August 2014

by Lance Roberts, Streetalk Live

In last week's newsletter, I wrote that the markets had issued a "confirmed sell" signal. Not surprisingly, such a statement sparked more than just a few emails given the fact I DID NOT change the portfolio allocation model. In this week's missive, I want to review what I wrote in the previous analysis and clarify what you should be doing with your portfolios now.

Follow up:

From "Sell Signal Triggered,"

"...I developed a series of 4 signals to drive portfolio allocation models. However, since I do believe in long term investing, the signals are based on weekly data to smooth out portfolio volatility and position turnover.

The signals are as follows:

  • Alert Signal- Pay attention
  • Sell Signal 1- Reduce equity allocation by 25%
  • Sell Signal 2- Reduce equity allocation by 25%
  • Sell Signal 3- Reduce equity allocation by 25%"

The first signal issued last week was the "Alert Signal" which simply means that you should be aware that something is occurring in the market, and you need to pay "attention" to your money. However, there is no allocation change involved with this signal.

The second signal, "Sell Signal 1," is an official sell signal which suggests that equity exposure in portfolios should be reduced by 25%.

As you will notice, if all 3 "sell signals" were triggered it would only reduce equity exposure in portfolios by 75% of the total. I would most likely never recommend going below that level of exposure. As I stated previously:

"Fully exiting the markets leads to emotional biases that make it extremely difficult to reenter markets near bottoms. By always maintaining a small piece of exposure to equities in portfolios, it is easier to add to existing positions when the sell signals above begin to reverse back to buy signals."

The chart below shows the history of the market and the relevant 'initial sell signals.'


The portfolio allocation model, which is the same as I use for the 401k plan manager below, shows the migration of signals and their impact on the reduction of equity related risks to conserve investment capital. Missing market declines is grossly more important to winning the long-term investment game than trying to capture all the gains.


Currently, only SELL SIGNAL 1 has been issued. Therefore, the current allocation for balanced portfolios is shown to be 45% equities, 20% cash and 35% fixed income.

If you notice, the FIXED INCOME allocation never changes in the model. That is because individual bonds "mature" at face value in portfolios and maintains a principal conservation feature. (Important note: this does NOT apply to bond "funds" or other "fund type" fixed income holdings. Such investments are ONLY a bet on the direction of interest rates and must be managed just like an equity fund.)

With this understanding, I wrote an important message last week that was overlooked by the majority of individuals sending me questions about what to do with their portfolios:


The current "sell" signal does not mean "panic sell" everything you own in your portfolio and run to cash. As shown in the chart above, these initial sell signals can be short lived particularly when the Federal Reserve is still intervening in the markets.

Furthermore, by the time a WEEKLY sell signal is issued the markets are OVERSOLD on a short term basis. It is very likely, that a rally will ensue in the markets over the next week back to resistance that could be used to rebalance portfolios and reduce risks more prudently."

The chart below is a daily chart of the S&P 500 going back to the beginning of the year AND updated from last week.


There are several very important things to note.

1) Last week ALL indicators were "oversold" on a short term basis (as noted by the vertical blue dashed line.) This oversold condition provided the "fuel" necessary for stocks to rebound this week as I predicted.

2) The short term moving average (green solid line) has now crossed below the longer duration moving average that now creates strong resistance at 1940. I stated last week that:

"Any rally back towards 1960 next week should be used to rebalance portfolios. (I will provide guidelines below for this exercise.)"

The rally this week was on very light volume and the market failed to clear resistance. I will reiterate the portfolio actions from last week that you should take NOW in portfolios.

3) It will likely require a move in the markets back to "new highs" in order to reverse the current sell signal. IF this happens then I will reverse the "sell signal" accordingly and begin to rebuild equity positions in portfolios. While this could happen, my bias is that with the Federal Reserve extracting liquidity from the markets - the highs for the markets this year may have already been seen.

I made a very specific point last week that I must reiterate:

"It is very likely that the recent selloff has reached a short term bottom. A rally back to the moving averages is very likely. A failure at those levels will be very important."

The rally back to the moving average has been completed. What happens next is what is critically important. Either the market will fail and turn lower thus validating the current signal or will blast to new highs invalidating the signal and requiring a reversal of current actions.


While it may seem frustrating that an instruction to reduce portfolio risk could be quickly reversed,, this is part of the "risk management" process of portfolios. Failing to act accordingly is what leads ultimately to larger than expected losses. However, this is why the instructions are in a series of deliberate "steps" as the MARKET, not our emotions, dictates what actions need to be undertaken.

Reducing Portfolio Allocation Model

With the rally back to resistance, as predicted last week, it is now time to lower the portfolio allocation model from 100% exposure to 75% exposure as dictated by our portfolio signals.

Here is the math:

  • Portfolio = 60% Equity and 35% Bonds and 5% Cash
  • Reduction = 60% Equity x .75% = 45% Equity
  • New Portfolio Allocation: 45% Equity, 35% Bonds and 20% Cash


Here is the order of actions to be taken to align your portfolio with the model. REMEMBER, these are tweaks to current portfolio allocation models, not wholesale liquidations.

  • Sell "laggards" and "losers" in FULL. These are positions that have performed very poorly relative to the markets. Positions that are out of favor on the runup - tend to fall faster in declines.
  • Trim positions that have been big winners in your portfolio, back to their original portfolio weightings. (ie. Take profits)
  • Positions which have performed inline with the market should also be reduced back to original portfolio weights.
  • Move trailing stop losses up to new levels.
  • Review your portfolio allocation relative to your risk tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

These are suggestions on how to align your portfolio with the current level of elevated risks. However, it is also important to remember that currently the Federal Reserve is still pushing liquidity into the markets, therefore, a surge to new highs is not entirely out of the question.

What if it doesn't?

By taking some precautionary actions we can reduce overall portfolio risk and protect our investment capital against a potential decline. If the correction does NOT happen, we simply put the excess cash back to work at less overbought levels in the markets.

How you personally manage your investments is up to you. I am only suggesting a few guidelines to rebalance portfolio risk accordingly. Therefore, use this information at your own discretion.

Please feel free to send your comments or questions to me at lance@stawealth.com or tweet me.

Next week will tell us much about where the markets are headed from here.

Have a great week.

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