October 20th, 2014
by Lance Roberts, StreetTalk Live
Okay, showing my age just a bit but "The Clash" released that tune in 1982 on their album "Combat Rock" and featured Mick Jones on lead vocals. It became the bands ONLY number-one single on the UK singles chart - a decade later. In 2004, it was ranked at 228 on the Rolling Stone "500 Greatest Songs Of All-Time List." Talk about delayed gratification.
The song jumped into my head this morning as I sat down to write this missive as this is currently THE question. Is this just another in a long series of "buy the dip" opportunities, the beginning of a more major intermediate term corrective action, or the initial "bow shot" of the next financial crisis?
Unfortunately, we won't know the answer to that question until after the fact that is why I have been discussing portfolio rebalancing over the last three (3) months in anticipation of this event. To wit:
"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.
2) Losing positions should immediately be sold in their entirety.
3) Interest rates have fallen as anticipated this year. This has been a boon for bond-related investments.
4) Reduce weighting to “high yield” or “junk bonds.” 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
These portfolio actions should have buffered some of the recent decline in the markets.
Furthermore, my call to "buy bonds" last year in anticipation of lower interest rates has also performed exceptionally well as yields plunged during the "flight to safety" as I stated would occur.
"For all of these reasons I am bullish on the bond market through the end of this year. Furthermore, with market volatility rising, economic weakness creeping in and plenty of catalysts to send stocks lower - bonds will continue to hedge a long-only portfolio against meaningful market declines while providing an income stream."
"I have been very vocal since the beginning of June that now is a great time to be adding bonds to portfolios. There are several fundamental reasons for my belief that the recent rise in interest rates was more related to a short-term liquidation cycle rather than a shift in global economic sentiment."
And most importantly I cited three reasons why interest rates would fall, however, most importantly:
"Money flows into U.S. Treasuries will likely increase as the slowdown in European, and Asian, economies seek safety and stability of the U.S."
Of course, that is exactly what we have seen occur as China has slowed more markedly than expected; Japan has fallen into recession, and the Eurozone is on the brink of one.
The reason for the history lesson is to provide an understanding that by the time a change in market dynamics has occurred, it is too late to take advantage of it. This is a problem with being a contrarian investor, while identifying major issues in advance of their occurrence is the key to successful investing; it is also a timing problem. This is a point that Howard Marks has eloquently stated:
"Resisting - and thereby achieving success as a contrarian - isn't easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while.(That's why it's essential to remember that 'being too far ahead of your time is indistinguishable from being wrong.)
Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one - especially as price moves against you - it's challenging to be a lonely contrarian."
So, what now?
Sell Signals Are In
Last week I stated:
"The markets are very oversold short-term which means that we should NOT "panic sell" at the moment. However, as I have recommended repeatedly over the last several weeks, on a bounce it is advisable to [rebalance portfolios].
Once the market does bounce I will likely reduce the portfolio allocation model by 25% depending on the strength and duration of that bounce. More importantly, a failure of the market to obtain a new high will likely indicate that a more immediate top is being formed with substantially more downside to come.
It will be critically important to pay attention to your portfolio in the coming weeks as things could begin to evolve quickly."
That is where we are currently. As shown in the chart below, the market deterioration has now confirmed the "signal limbo" that we have wrestled with over the last couple of weeks.
As shown, the two lower indicators are the "buy/sell" instructions. Last week, the initial sell signal was triggered, but I suggested NOT taking action at that time because, on a "short-term" basis, the markets were oversold. I suggested waiting for a bounce to resistance to begin taking further actions in portfolios outside of the rebalancing instructions I have issued over the last couple of months.
With the initial sell signal in place, it is time to take further actions in portfolios for now. As shown, I am reducing the model by 25% currently and suggesting using the reflex bounce in the markets to underweight portfolios temporarily.
If the second signal confirms in the days or weeks ahead, it will require a further reduction in the model.
What To Look For
As shown above there are three key levels of resistance that the markets are going to struggle with going forward particularly if the Federal Reserve does end its bond purchases next week.
1900 - is the previous psychological support which is now resistance. This is a good level to reduce major laggards or losers in the portfolio. A little "house cleaning" will free up cash for reinvestment at a later date.
1925 -This is the long-term moving average that has held the bullish uptrend since 2012. This moving average is now major resistance for the market and a failure at this level will signal that the correction is not yet complete. Reduce more towards target levels if this level is reached.
1960 -This is the short-term moving average which is also now resistance. If the short-term moving average crosses below the long-term, we have a real problem. I seriously doubt that the markets can make it above this level in the near term.
However, should the markets somehow find the strength to surge to all-time highs from here, which is a possibility, then the cash raised from the rebalance and portfolio cleanup can then be reallocated back into portfolios.
"While I am not stating that the 'polar icecaps' are melting and that we are about to experience 'tidal destruction'; I am suggesting that the potential for further declines in the market are a significant possibility. Therefore, reducing portfolio risk in the short-term will provide capital to reinvest at a more favorable point in the future. If the market surges back to new highs, and re-establishes the previous "bull trend," then the capital raised can be reinvested with greater confidence of a continued advance.
There is little risk in practicing some form of portfolio 'risk management.' The real risk is doing nothing and then spending the next advance in the market making up previous losses. That has been a successful investment strategy 'nowhere, never.'"
Reflex Rally - Does Not A Bull Market Make
Thursday night on "Streettalk with Lance Roberts" I stated:
"It is very likely that the markets will rally on Friday. I would not be surprised to see the markets up 30 points or more."
At the time of this writing, the market is currently up 31 points.
This rally is an oversold, short-covering and options rebalancing rally. This is not the resumption of the "bull market" and will likely fail at one of the three important resistance levels as shown above.
The chart below is a very short-term daily chart that shows the relative overbought/sold condition of the market. When the market is extremely oversold, it has "fuel in the tank" for a rally. As the market rallies that "fuel" is consumed quickly and can leave the markets "running on empty" without enough thrust to crest the top of the hill. This is where the rallies fail and the corrective process continues.
As you can see, the market is currently as oversold on a short-term basis as it has been previously. However, the difference THIS time is that the market has violated its long-term bullish trend support. As stated above, this line becomes extremely difficult resistance. The market will likely fail at this level, sell-off and begin either basing and consolidating, if the bull market is going to continue, OR will develop into a much deeper intermediate term correction.
Important: Both of these outcomes will be "buyable" opportunities at some point in the future. It is just not now.
It is suggested that you maintain patience during this process. The only people suggesting that you "buy" right now, using some form of skewed "valuation" argument, are those trying to sell you a product or service.
The worst offenders are those that have been preaching the "buy and hold" mantra. Now that they are getting "monkey hammered," they have resorted to "well, you can't time the market."
You can actively manage portfolio risk. Is it going to be right 100% of the time? Of course, not. However, it will be right more often than not, and most importantly, the risk management process protects you from periods of massive capital destruction.
"If price is a primary component of many of the major fundamental valuation measures, (i.e. Price to Earnings, Sales, Book, Dividends, etc.), then why wouldn't you pay primary attention to what price is doing?"
We will see what next week brings and provide further instructions from a clearer vantage point.
Have a great week.