January 5th, 2015
by Lance Roberts, Streetalk Live
Last year came and went but not without a good bit of excitement and intrigue along the way.
- The rise of ISIS in the Middle East
- The death of several famous celebrities including the witty Joan Rivers
- The end of the Federal Reserve's QE campaign
- The unexpected declines (except by me - here and here) in oil prices and interest rates
- Several scandals from the White House
- A surge in racial tensions
- Three major Asian airline catastrophes
- The potential start of the next "cold war" with Russia over their actions towards the Ukraine
- A sweeping win by Republican's in the mid-term elections
- A failure by Republican's to uphold their promises to the American voter
- A stock market that gained amid a pickup in volatility
- A surge in the US dollar as deflationary pressures swept the globe
- A steady stream of employment that failed to reduce the labor force slack
- An unprecedented number of Americans living paycheck to paycheck or on some form of government assistance while the economy showed statistical signs of improvement.
And that is just a partial list.
In the last newsletter, I focused on the statistical probabilities of stock market performance in 2015 based on the Presidential and Decennial cycles.
As I stated in that missive:
"'Predictions Are Difficult...Especially When They Are About The Future' - Niels Bohr
We can't predict the future - if it were possible fortune tellers would all win the lottery. They don't, we can't, and we aren't going to try to. However, we can analyze what has happened in the past, weed through the noise of the present and try to discern the possible outcomes of the future."
Currently, every single Wall Street analyst surveyed currently expects 2015 to continue its current six (6) year string of bullish advances into a seventh (7th). From a contrarian standpoint, when everybody agrees something else tends to happen.
My friend Bob Bronson sent me the following note this past week:
"Keeping it simple: there have never been more than seven years without a bear market or at least a negative calendar year - or both - in at least 144 years of the U.S. stock market, so why will 2015 be different?
Maybe this is not numerology: the last time Dec was a down month and the seven-trading day so-called Santa Claus rally was negative at year end was 2007, a precursor to the 38% decline the following calendar year of 2008 and an accelerator to the 17-month, 58% bear market from the Oct 7 '07 high (SPX 1576.09) through the March 9 '09 low (SPX 666.79)."
Furthermore, John Hussman also commented on some of the potential problems that could derail the bullish forecasts going into 2015.
"It's unfortunate that serious investors would even entertain superstitions of this type, but with valuations higher than they were at the 1929, 1972 and 1987 market peaks, I suppose that investors have to reach for something.
In this case, bullish arguments have increasingly included the observation that there have been no down years ending in 5 over the past century.
Now, stare at that for a second. Historically, the market has advanced some 70% of the time, declining the other 30%. Over the past century, a year ending in any particular number has had 10 times to show its stuff. So the probability of getting an advancing year 10 times in a row for a year ending in any particular number is just (0.7)^10 = 2.82%.
Of course, there are 10 digits that you could end with, so the probability that you would have seen all advances in at least one of those ending-digits is 1 - (1 -.0282)^10 = 24.9%, which is relatively low, but not strikingly mysterious. Of course, if you mine the historical data a dozen independent ways for patterns like this, each having only a 24.9% chance of showing up, the probability that at least one such pattern will emerge is 1 - (1 - .249)^12 = 96.8%.
In short, if you give me a dozen opportunities to mine the data in ways that have even modest probability of coming up with an interesting superstition, it's almost certain that I'll come up with an interesting superstition.
Notice that this is why you should always be aware of the sample size and the number of groups included in a particular analysis. For example, if every year ending in an even number had been an advancing year over the past century, there would be 50 such events, and the probability of all being advances would be (0.7)^50 = 0.000000018. Even allowing 2 groups (even/odd), and the opportunity to mine the data for thousands of similar relationships, the likelihood of this being a chance outcome would still be nearly zero.
As for years ending in "5," the statistics are completely unimpressive. Don't step under any ladders, now."
Back to Bob for a moment:
"And in any case, such bullish numerologists should be much more fearful of the seven-year bearish cycle, and not necessarily because of Biblical warnings. Since 1959, every following seventh calendar year has been down or had a Crash: 1959, 1966, 1973, 1980, 1987 Crash, 1994, 2001, and 2008. So watch out for 2015, huh?!
And note that this seven-year bearish cycle pattern is counter to the very long-term uptrend in the stock market since at least 1870, so it's twice as statistically significant as a counter-trend pattern since more than two-thirds of more than 144 calendar years have been up."
Bottom line: if 2015 is an up year, then the years-ending-in-five pattern will have "worked" in 14 out of 15 times, but if 2015 is a down year then the seven-year bearish cycle will have "worked" 14 out of 15 times. So it appears that it's a 50-50 comparison with 50-50 odds, but shouldn't investors pay much more attention to countertrend patterns?"
Here is the point. Trying to forecast the future is a "sucker bet" at best and it is important to remember that you are "betting" your hard earned "savings" on a "hope" that things will work out to your benefit. About 70% of the time they do. However, it is the 30% of the time that you are wrong that devastates your retirement goals. This is why I focus so heavily on that 30% probability.
With the market now entering one of its longest bull market stretches in history, backed by extremely weak domestic and global economics, the risks are rising that you will lose your "bet" over the next 12-24 months.
This is why our model is so heavily focused on "price" and a measure of market psychology. While "fundamentals" are an excellent measure for defining "what to buy," by the time the fundamental story changes it will be far too late for you to be proactive in protecting your capital.
A Quick Review Of 2014
For the entire year, on a capital appreciation basis only, here are the returns of several portfolio models. For representative returns of the market indexes on a "real" basis, I have used the one-year return of the Vanguard S&P 500 Index (VFINX) for the S&P 500 Index, the Vanguard Total Bond Index (VBTIX) as a proxy for the bond market, and the Total International and Total Stock Market Index funds (VGTSX and VITNX) for the Diversified Allocation.
As you can quickly see, any portfolio that contained international equities lagged in performance. This is why I had recommended getting out of emerging markets in February of 2014 and international entirely in August of this past year.
Those two calls, along with the calls on interest rates and energy, helped keep portfolios out of harm's way over the past year.
Those recommendations, along with the adjustments to overall portfolio risks, allowed the model allocation to perform quite well over the past twelve months with very little exposure to overall capital risk.
The chart below shows the relative performance of the X-Factor Risk Adjusted 60/40 Allocation Model as compared to the S&P 500 Index. The one-year return for the X-Factor Allocation Model last year was 8.9% which outperformed the 7.20% for a relative 60/40 allocation model.
Importantly, that near 9% return was delivered with nearly 20% in cash reserves for almost the last half of the year. This excess cash holding paid huge dividends during the October and early December drawdowns where the portfolio experienced very little overall downside draw.
Two weeks ago I returned the allocation model to 100% exposure but with the following caveat:
"I am NOT CONVICTED that the rally this week is sustainable and suggest adding exposure slowly at this point."
That concern played out well with the last couple of days of December giving up the month's gains overall.
As we head into January, I remain concerned about the potential for a repeat of last year's early performance drag given the global weakness and rising policy risk. While there is an ongoing acceptance that the U.S. can remain a beacon of economic strength amid a global deflationary storm, the reality is that there is no precedent in history of such an outcome.
As I have stated before, with the global community so tightly interconnected, the impact to corporate profits is likely to be substantially greater than currently expected. That coupled with the recent collapse in oil prices puts the outlook at further risk as planned capital expenditures get cut, layoffs rise and profitability is reduced.
Happy New Year
The road ahead for the financial markets is not clear. Risks are rising, and the likelihood is that the majority of the current market expectations will be deeply disappointed. But then again, maybe not?
I honestly don't know what 2015 will bring. However, this is why I continue to analyze price action closely and relay my observations to you each week. My job is NOT to predict outcomes, but rather to the alert you to actively "react" to events as they occur.
The majority of advisors and money managers will be blindsided by the coming reversion when it occurs. The losses will be large and the excuses as to why "no one could have seen it coming" will be plentiful.
I want better than that for you.
Thank you for readership over the last year, and I want to wish you a happy, safe and prosperous New Year.
Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer at the bottom of this report.