March 24th, 2015
by Lance Roberts, StreetTalk Live
Would You Like Some "Volatility" With That?
I forgot to warn you before I left for spring break that markets tend to decline when I am out of town. However, since my return, the markets have jerked their way back in a recovery with each rally day followed by a sell-off.
The lower part of the chart shows a simplistic short-term overbought/oversold indicator. As you can see the markets were oversold following the previous week's sell-off, but that condition has now worked off. Importantly, the markets have now become overbought again WITHOUT the markets making new highs. While it is too early to call as of yet, these are classic signs of a market that is in a topping process.
However, despite the choppy action over the last few months, investor complacency has once again returned towards historical lows. Of course, the "lack of fear," from a contrarian standpoint, is "something to fear" in and of itself.
While price action has been substantially more volatile as of late, the number of investors "fearing" a market correction has evaporated once again.
This also coincides with something I tweeted earlier this week:
However, despite the volatility and market rhetoric, the trend of the market remains intact and currently suggests that portfolios remain fully invested at target weights at the current time.
Importantly, notice that I said "at the current time." Things can and will change and when they do portfolios will need to be adjusted accordingly.
A Bit Of History
Let's take a step back and analyze the bigger picture for a moment. The chart below shows the S&P 500 going back 10-years.
As you will see, following the financial crisis sell-off, the markets began to rally from a deeply oversold and very psychologically negative market bottom. The surge in asset prices was boosted by the onset of the Fed's first round of quantitative easing.
The market then sold off back to initial support in the summer of 2010 as the Fed's monetary program came to an end. With the Federal Reserve worrying that the sell-off might accelerate they once again intervened with QE-2, which lifted markets higher once again.
That following summer, as QE-2 came to an end, the markets were rocked by the debt-ceiling debate combined with the manufacturing shutdown in Japan which was caused by the earthquake and tsunami.
The market began a near 20% correction but was once again rescued by the Federal Reserve, who stepped in with discussions and implementation of a debt-rollover and reinvestment program which became known as operation twist. While not as effective as direct QE in lifting asset prices, it did arrest the plunge in stock price enough to establish a new lower bullish trend (bottom dashed line.)
In December of 2013, as the threat of the "fiscal cliff" loomed, then Fed Chairman Ben Bernanke took action to stem the potential negative impact of government spending cuts and automatic tax increases by launching the biggest QE program in history. QE3 was a monster program consisting of $85 billion a month in asset purchases which would flood the financial markets with liquidity.
The plan worked and asset prices soared over the next 18-months. As shown above the bullish trend line (red dashed) accelerated sharply.
That accelerated bullish trend remains intact currently.
In a market where fundamentals are no longer cheap by any measure (on a 50-year basis), is has now simply become a momentum push as the "fear" of "missing out" overwhelms more logical investment analysis.
However, this is also an interesting dichotomy for financial advisors. Here's why:
- An individual hires a financial advisor to manage their investment portfolio.
- Markets rise to levels of extreme valuation
- Advisor sells assets and raises cash (sell high so they can buy low later.)
- Market moves higher due to "irrational exuberance."
- Client moves money from cautious advisor to another advisor chasing the market.
- Market eventually crashes wiping client out.
- Client seeks out conservative advisor, so that does not happen again.
- Wash, Rinse, Repeat Until Broke
Performance chasing is the root of more investor losses than just about any other activity. However, the financial media continues to promote exactly that kind of activity with commentary about "buy and hold" investing (which benefits them, not you) and why not being invested makes you a loser (again, benefits them, not you.)
As I have written before, the main problem of being an investment manager is the career risk of being out of the market too soon. As Howard Marks once stated:
"Being right, but early, is the same as being wrong."
However, since we are really "savers" trying to achieve specific goals within specific time frames, doesn't it make sense to think about "investing" a bit differently. After all, it is your money.
The Trend Is Your Friend Until It Isn't
Despite the fact that all the fundamentals suggest that an investor should move a lot of their investment portfolio to cash (sell high) to wait for a better investment opportunity later (buy low), the reality is that few investors actually have the patience and willpower to do so. This is why, when fundamentals are no longer a valid investment measure, the focus must change to a "price momentum" analysis.
"There have been many studies published that have shown that relative strength momentum strategies, in which as assets' performance relative to its peers predicts its future relative performance, work well on both an absolute or time series basis. Historically, past returns (over the previous 12 months) have been a good predictor of future results. This is the basic application of Newton's Law Of Inertia that states "an object in motion tends to remain in motion unless acted upon by an unbalanced force."
In other words, when markets begin strongly trending in one direction, that direction will continue until an "unbalanced" force stops it. These momentum strategies, which are trend following strategies by nature, have been proven to work well in extreme market environments, multiple asset classes and over historical time frames.
While there is substantial evidence that market valuations and fundamentals are not supportive of asset prices at current levels, investor psychology has likewise reached extremes. In such an environment, investors need to shift focus to momentum based strategies. This is because the most common explanation for profitability of both momentum and trend-following strategies has to do with behavioral factors such as anchoring, herding, and the disposition effect.
Fundamentally based investors are slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late cycle stages.
The other inherent problem of primarily data-based investors is the "herding" effect. As prices move higher, valuation arguments lose relevance. However, the need to produce investment performance in a rising market, leads to "justifications" to explain over-valued holdings. In other words, buying begets more buying.
Lastly, as the markets turn, the "disposition" effect takes hold and winners are sold to protect gains, but losers are held in the hopes of better prices later. The end effect is not a pretty one.
By applying momentum strategies to fundamentally derived investment portfolios it allows the portfolio to remain allocated to rising markets while managing the inherent risk of behavioral dynamics.
This is why, despite the fact that I write like a "bear," the portfolio model has remained allocated like a "bull" during the markets advance. The point is simple, our job as investors is to make money when markets are rising. We can debate the valuation metrics and argue with each other why markets should not be rising, and eventually those arguments will be correct. However, for now markets are rising, and we need to participate until the trends change to the negative. Of course, if your current portfolio management philosophy does not have a method to understand when "trends" have changed, how will you know when it is time to step away from the poker table?"
The chart below shows a basic momentum model of the S&P 500 going back 50-years.
Following a basic momentum structure would have kept investors out of the majority of harm's way during market declines and captured the majority of market advances. However, it is worth noting that while not every signal was perfect, the majority were and would have created substantial outperformance over any given period.
Currently, there are some very early warning signs that momentum is deteriorating. However, I will cover this more in detail in the sector analysis another time.
For now, the bull trend and momentum remain intact. Again, that is for now. Things will change and being extremely complacent in this market environment is a potential recipe for disaster.
Stay tuned. I think the next couple of weeks could be a bit more interesting.
Have a great week.
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.