October 6th, 2015
by Lance Roberts, StreetTalk Live
Earlier this week, I penned a discussion on whether this past week's retest of the previous lows was a successful retest of the previous lows or potentially just a bounce on the way lower?
"With the market once again very oversold on a short-term basis, it is likely that the markets could manage a weak rally attempt over the next few days. The good news is that such an attempt will provide individuals another opportunity to reduce portfolio risk accordingly.
The bad news is that the rally will likely fail due to the same factors I discussed last week. The failure at overhead resistance, combined with a continued weak technical backdrop of momentum and relative strength, suggests that a retest of lows in the weeks ahead is a likely probability.
As shown in the chart below, the deviation from the long-term bullish trend line was greater than at the previous two bull market peaks. In both previous cases, a break of the market below the shorter-term moving average (red dashed line) subsequently led to a least a test of the longer-term bullish trend line. However, a 'test' would assume that the current cyclical bull market is still intact.
If the market fails to hold support at the long-term bullish trend, currently at 1860ish, such a failure will dictate a fully completed transition into a more destructive cyclical bear market."
As stated the market is currently very oversold, sentiment is bearish, and volatility is mildly elevated. While none these issues suggests a resumption of the long-term bull market, it does suggest that a reflexive rally is at hand. As stated, for now, any such rallies should be used to rebalance portfolios and lower aggressive equity risk exposure.
The 2016 Recession And Market Reversion
In January of 2014, I penned an article entitle "The Coming Market Meltup and 2016 Recession." That article discussed several historical statistical precedents for such, at that time, an outrageous piece of analysis. To wit:
"However, looking ahead to 2015 is where things get interesting. The decennial pattern is certainly suggesting that we take advantage of any major correction in 2014 to do some buying ahead of 2015. As shown in the chart above, there is a very high probability (83%) that the 5th year of the decade will be positive with an average historical return of 21.47%.
The return of the positive years is also quite amazing with 10 out of the 15 positive 5th years (66%) rising 20% or more. However, 2015 will also likely mark the peak of the cyclical bull market as economic tailwinds fade and the reality of an excessively stretched valuation and price metrics become a major issue.
As you will notice, returns in the 6th and 7th years (2016-17) become substantially worse with a potential of negative return years rising. The chart below shows the win/loss ratio of each year of the decennial cycle."
"The statistical data suggests that the next economic recession will likely begin in 2016 with the negative market shock occurring late that year, or in 2017."
It is important to remember one simple phrase that is too often forgotten by the "bullish crowd:"
"Past Performance Is No Guarantee Of Future Results."
There are plenty of reasons that that the market could lapse into a far bigger correction sooner than the historical evidence would otherwise suggest. Such an event would not be the first time that an "anomaly" in the data has occurred.
However, with a Presidential election forthcoming there is sufficient reason to believe that "all guns will be brought to bear" to forestall the onset of an economic recession and major market correction. This reason I say this is because since individuals "vote their pocketbook."
A recession/market correction would ensure a Republican victory. With Democrats currently in charge, it would not be surprising to see the Federal Reserve pushed into action with some form of monetary interventions, or negative interest rates, if the current market correction worsens.
As shown in the chart below, the Federal Reserve has already once again began to quietly expand their balance sheet following the recent downturn. If such minor interventions fail to stabilize the market, a more aggressive posture could be taken.
As I stated back in 2014:
"The inherent problem with the analysis is that it assumes everything remains status quo. The reality is that some unexpected exogenous shock is likely to come along that causes a more severe reversion as current extensions become more extreme."
Of course, since then, China has become a severe drag on the global economy which is now filtering rapidly into the domestic economy. Given the weakness in the recent economic data from manufacturing to employment and production, Q3 GDP will very likely be well below 1% growth.
This means two things.
The Federal Reserve WILL NOT raise interest rates this year.
If the data continues to worsen, expect the Federal Reserve to become more "accommodative" for a period of time.
Such actions will likely, as stated, continue to "float" the markets for a while which will provide the time necessary to pass the election in 2016. This will also align with historical full market cycle as shown in the chart below.
You Can Trade It, Just Don't Buy It
For individuals willing be more tactical in the portfolio management strategies, and have a very disciplined "buy/sell" approach, there is likely a tradeable advance in the market through the end of this year particularly as we head into the seasonally strong period of the year.
However, this is not a "buy for the long-term" opportunity. The markets remain grossly overvalued, overbought and extremely deviated from its long-term mean. As John Hussman wrote last week:
"If there is a single pertinent lesson from history at present, it is that once obscenely overvalued, overvalued, overbullish market conditions are followed by deterioration in market internals (what we used to call "trend uniformity"), the equity market becomes vulnerable to vertical air-pockets, panics and crashes that don't limit themselves simply because short-term conditions appear 'oversold.'
While the concept of mean-inversion seems strange - almost preposterous - it actually aligns very well with what we know about so-called "secular" market phases. Specifically, we can describe a "secular bull market" as a period that comprises a number of individual bull-bear market cycles, typically reaching successively higher valuations at the peak of each bull market advance. Conversely, a "secular bear market" comprises a number of individual bull-bear market cycles, typically reaching successively lower valuations at the trough of each bear market decline. These "secular" bull and bear phases are each commonly recognized as lasting somewhere about two decades."
What most investors do not realize currently is that they could go to "cash" today and in five years will likely be better off. However, since making such a suggestion is strictly "taboo" because one might "miss some upside," it becomes extremely important for measures to be put into place to protect investment capital from the coming downturn.
(In other words, if you didn't like the recent 10% correction, you are not going to like what comes next.)
However, the importance of cash should not be dismissed. As I wrote in April of this year:
"The chart below shows the inflation adjusted return of $100 invested in the S&P 500 (using data provided by Dr. Robert Shiller). The chart also shows Dr. Shiller's CAPE ratio. However, I have capped the CAPE ratio at 23x earnings which has historically been the peak of secular bull markets in the past. Lastly, I calculated a simple cash/stock switching model which buys stocks at a CAPE ratio of 6x or less and moves to cash at a ratio of 23x.
I have adjusted the value of holding cash for the annual inflation rate which is why during the sharp rise in inflation in the 1970's there is a downward slope in the value of cash. However, while the value of cash is adjusted for purchasing power in terms of acquiring goods or services in the future, the impact of inflation on cash as an asset with respect to reinvestment may be different since asset prices are negatively impacted by spiking inflation. In such an event, cash gains purchasing power parity in the future if assets prices fall more than inflation rises.
While no individual could effectively manage money this way, the importance of "cash" as an asset class is revealed. While the cash did lose relative purchasing power, due to inflation, the benefits of having capital to invest at low valuations produced substantial outperformance over waiting for previously destroyed investment capital to recover.
While we can debate over methodologies, allocations, etc., the point here is that "time frames" are crucial in the discussion of cash as an asset class. If an individual is "literally" burying cash in their backyard, then the discussion of loss of purchasing power is appropriate. However, if the holding of cash is a "tactical" holding to avoid short-term destruction of capital, then the protection afforded outweighs the loss of purchasing power in the distant future.
Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time."
Portfolio Management Instructions
Repeating instructions from last week, it is time to take some action if you have not done so already.
- 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 run-up, generally tend to fall faster in declines. (Energy, Industrials, Materials, International, Emerging Markets, etc.)
- Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits) (Discretionary, Healthcare, Technology, etc.)
- Positions that performed 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.
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.
Potential For A Bounce
As discussed in the body of this week's main report, the markets have reached a sufficiently short-term oversold and bearish condition which could provide for a reflexive market rally in the months ahead.
As shown in the chart below, the markets are trapped between previous resistance and support at the recent lows. However, importantly, notice that the two long term moving averages are about to cross. This does not happen outside of a more critical bear market cycle.
This is another reason why I stated that any rallies should be traded and not "bought." Currently this is very likely not a "buy the dip" market any longer.
As I stated last week in reference to the current deteroration of internal measures:
"While this does not mean that a major 'bear market' is about to commence, these are the hallmarks that have preceded more severe market declines. THEREFORE, it makes much sense currently to remain more cautious allocation wise while awaiting a more secure entry point in the future."
Interest Rates - Take Profits In Bonds
A couple of months ago I suggested that bonds could be opportunistically added to portfolios as rates had risen back into overbought conditions. This cyclical trading swing in interest rates is likely to be with us for quite a long time ahead as the realization of a "liquidity trap" slowly comes to pass.
With rates now once again back below 2%, much of the potential has gain has been seen to this point. It is therefore prudent to once again "take profits" in bond holdings and reduce exposure back to target rates.
With the market oversold it is very likley that any ensuing rally in the market will push rates back up to 2.4% as money rotates from "safety" to "risk." Such an opportunity will once again provide another opportunity to buy bonds more prudently.
Importantly, when the economy does eventually slip into the next recession, rates will approach 1% or less. It will likely happen very quickly which is why I continue to recommend maintaining target weighted exposure to bonds for now.
Working With A Model Allocation
Let's review the model.
NOTE: The following is for example purposes ONLY. It is in no way a suggestion, recommendation, or implication as to any portfolio allocation model currently in use. It is simply an illustration of how to overweight or underweight a model allocation structure.
Again, this is just for educational purposes, and I am not making any specific recommendations. This is simply a guide to assist you in thinking about your own personal position, how much risk you are willing to take and what your expectations are. From that starting point design a base allocation model and weight it accordingly. The closer you want to track the S&P 500 Index, the less fixed income, real estate and cash your portfolio should have. For a more conservative allocation reduce allocations to equities."
Got it? Okay.
Last week, I stated that on a rally this week, which has now occurred, to begin reducing the model holdings to align with the target model allocation by:
- selling laggards
- trimming winners
- raising "cash."
First, let's review the Sector Allocation Rotation Model.
The Sector Allocation Rotation Model (SARM) is an example of a basic well-diversified portfolio. The purpose of the model is to look "beneath the hood" of a portfolio to see what parts of the engine are driving returns versus detracting from it. From this analysis, we can then determine where to overweight sectors that are leading performance, reduce in areas lagging, and eliminate those areas that are dragging.
The Sector Allocation Rotation Model continues to deteriorate suggesting that markets are significantly weaker than they appear. As suggested all through this missive, a reflexive bounce in the market can be traded but not bought.
While much of the market has deteriorated in recent weeks, particularly as global economic weakness was reflected in commodities and industrial measures, Financials, Healthcare and Discretionary stocks were outperforming the broader market. However, that picture has deteriorated considerably.
Importantly, notice that while Discretionary, Staples, and Technology are currently leading the market, they are only doing so by not being down as much. This is not really a victory from a portfolio management standpoint as losses still erode capital over time. They are just not eroding as fast.
This is why several weeks ago I began recommending that it was time to "take profits" in these sectors and reduce allocations.
Over two months ago, I began recommending reducing/eliminating exposure in basic materials, industrials and international stocks as the brief leadership on expectations of economic recovery failed along with those hopes. That has turned out to be very prudent and timely. Furthermore, the economic "uptick" in Europe has now faded which will likely increase downward pressures on these sectors. It is now time to further reduce exposure in these areas, particularly in emerging market economies.
Small and Mid-capitalization stocks have broken down considerably and the suggestion to severely restrict allocations in these sectors several weeks was prescient. Volatility risk is substantially higher in these areas and are better used during a firm growth cycle versus a weak one. While we are seeing some short-term improvement in performance, the risk is still too elevated to additional exposure now. However, there could be a tradeable opportunity in the weeks ahead.
As I have recommended over the past two months, bonds have been markedly improving in recent weeks from previous oversold conditions. The recent rally in bonds has reduced the previous oversold conditions, and it is now time to REDUCE allocations in portfolios back to original allocations (take profits).
REITS have also been improving as of late and suggests that weightings be maintained there this week. However, I will continue to monitor this sector closely. REITS ARE NOT a replacement for fixed income.
As I stated seven weeks ago:
"I reiterate, adding Bonds, Utilities, Staples and REITs to portfolios going into August and September are likely to be a good choice as any market disruption will send money flowing into safety related areas."
The recent bounce in the market has achieved initial goals for cleaning up portfolios and reducing overall equity risk. The recommendations for "pruning and trimming" exposure over the past couple of months has already done a big chunk of this work so there should be relatively little impact to portfolios currently.
S.A.R.M. Model Allocation
I stated that according to the S.A.R.M. model, those actions, on a reflexive bounce in the markets, would potentially include:
- eliminating materials
- eliminating industrials
- eliminating energy
- eliminating international/emerging markets
- eliminating small capitalization
- eliminating mid capitalization
- reduce discretionary
- reduce healthcare
- reduce financials
- reduce technology
- hold utilities
- hold staples
- hold reits
- hold bonds
These actions would rebalance the example portfolio to the following:
With the rally over this past week, we have a good opportunity to raise extra cash to protect yourself in the face of a deeper correction should one occur. As you will notice in the SAMPLE model below cash will be increased to 35% of the portfolio. It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance.
As you can see, there are not DRASTIC movements being made. Just incremental changes to reducing overall portfolio volatility risks. However, if the expected bounce fails at resistance, then further reductions will be required in accordance with the risk reduction modelling.
Remember, as investors, our job is not to try and capture every single relative point gain of the market as it rises. While we certainly want to participate in the rise, our JOB is to protect our capital against substantial losses in the future. A methodology that regularly harvests gains, reduces risk and keeps the portfolio focused on longer-term goals will lead to a more successful outcome.
401-k Plan Manager
Continue To Fade Rallies For Now
As shown in the chart above, the market has now triggered all THREE sell signals which technically warrants a reduction in portfolio allocations by 75%.
For those that are much more risk IN-tolerant, using rallies to reduce further risk in portfolios, and raise cash, is completely acceptable.
HOWEVER, for longer-term investors, while the market is decidedly under pressure, it has not broken the bullish trend that began in 2009. It is the break of that trend that will denote a change from a bullish to bearish market and require further allocation reductions. Currently, a break and close below the October lows will denote such a change.
In the short-term, the markets are oversold enough for a bounce, however, such short-term bounces should be used for a continuation of portfolio rebalancing processes.
Continue to review your current portfolio holdings and make adjustments as needed.
- HARVEST: Reduce "winners" back to original portfolio weights. This does NOT mean sell the whole position. You pluck the tomatoes off the vine, not yank the whole vine out of the ground.
- WEED: Sell losers and laggards and remove them garden. If you do not sell losers and laggards, they reduce the performance of the portfolio over time by absorbing "nutrients" that could be used for more productive plants. The first rule of thumb in investing "sell losers short." So, why are you still hanging onto the weeds?
- FERTILIZE AND WATER: Add savings on a regular basis.A garden cannot grow if the soil is depleted of nutrients or lost to erosion. Likewise, a portfolio cannot grow if capital is not contributed regularly to replace capital lost due to erosion and loss. If you think you will NOT EVER LOSE money investing in the markets...then STOP investing immediately.
- WATCH THE WEATHER: Pay attention to markets. A garden can quickly be destroyed by a winter freeze or a drought. Not paying attention to the major market trends can have devastating effects on your portfolio if you fail to see the turn for the worse. As with a garden, it has never been harmful to put protections in place for expected bad weather that didn't occur. Likewise, a portfolio protected against "risk" in the short-term, never harmed investors in the long-term."
Current 401-k Allocation Model
30% Cash + All Future Contributions
Primary concern is the protection of investment capital. Examples: Stable Value, Money Market, Retirement Reserves
35% Fixed Income (Bonds)
Bond Funds reflect the direction of interest rates. Examples: Short Duration, Total Return and Real Return Funds
30% Equity (Stocks)
The vast majority of stock funds track an index. Therefore, select ONE fund from each category.
Keep It Simple.
- 15% Equity Income, Balanced or Conservative Allocation
- 15% Large Cap Growth (S&P 500 Index)
- 0% International Large Cap Value
- 0% Mid-Cap Growth
|Common 401K Plan Holdings By Class|
The above represents a selection of some of the most common funds found in 401k plans. If you do not see your SPECIFIC fund listed simply choose one that closely resembles the examples herein. All funds perform relatively similarly within their respective fund classes.
I will modify this list over time as the asset allocation model changes to reflect international holdings, emerging markets, commodities , etc. as the model changes to reflect the addition of those holdings.
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. At times, the positions of Mr. Roberts will be contrary to the positions that STA Wealth Management recommends and implements for its clients' accounts. All information provided is strictly for informational and educational purposes and should not be construed to be a solicitation to buy or sell any securities.
It is highly recommended that you read the full website disclaimer and utilize any information provided on this site at your own risk. Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level, be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and applicable laws, the content may no longer be reflective of current opinions or positions of Mr. Roberts. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his or her individual situation, he or she is encouraged to consult with the professional advisor of his or her choosing.