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posted on 08 May 2016

Should I Stay Or Go?

by Lance Roberts, Clarity Financial

Over the last couple of weeks, the market has been working off the overbought condition that accrued from the surge off the February lows.

As I wrote recently:

"With the markets still extremely overbought from the previous advance, the easiest path for prices currently is lower. The clearest support for the markets short-term is where the 50 and 200-day moving averages are crossing. I currently have my stop losses set just below this level as a violation of this support leaves the markets vulnerable to a retest of February lows."

SP500-Chart1-050616-2

"On a short-term (daily) basis, the current correction is still within the confines of a more normal "profit-taking" process and does not immediately suggests a reversal of previous actions. As shown in the chart above, support currently resides at 2020 & 2040 with the 50-day moving average now trading above the 200-day. "

The yellow band in the chart above is the ongoing trading range the market has remained mired in since May of 2014.

As I have stated in the past, by the time a rally occurs that is strong enough to reverse bearish signals, the market is generally extremely overbought. The market must then work off that overbought condition before the next advance can occur.

"The current correction was not unexpected. It was a function of time before the extreme short-term extension of the market corrected. Like stretching a rubber band to its limits, it must be relaxed before it is stretched again. The question is whether this is simply a "relaxation of the extension" OR is this a resumption of the ongoing topping and correction process?"

Should I Stay Or Go?

It is the last part of the statement above that I want to address this week.

Is this just a correction within the confines of a bullish advance OR is the recent market action just a continuation, and eventual completion, of a market topping process?

The answer: It depends on your investment time frame.

If you are a trader with a time horizon that is from days to a couple of months, the backdrop to the markets are currently more bullish than bearish. As shown below, the number of advancing stocks has broken out of recent downtrends which has historically related to more bullish underpinnings.

SP500-Chart2-050616

However, if you are a longer-term investor, particularly within a couple of years of retirement, market dynamics are still exceedingly negative. As shown below, despite the recent surge in the market, not unlike that seen in Oct 2014 and 2015, is still contained within a topping process as witnessed during the peaks of the previous two bull markets.

SP500-Chart3-050616

As Michael Kahn penned this past week in Barron's:

"Like life, the stock market is rarely black or white. Right now, however, the outlook is particularly muddled. In technical analysis, when moving averages cross over each other to the downside we call it black. When they cross to the upside we call it golden. Now, the market is giving off mixed signals, making it no more than a bland beige."

This is a problem for investors, who despite saying they are long-term investors are always driven by short-term market swings which impact emotional biases. He concludes:

"There is a good argument that stocks are ripe for a correction after a sharp rally, but with the undercurrents in sectors, interest rates, and breadth there is not enough evidence to hand the reins over the bears. Bulls, however, do not have much room for error. The falling U.S. dollar may be the handwriting on the wall, and the Fed better be very careful with its decision at next month's meeting."

It is this ongoing "limbo" that continues to weigh on investor sentiment. While the "bulls" have once again emerged onto the field, there is not enough "evidence" currently to suggest an aggressive risk posture in portfolios.

As Bill Henry once quipped:

"It is better to be out of a bull market than fully invested in a bear market."


It's All Connected

This idea of elevated risk is clearly prevalent in the analysis by David Keohane via Financial Times.

"HSBC's FX team last week as they reissued their RoRo charts and warnings. Remember, red means strong positive correlation, blue means strong negative correlation, green and yellow means correlations are heading to zero. So, as HSBC say: the RoRo 'paradigm' can be defined by three key features:

  1. "Risk-on" assets are positively correlated with each other

  2. "Risk-off" assets are positively correlated with each other

  3. "Risk-on" assets are negatively correlated with "risk-off" assets

This is what those correlations look like now:"

KEO-1

"This, from a previous post in 2012, shows what that chart looked like pre-Lehman and in a strong RoRo period in 2012:"

KEO-6

"Remember too that RoRo very probably comes into its own when assets markets face extreme, near binary, outcomes. Think just after 2008 when, as HSBC put it, 'events happened which changed the consensus probabilities being ascribed to... two outcomes, there were large, synchronised price moves in most asset classes. So the crux of our explanation for RORO is a highly-volatile market consensus.'"

Here is the important point that David points out as the key problem as the effects of QE wane.

"... as soon as the Fed actually raised rates, fear set in and 2016 began with worry, uncertainty and very negative sentiment. In addition to worries over the Fed hiking cycle, there were heightened concerns over weakening oil prices and the growth and policy outlook for China. Risk assets were punished during this period. From mid-February, however, sentiment shifted suddenly. Since that point risk has very much been on; risk assets have rallied and the fear of missing out is now crowding out the fear of losing money.

These sudden shifts in consensus are bringing RORO correlations to the fore again and investors are once more obsessing about whether we are in a risk-on or risk-off period."

By reducing the markets to a much more simplistic analysis, and removing the emotionally driven biases from the investing process, we begin to see a clearer picture of the potential risks to aggressively allocated portfolios.

So, as I stated above, the decision about whether this is a bull market or an ongoing correction process is really about time frames.

The biggest mistake that investors make, hands down, is the failure to match their investment time horizon to their allocation structure. This is called "duration matching." If you have a short-term window to your goals but build a long-term portfolio model, things will likely not work out well for you.


Sell In May & Go Away?

I have written in the past about the historical precedent of "Sell In May & Go Away." Every year, there is always a litany of articles written about why it is such a bad idea, you need to just buy and hold, blah...blah...blah.

Last year, selling in May, as I recommended, saved your bacon a lot of grief during the August dive.

However, there are indeed some years where markets rose during the summer months.

"Opps...you missed out. What a loser you are."

For a moment set aside the inherent biases of media and investment firm publications designed to keep you invested at all times so they can collect a fee or ad revenues. Instead, let's discuss the "Sell In May" issue from a more technical and statistical basis.

First, "selling in May" does not necessarily mean going to cash. Can we please stop using extremes to try and prove a point.

"Selling In May," at least in my world, is the process of reducing risk during a period time where historical returns have tended to be poor. Take a look at the chart below which shows a $10,000 investment into markets during the "Seasonally Strong" vs. "Seasonally Weak" periods. Did you really miss anything by skipping the summer months?

Sell-In-May-050616

Let's dig a little deeper. Just recently, Carl Swenlin at Decision Point published the following tidbits.

"The chart below shows the favorable six-month period just ended, and we can see that SPY closed less than one point above its starting point at the end of October. Technically, it fulfilled its positive expectations, but as a practical matter the sharp decline into the February low would have made holding a long position based solely on seasonality a painful experience."

StockCharts-1

"Now let's look at the last six-month unfavorable period from May 1, 2015 through October 30, 2015 on the chart below. It is amazingly similar to the favorable period just ended. Negative expectations were fulfilled with the turbulence in August and September, but price recovered so that SPY closed slightly above the May starting point.

StockCharts-2

"Now let's go back one more period to the favorable period from November 2014 through April 2015. Finally, we have a period that meets bullish expectations without a great deal of volatility."

StockCharts-3

"While the title of this article announces the end of a favorable period, the real news is that a new unfavorable six-month period will begin on Monday, and we are reminded of the old saying, 'Sell in May, and go away.' Unfortunately, we can see from the first two charts that seasonality rules are not always reliable. Rather, it is important to remember that seasonal tendencies will be working to pull prices down. Whether or not negative seasonality will prevail over more positive forces that may materialize we can't know, but we should be aware of historical tendencies that will be influencing the market for the next six months."

Carl is absolutely correct. It is not whether the summer is negative that is important, but the amount of volatility that you suffer in the meantime. Furthermore, when you combine seasonality with weak earnings and a Presidential Election; you have all the ingredients needed for a "sit on the sidelines" portfolio.

In other words, by the end of summer, we may be no better off than we are right now.

Just something to think about.

"There is only one side to the markets; it is not the bull side or the bear side, but the right side." - Jesse Livermore

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