posted on 17 July 2016
by Lance Roberts, Clarity Financial
Last Tuesday, I discussed the market's breakout to the upside and the increase in equity exposure in client's portfolios.
What Happens Next Determines Action
This week, I am adjusting the model allocations up to 75%. Review last week's missive for the individual sector analysis for recommendations leading up to the model change.
However, while I am changing the model, this does not mean going out and clicking the "buy" button on everything you can find. We must now wait for the right entry point to increase equity allocations to the new model weights.
As shown below, the market is currently 3-standard deviations above its 50-day moving average. This is "rarefied air" in terms of price extensions and a pullback is now necessary to provide a better entry point for increasing equity allocations.
However, as I have noted, there is a difference in pullbacks.
While the breakout this week is certainly "bullish" and should not be dismissed lightly, it is valid if the breakout holds. However, as I noted on Tuesday, the rotation from bonds to stocks is confirming the push higher currently. Much of the sustainability of the rally going forward is dependent upon the ongoing rotations from "safety" back into "risk."
Importantly, despite the breakout and increase in bullish exuberance, the markets are overly extended, overly bullish and excessively complacent. Such a combination of factors greatly increase investment risk.
However, given the long consolidation process of the market since May of last year, the markets are confirming their ongoing bullish trend. As stated above, this requires me to increase equity exposure to 75% of target weightings. After such an extended run in the markets, this seems somewhat counter-intuitive. It is. But, as Bill Clinton once famously stated; "What is....is."
While the market "IS" currently acting bullishly, it doesn't mean such will always be the case.
As investors, we must modify Clinton's line to: "What is...is...until it isn't." We must be able to recognize, and be responsive to, changes in underlying market dynamics if they change for the worse and be aware of the risks that are inherent in portfolio allocation models.
If the bullish trend holds, works off the excessive overbought conditions and resets investment risk, the models will be adjusted back to 100%.
A Quick Note On Portfolio Management
Here are the guidelines to follow in adjusting your portfolio allocation model.
The "Rothschild 80/20" Rule
While I have often been chastised for not "chasing markets," I am also not working my way back to even. Having been underweight equity risk in recent months has paid dividends by reducing portfolio volatility and emotional stress.
Here is my point. As a long-term investor, I don't need to worry about short-term rallies. I only need to worry about the direction of the overall market trends and focus on capturing the positive and avoiding the negative.
As Baron Nathan Rothschild once quipped:
This is the basis of my 80/20 investment philosophy and the driver behind the risk management process.
While I may not beat the market from one year to the next, I will never have to suffer the time loss of required by"getting back to even." In the long run, I will win.
As shown in the table below, a $100,000 investment in the S&P 500 returns a far lower value than the "Rothschild 80/20 Rule" model. This is even if I include a ridiculous 2% management fee.
But here is how it plays out over the long-term.
Yes, it's only a couple of million dollars worth of difference, but the reduced levels of volatility allowed investors to emotionally "stick" to their discipline over time. Furthermore, by minimizing the drawdowns, assets are allowed to truly "compound" over the long-term.
Get it. Got it. Good.
So...Do I Adjust My Portfolio Now
The short answer is "NO, Not Yet."
As stated above, the market needs to blow off some of the excess overbought condition in the market.
Secondly, we are moving into two of the worst months of the year seasonally speaking combined with a Presidential election. It is very likely that we will see a correction in the market during this period. As Dana Lyons' pointed out this week:
However, as I have noted previously, my expectations are for a correction of some sort in August and/or September. Notice the 12-month tops have occurred 5-times in September nearly tying the six in January.
For now, there are plenty of bullish arguments piling up to support markets over the next few weeks:
There is also a possibility this central bank driven liquidity push is a giant "trap" waiting to be sprung on unwitting investors.
The current rally is built on a substantially weaker fundamental and economic backdrop. Therefore, it is extremely important to remember that whatever increase in equity risk you take, could very well be reversed in short order due to the following reasons:
It is worth remembering that markets have a very nasty habit of sucking individuals into them when prices become detached from fundamentals. Such is the case currently and has generally not had a positive outcome.
The chart below illustrates point #5 above. There are still WAY too many negative divergences in underlying indicators to suggest an "all clear" for investors currently.
What you decide to do with this information is entirely up to you. As I stated, I do think there is enough of a bullish case being built to warrant taking some equity risk on a very short-term basis. We will see what happens next week.
However, the longer-term dynamics remain bearish. When those negative price dynamics are combined with the fundamental and economic backdrop, the "risk" of having excessive exposure to the markets greatly outweighs the potential "reward. "
Could the markets rocket up to 2200 or 2300 as I suggested earlier this week? It is quite possible given the ongoing interventions by global Central Banks.
The reality, of course, is while the markets could reward you with 160 points of upside, there is a risk of 600 points of downside just to retest the previous breakout of 2007 highs
Those are odds that Las Vegas would just love to give you.
Please be careful.
Investing is not a competition.
It is a game of long-term survival.
EDITOR'S NOTE: There will be NO article next week as Lance will be traveling.
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