by Lance Roberts, Streetalk Live
It is hard to believe that summer is rapidly coming to an end. This weekend is the last “summer trip” before the children head back to school. For them, the mere mention of “back to school” should rank higher on the CDC’s threat list than the current Ebola outbreak. You almost have to laugh when you think about how good life was at that age.
The market decline certainly woke people up over the last week or so. Therefore, this week’s newsletter will focus on the important question: “Is this just a “dip,” or the beginning of a more significant correction?”
Four decades ago, fundamental arguments over valuation, earnings, profits and economic variables were important in portfolio management as the average hold time for positions ran about six years. With such a long holding period, these fundamental arguments played an important role.
However, in the fast paced, information overloaded, and manipulated markets of the 21st century driven by program and high-frequency trading, hold times have now dropped to as little as five days. That’s right – long term investing is now down to a week.
Therefore, while discussions over economics, earnings, and other fundamental factors can certainly be interesting – they have almost nothing to do with the outcome of your investments today. This is why I rely so heavily on price trend and momentum as it tells you what investors are doing versus what you “hope” will happen.
It is from this basis that I developed a series of 4 signals to drive portfolio allocation models. However, since I do believe in long term investing, the signals are based on weekly data to smooth out portfolio volatility and position turnover.
The signals are as follows:
Alert Signal – Pay attention
Sell Signal 1– Reduce equity allocation by 25%
Sell Signal 2– Reduce equity allocation by 25%
Sell Signal 3– Reduce equity allocation by 25%
If all of the sell signals were in place it would only reduce the allocation to equities in portfolios by 75% in total. I would most likely never recommend going below that level of exposure. Fully exiting the markets leads to emotional biases that make it extremely difficult to reenter markets near bottoms. By always maintaining a small piece of exposure to equities in portfolios, it is easier to add to existing positions when the sell signals above begin to reverse back to buy signals.
The chart below shows the history of the market and the relevant “initial sell signals.”
The portfolio allocation model, the same as we use for the 401k plan manager below, shows how the migration works to reduce overall portfolio risk and conserve investment capital.
IMPORTANT MESSAGE BEFORE YOU SELL ANYTHING
The current “sell” signal does not mean “panic sell” everything you own in your portfolio and run to cash. As shown in the chart above, these initial sell signals can be short lived particularly when the Federal Reserve is still intervening in the markets.
Furthermore, by the time a WEEKLY sell signal is issued the markets are generally OVERSOLD on a short term basis. It is very likely, that a rally will ensue in the markets over the next week back to resistance which could be used to rebalance portfolios and reduce risk more prudently.
The chart below is a daily chart of the S&P 500 going back to the beginning of year.
There are several very important things to note.
1) ALL indicators are currently “oversold” on a short term basis. This oversold condition provides the “fuel” necessary for a stock rebound such as was seen at the end of last week.
2) The short term moving average (red dotted line) has now crossed below the longer duration moving average which now creates strong resistance at 1940. Any rally back towards 1960 next week should be used to rebalance portfolios. (I will provide guidelines below for this exercise.)
3) The current correction is very similar in nature to what was seen in February of this year. The main difference between that correction and now is the continued extraction of the Federal Reserve from the markets. Less liquidity suggests that the easiest direction for prices in the near term is likely lower.
4) It will likely require a move in the markets back to “new highs” in order to reverse the current sell signal. While this could happen, it is likely that with the Federal Reserve extracting liquidity from the markets – the highs for the markets this year have already been seen.
It is very likely that the recent selloff has reached a short term bottom. A rally back to the moving averages is very likely. A failure at those levels will be very important.
Longer Term Correction – How Big Could It Be
The first chart is a simple trend-line analysis of the weekly S&P 500 index.
As shown, the bull market trend that began in 2009 remains currently intact (dashed blue line). A correction from current levels back to that bullish uptrend line, which occurred in both 2011 and 2012, would entail a decline to 1700. That would be a 14.6% decline from the recent intra-week market peak. While not technically a “bear” market, for many investors it will certainly “feel” like one.
However, in December of 2012, Ben Bernanke launched the latest round of monetary stimulus at a whopping $85 billion dollars a month. At that point, the markets elevated away from the previous bullish trend to establish a new trend (black dashed line). At the current time the intersection of that elevated bullish trend, which has repeatedly acted as support for the markets since the end of 2012, is at 1900. There is also some more minor support just below at 1850.
Currently, there seems to be nothing on the horizon to intensify the current “pullback” into a selling “panic.” Geopolitical events, weak underlying economic data, and extremely stretched market valuations have posed no immediate threat to the markets. This is clearly shown in the 6-month average of the Volatility (VIX) Index (a 6-month average is used to smooth the volatility of the volatility index.)
The 6-month average of the VIX is currently at the lowest levels of this century. Understand that it is NOT the decline in the VIX that is important, but rather the point at which the 6-month average turns higher. If you look at the chart you will see that 6-month average of the VIX turned, and begin to trend higher, just prior to the peaks of the market in 2000 and 2007. The same occurred in 2011 and 2012.
Currently, the 6-month average of the VIX is still trending lower which suggests that the current correction, at this point, is just a pullback within the current uptrend. However, as you can see above, that can change very rapidly.
Should volatility begin to accelerate, this would be coincident with a much larger correction that would bring into focus the 2009 bullish trend line, as shown in the chart above. However, another way to look at potential corrections is to use a “Fibonacci Retracement” analysis as shown in the chart below. As defined by Investopedia:
“The Fibonacci retracement is the potential retracement of a financial asset’s original move in price. Fibonacci retracements use horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before it continues in the original direction. These levels are created by drawing a trendline between two extreme points and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.”
As identified in the chart, the 23.6% retracement level basically confirms the 2009 bullish uptrend line around 1700 currently. If the market begins a more serious correction, this level should provide support for a short-term bounce that should be used to “sell” into to decrease equity risk in portfolios. The bounce from this support will most likely fail in short order. The markets will then either:
a) retest support at the bullish uptrend/23.6 retracement level and turn higher allowing equity risk to be increased, or;
b) that support will be violated, and the market will likely seek out the 38.2% retracement level at 1490.50. Such a decline would increase the magnitude of the correction to 25.14%. This would officially push the markets into “official” bear market territory.
While it is entirely possible, it is unlikely that (b) will happen outside of the onset of a recession. When the eventual “recession” does return to the economy, it is very likely that the markets could test the lower Fibonacci bands of 50% and 61.8% retracement levels.
The next chart is a “relative strength” and a “2-standard deviation” analysis of the weekly chart of the S&P 500. First, in the chart below, it is unusual for the markets to consistently push 2-standard deviations above the 50-week moving average for such a long period without a correction back to it. A correction back to the 50-week moving average at this point would entail a decline to 1829.31, a 8.12% decline from the recent peak.
Importantly, a decline to 2-standard deviations below the 50-week moving average would converge at the 1700 level, which as discussed above, is also home to the 2009 bullish trend line and the 23.6% retracement level.
The lower part of the chart is the “relative strength” index (RSI). This index has turned lower as of late with the recent correction and is currently posted a reading of 60. Levels of 80 represent “overbought” markets and levels below 40 represent periods of being “oversold.”
I have notated (vertical red lines) points at which the RSI had peaked and turned lower. Historically, the RSI tends to oscillate between 80 and 40 on the index. However, since the beginning of the latest round of Quantitative Easing (QE) by the Federal Reserve, the range has remained between 80 and 60. The same anomaly is shown in the next chart which is an analysis of the market relative to the Williams %R indicator.
The Williams %R indicator, like RSI is a representative of “overbought/oversold” conditions in the market by measuring changes in the momentum of prices over a specific period of time. From the beginning of 2009 to the end of 2012 (highlighted in gold), the index oscillated between levels of -20 or less, “overbought,” to -80 or greater,” oversold.” However, beginning in 2013 the oscillation has remained tightly constrained between ZERO and -30. This is unsustainable longer term and a break below the -30 level on the Williams %R will likely indicate a more severe deterioration in the markets.
There is no exact answer to the potential magnitude of a correction in the markets. “This” depends on “that” to occur which is why trying to predict markets more than a couple of days into the future is nothing more than a “wild ass guess” at best. However, from this analysis, as shown in the table below, we can make some reasonable assumptions about potential outcomes.
Currently, there is a convergence of points between 1650 and 1700 on the index that will present rather important levels of support for the market currently. Not only would a correction to such levels be a “healthy” event in order for the current “bull market” cycle to continue, it would also likely present a fairly decent opportunity to increase equity exposure in portfolios.
As I noted above, a correction of 14-16% is far outside of the expectations of the market currently. Such an event will likely “feel” much worse to individuals that have inadvertently taken on excessive risk in their portfolios by “chasing” markets and “yield.”
However, while I show that the greater levels of a potential correction will likely be coincident with a recession, as they have historically been, it does NOT mean that a recession is required. A sharp rise in interest rates or inflation, a downturn in economic growth, deflationary pressures from the Eurozone, or a credit related issue in the “junk bond” market could all do the trick.
No one will know, until in hindsight, what the catalyst will be that ignites a “panic” in the market. This is why we do analysis to understand the potential risks in the market as compared to expected reward. What is abundantly clear is that the potential “upside” in the market is currently outweighed by the “downside” risk. It is important to remember that our job as investors is to “sell high” and “buy low.” Unfortunately, for most, it is exactly the opposite.
There is one important truth that is indisputable, irrefutable, and absolutely undeniable: “mean reversions” are the only constant in the financial markets over time. The problem is that the next “mean reverting” event will remove most, if not all, of the gains investors have made over the last five years. Hopefully, this won’t be you.
Reflex Rally Portfolio Management Instructions
It is this POTENTIAL rally that we want to use to rebalance portfolios according to the following instructions. (The reason I say potential is that while I expect a rally – there is a possibility that the markets could do something entirely different. We need to be prepared to take immediate action if things to go according to plan.)
- 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.
- Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits)
- Positions that performed with the market also reduce 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.
Have a great week.