Market Correction Or Dip?

X-factor Report 29 September 2014

by Lance Roberts, StreetTalk Live

“Be not afeard: the isle is full of noises,
Sounds and sweet airs, that give delight, and hurt not.
Sometimes a thousand twangling instruments
Will hum about mine ears; and sometime voices,
That, if I then had wak’d after long sleep,
Will make me sleep again: and then, in dreaming,
The clouds methought would open and show riches
Ready to drop upon me; that, when I wak’d
I cried to dream again.”

-William Shakespeare, The Tempest (3.2.96-104)

This past week’s sell off certainly awoke many market participants that had fallen into the complacent slumber of the Fed driven markets. This week’s newsletter is primarily focused on the technical underpinnings of the market and contained in “Sector Analysis” section below.

However, before I get into that, I want to discuss the current status of the market and the potential impact to portfolio allocations.

As shown in the chart below, the market has held onto its critical moving average since December, 2012 when the Fed initiated its latest liquidity intervention program (QE3).

Importantly, I have noted when the markets have reached short-term oversold conditions (red-dashed lines). For investors, it is always important NOT to PANIC SELL market declines and utilizing some form of technical analysis can help avoid doing so.

There is NO WAY currently to tell if this is just another in the long series of “dips” that we have seen since the onset of QE3, or if this is the beginning of a more severe decline. However, there are two points that need to be addressed:

1. The market, while currently oversold, has not retraced back to its long-term moving average. Moving averages, as discussed in the past, act like gravity and pulls on prices. While it is not required that the markets retrace all the way back to the moving average, it is a healthier entry point when they do.
2. The oversold condition suggests that the markets market “bounce” on Friday will likely last into next week. This bounce SHOULD be used to rebalance portfolios by taken the following actions to reduce overall risk:
   1. Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.
   2. Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.
   3. Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

3. Review your overall allocation model and adjust weightings to realign it with your longer term goals.

These actions will help reduce the risk in the event that the current sell-off begins to mature into a bigger decline.

Status Of Sell Signals

Both of our sell signals have been whipsawed over the summer as price volatility has risen. Currently, those signals are flirting with the zero line and will become more definitive next week depending on market action.

While there is no reason to adjust macro portfolio allocations currently, I will continue to monitor those signals and alert you accordingly.

I suspect that, as stated above, the markets will rally next week as mutual funds and investment managers “window dress” their portfolios for the end of the quarter reporting. However, such action would leave the first two weeks of October open to a rather sharp reversion if things to begin to improve markedly.

It is time to pay much closer attention to your portfolio.

The Zurich Axioms

One of my favorite reads of all time was the “Zurich Axioms” by Max Gunther. If you can find a copy of the book, it is a highly suggested read. However, there are several very important points that he makes with regards to portfolio management practices:

On Greed:Always take your profit too soon. Decide in advance what gain you want from a venture, and when you get it, get out. Most investors make an investment but have NO idea when they should sell it which is the ONLY way you actually make money. This is why most investors buy a stock, watch it rise, then fall, and then sell it at a loss.

On Hope: When the ship starts sinking, don’t pray. Jump. Accept small losses cheerfully as a fact of life. Expect to experience several while awaiting a large gain.

On Forecasts: Human behavior cannot be predicted. Distrust anyone who claims to know the future, however dimly. The most accurate forecasters in the world are weathermen who are accurate out to three days. If you are trying to predict long term future returns from a market ruled by emotion and human behavior, you are only fooling yourself.

On Mobility: Avoid putting down roots. They impede motion. The biggest mistake that many investors make is to become “trapped” a souring venture because of sentiments like loyalty and nostalgia. Never hesitate to abandon a venture if something more attractive comes into view.

On Optimism & Pessimism: Optimism means expecting the best, but confidence mean knowing how you will handle the worst. Never make a move if you are merely optimistic. Furthermore, never invest hard earned capital without knowing how you will handle the loss of it all. Making money is the easy part, losing it is what hurts.

On Stubbornness: If it doesn’t pay off the first time, forget it. The one rule of investing that should NEVER be broken is trying to save a bad investment by “averaging down”.

On Planning: Long-range plans engender the dangerous belief that the future is under control. It is important never to take your own long-range plans or other people’s seriously. Financial and investment planning is primarily used by charlatans to separate you from your savings. While planning is always a necessary process, it is important to remember that it is only a valid plan until things change. Individuals consistently fall short of their “financial goals” because they failed to change with the environment.

In essence these axioms point to the benefit of having an investment strategy and sticking to it, regardless of what other investors say or do. The difference between success and failure in portfolio management is having a strictly defined investment process that is definable, repeatable and devoid of emotional biases. For most, emotions rule their investment process as they buy investments they like, hold losing positions “hoping” they will recover, or use some type of fundamental analysis to create a confirmation bias by ignoring the facts that don’t fit. Eventually, the lack of a stringent “buy/sell” discipline destroys the inherent portfolio value.

As I will discuss below. The underpinnings of the market are weakening. As with the onset of a “cold,” the early symptoms warn you of what is to come. You can either treat the symptoms early and minimize the impact of the virus, or deal with the full blown consequences. That decision is up to you.

Have a great week.