Storm Watch Continues

X-factor Report for 16 August 2015

by Lance Roberts, StreetTalk Live

Last week, I started off this missive stating:

“Well…after months and months of indigestion, the markets MAY, and I repeat MAY, have finally come to a decision to end the current bull market run.

The reason I say MAY, and not definitely, is that we have seen initial breaks of trends previously (red circles in the chart below) that were quickly resolved by rapid Federal Reserve interventions.”

The chart below is updated through Thursday’s close.

Here is the problem. In years past, when you had this kind of technical deterioration, a move to substantially all cash within portfolios would have been both a wise and timely move. However, the problem currently is that the ongoing interventions of Central Banks globally are keeping asset prices inflated which increases the risk of being “wrong” with respect to the timing of a “risk reduction” strategy.

This point is crucially important to understand.

Are You An Investor Or A Speculator

To explain this take the following quiz:

• Do you check the markets at least once a day?
• Do you check the value of your portfolio more than once a week?
• Do you regularly engage in conversations with friends or family about the markets?
• Do you compare the performance of your portfolio to some random benchmark index to “see how you are doing.”
• Over the last two months have you considered, or have you, made a decision to “sell” something based on how you “feel.”

If you answered “yes” to any of those questions you are NOT a “long-term investor” – You are a “speculator.”

If you are truly a “long-term” investor, then short-term volatility in markets should not be a concern to you. As a long-term investor there is little need to check on market updates, headline news or where the markets closed from one day to the next. As a long-term investor, your decisions would be based on a sound investment discipline based on a fundamental understanding of the investments. The investments would then be purchased and allowed to mature over a given time span which would be measured in years rather than months or weeks.

For example. When Warren Buffett bought into railroads, he commented that over the next 30-years the invested capital would have a handsome return. With Buffett in the later stages of his life, he will not be around when the 30-year window concludes. But that is the nature of long-term investing.

However, for the vast majority of individuals, they have become convinced by the Wall Street money machine they MUST be invested in the financial markets at all times. Furthermore, they also MUST beat some random benchmark index, or they must move their money to someone else to try.

Here is the secret that you are never told – “Money in motion creates fees and profits.”

Here is the revenue for a few of the Wall Street banks for the year:

• Goldman Sachs – 40 billion
• CitiGroup – 61.7 billion
• JP Morgan – 51.5 Billion
• Bank of America – 50.8 Billion

These are BILLION’s of dollars. To put this into some perspective – this is how much they are earning PER SECOND of EVERY DAY.

• Goldman Sachs – $1,268.39 per second
• CitiGroup – $1,956.49 per second
• JP Morgan – $1,633.05 per second
• Bank of America – $1,610.85 per second

What Wall Street has managed to do for their financial benefit is convert a nation of “savers” into a pool of “gamblers.”

This “gambling” mentality is most clearly shown in the historical returns of investors relative to that of the market, something I addressed previously in “Why Investors Suck:”

“It is important to note that it is impossible for an investor to consistently “beat” an index over long periods of time due to the impact of taxes, trading costs, and fees, over time. Furthermore, there are internal dynamics of an index that affect long-term performance which do not apply to an actual portfolio. (For more on the reasons why benchmarking is a bad strategy click here and here.)

However, even the issues shown above do not fully account for the underperformance of investors over time. The key findings of the study show that:

• In 2014, the average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%. The broader market return was more than double the average equity mutual fund investor’s return. (13.69% vs. 5.50%).
• In 2014, the average fixed income mutual fund investor underperformed the Barclays Aggregate Bond Index by a margin of 4.81%. The broader bond market returned over five times that of the average fixed income mutual fund investor. (5.97% vs. 1.16%).
• In 2014, the 20-year annualized S&P return was 9.85% while the 20-year annualized return for the average equity mutual fund investor was only 5.19%, a gap of 4.66%.
• In 8 out of 12 months, investors guessed right about the market direction the following month. Despite “guessing right” 67% of the time in 2014, the average mutual fund investor was not able to come close to beating the market based on the actual volume of buying and selling at the right times.”

The reason that individuals perform so badly over time is the lack of adherence to a discipline. One of the biggest reasons for their underperformance, to Wall Street’s benefit, is “performance chasing.”

Wth the mainstream media continually bleating on about how the markets are doing, and who did what where; investors are lured to chase last year’s “hot hand.” The problem is that last year’s winners generally become next year losers due to market dynamics. This continually keeps investors in the loop of chasing returns and creating fees for Wall Street rather than returns for themselves.

However, there are also many other factors that lead to continued underperformance by individuals such as:

While the inability to participate in the financial markets is certainly a major issue, the biggest reason for underperformance by investors who do participate in the financial markets over time is psychology. Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:

• Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as “panic selling.”
• Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
• Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
• Mental Accounting – Separating performance of investments mentally to justify success and failure.
• Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
• Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
• Regret – Not performing a necessary action due to the regret of a previous failure.
• Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
• Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

The biggest of these problems for individuals is the “herding effect” and “loss aversion”.

These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”

As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip” opportunity. As losses mount, the anxiety of loss begins to mount until individuals seek to “avert further loss” by selling. As shown in the chart below, this behavioral trend runs counter-intuitive to the “buy low/sell high” investment rule.

So What?

Despite what you think you are. you are most likely a speculator. You are invested in the market hoping that it will rise. In many cases, you are hoping that it will rise enough to offset your lack of savings. You “hope” that what you have invested will create the “retirement” opportunity touted on television by the Wall Street firms.

There is NOTHING wrong with that. It is just important to have the RIGHT PERSPECTIVE.

Understanding that your view is really MUCH shorter in nature than what you tell your advisor, it is important to match that view to the market.

Therefore, if I tell you to go to cash too soon, and the market rises without you, then you figure I don’t know what I am talking about and quit reading the newsletter. If I tell you too late…same thing.

As Howard Marks once stated:

“There is no difference between being early (in making a call) and being wrong.”

As shown in the chart above, the market has NOT YET violated its major “bull market” trend (dashed red line.) But, as identified by the downward sloping triangle, market action is VERY weak. Also, the markets are currently pinned below a previous important support level.

However, as I stated above, while my “gut” tells me that we should become substantially more defensive, each previous selloff in the markets have been met by a variety of Central Bank interventions either in action or verbal. Just this past week, Fed officials uttered the words “QE4.”

Therefore, the problem of reducing the portfolio allocation model currently is without a violation of the running “bull trend” support I run the risk of being early. In other words, I would be “wrong.”

I will leave you with the following for this week. The chart below is a simple moving average crossover indicator that has correctly identified market trends during this Central Bank driven frenzy. Notice that each “sell signal” was previously reversed by Central Bank interventions.

While not a “sell signal” yet, should one register in the next couple of weeks it will likely be one worth paying attention to.

For now, keep your “hatches battened down” as the “storm watch” continues.

Have a great week.

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. Please read the full disclaimer.