Storm Arrives – Time To Take Shelter

X-factor Report 23 August 2015

by Lance Roberts, StreetTalk Live

Editor’s note: This was written before Monday trading started anywhere in the world.

Two weeks ago, 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 LAST Thursday’s close.

Here is the problem. Here is the that same chart updated through Friday morning’s open.

As I stated last week:

“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.”

The time has now come to start moving more heavily to cash. As I will discuss throughout this weekend’s missive, including the 401k-Plan Manager, it is now time to “OPPORTUNISTICALLY” REDUCE PORTFOLIO ALLOCATIONS.

As noted in the chart above, the markets are now once again extremely oversold. As I have often stated in the past:

“By the time a market signal is given in the market, the markets are very likely at a point of extreme oversold or bought conditions. Therefore, it is always better to use the subsequent relaxation of those extreme conditions to add or reduce portfolio exposure.”

This is why it is never a good idea to “panic” when something initially goes wrong.

With the markets now deeply oversold, it is VERY likely that the markets will bounce next week. The problem, for those with “buy and hold” bullishly biased strategies, is the “bull market” has now ended…at least for now.

As shown in the next chart, and confirmed by the above, is that a bounce from these oversold levels will run into a substantial amount of overhead resistance where the rally will very likely fail. THIS WILL BE THE POINT TO LIQUIDATE HOLDINGS.

I will discuss WHAT and HOW MUCH to sell momentarily.

But first, I just want to discuss a couple of more charts that provide substantially further evidence that the bull market has now very likely ended.

The first shows the bull market trend that begin in late 2012. We have now DECISIVELY broken that bullish trend. As the old adage goes:

“The trend is your friend…”

The problem is that most forget that it applies in both directions.

The next chart steps back further to look at the bull market that began in 2009. While you have NOT yet confirmed the end of the long-term bull market, you are exceedingly close. It will take a very strong rally to re-establish the “bull market” trend at this point, and at such a late stage of the market cycle. the odds are heavily against such an event.

Stepping back even further to look at the entirety of the previous two full market cycles I see a very interesting story developing.

Both bull markets have previously ended when the relative strength of the advance declined into bear territory combined with a break of the 70-week moving average. Currently BOTH of those ingredients have now occured.

There is a strong possibility that any advance in the next week or so will be one of the last opportunities to lift excess risk from portfolios before a continuation of the market correction occurs.

What If I’m Wrong

Could I be wrong? Absolutely. With Central Banks globally “at the ready,” there is a real possibility that markets could be surprised by what happens next.

However, at this critical junxture, there are only a couple of things I see that could potentially save the current bull market advance from ending.

1. There is NO WAY that the Fed will hike rates in September. Of course, I have been a strong proponent since early this year that the Federal Reserve would be unable to do so given the underlying weakness in the economy. (See “Fed Stumbles” for history of my calls)
2. The Fed launches another “Quantitative Easing” program. Such a move would inject liquidity back into the stock market (and could be combined with a ban on “short selling”) lifting asset prices temporarily.

If the market bounces. and you reduce your portfolio allocation as I suggest, you will have captured previous gains. However, if the Fed should launch a QE program and the market re-establishes its bullish trajectory, it will simply be a function of re-allocating risk back into portfolios.

Yes, you may miss a small portion of the move, but such a “miss” will be far less of a consequence than a potential 20-30% correction if I am right.

Remember, our job as investors is NOT to try and beat some random benchmark index, but to grow our savings in a manner that conserves our principal over time.

Adjusting The Model

Over the last 25-years of “trial and error,” and trust me there have been many “trials” and “errors” along the way which is to be expected in portfolio management, I developed a series of 4 signals to drive portfolio models. However, since I do believe in long term investing, the signals are based on weekly data to smooth out portfolio volatility and significantly reduce 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.”

(Important Note: The selloff in the market over the last few weeks was enough to trigger both sell signals #1 and #2. This brings portfolio exposure down by 25% as shown below.)

Notice, however, that in the chart above that “panic selling” the initial breakdown was generally not a good idea. Being patient and waiting for the reflexive bounce provided a much better exit point to reduce portfolio risk.

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.

Reducing The Model By 25%

Let me reiterate again. 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 sell signals are generated when markets are oversold enough to generate a short-term reflexive bounce.

As stated and shown in the charts above, it is very likely that the recent selloff has reached a short term bottom. A rally back towards the 200-day moving average is very likely. A failure at those levels is extremely important.

With the two primary sell signals in place, combined with a significant break of long-term bullish support, it is time to PREPARE to take actions in portfolios during a reflexive rally. As shown, I am reducing the model by 25% currently and suggesting using the reflex bounce in the markets to underweight portfolios temporarily.

NOTE: If the expected reflexive rally fails at resistance, this will trigger another IMMEDIATE reduction of 25% in the allocation model. Be prepared to take action accordingly.

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.)

1. 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. (Energy, Industrials, Materials, International, Emerging Markets, etc.)
2. Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits) (Discretionary, Healthcare, Technology, etc.)
3. Positions that performed with the market should also be reduced back to original portfolio weights.
4. Move trailing stop losses up to new levels.
5. 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.

However, if you need assistance do not hesitate to send me an email. Also, follow me on FACEBOOK or TWITTER as I will be updating this analysis intra-week as developments occur.

Hang on to your hats, things are likely to be very bumpy over the next several weeks.

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.