by Lance Roberts, Clarity Financial
In the short-term, the market seems headed higher. However, it is worth remembering the reason it is called a “market peak.” Such is the point where prices stopped going up. Previous peaks are the graveyard of investors who believed prices could not go down.
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Currently, there are some signs of more extreme conditions that have previously suggested investor caution. For example, the Russell 2000 is now as deviated from its 200-dma as it was in 1999.
Over the past 15-years, there is no point where IWM was more than 3-standard deviations above its 200-week (4-year) moving average, overbought, and trading above 3.5 on its MACD.
While these extreme measures can indeed be maintained “longer than expected,” the very laws of physics require a reversion in price.
S&P Extremes
We also see the same issues presenting themselves in the S&P 500 index as well.
- Despite the rally since 2018, the market has continued to exhibit a negative divergence in relative strength.
- The market is once again pushing well into 3-standard deviations above the 4-year (200-week) moving average.
- The market is now 13.37% above the 26-week moving average, which matches previous highs.
Currently, the evidence is mounting that markets are reaching the limits of the current move. By themselves, these signs reflect the prevailing extremely bullish attitude of market participants.
However, importantly, these more extreme extensions provide the “fuel” for a sell-off given an unexpected catalyst. The ensuing “reversion” tends to catch overly confident “bulls” off guard.
Calculating The Madness
Let me repeat something which seems apropos currently:
Sir Isaac Newton once said:
“I can calculate the motions of the heavenly bodies, but not the madness of the people..”
As we head into year-end, we will be navigating the risk of overly extended and bullish markets against the seasonally strong end of year period.
We believe that over the long-term, capital preservation and risk management leads to better outcomes. However, sometimes, in the short-run, managing risk can undoubtedly be a frustrating endeavor as the “Fear Of Missing Out” overrides common sense and logic.
If you disagree, that is okay.
When the opportunity presents itself, and the “madness has subsided,” these are the questions we will ask ourselves before we add exposure to portfolios:
- What is the expected return from current valuation levels? (___%)
- If I am wrong, given my current risk exposure, what is my potential downside? (___%)
- If #2 is greater than #1, then what actions should I be taking now? (#2 – #1 = ___%)
How you answer those questions is entirely up to you.
What you do with the answers is also up to you.
We are all trying to answer the question, “how much of the ‘narrative’ already got priced into the market?”
By looking at the data, it would be easy to assume the answer is “much.”
Portfolio Positioning Update
While we remain primarily long-biased in our portfolios, we hold a higher than average level of cash. Such is for several reasons.
- Cash provides a risk-free hedge against market volatility.
- It provides us an opportunity to add exposure for a year-end “Santa Rally” selectively.
- It also gives us the ability to reposition into either further defensive or offensive, positioning depending on outcomes.
In short, having cash gives us the flexibility to take advantage of “dumb money,” which is historically wrong near market peaks. The trick is having the patience to wait it out.
Lastly, we are also watching the U.S. Dollar very closely. It is now extremely oversold with a large net-short position. Such is a prime setup for a rather sharp reversal, which would lead to lower prices in commodities, stocks, emerging markets, international markets, and bitcoin.
The markets are indeed currently exceedingly exuberant on many fronts. With margin debt back near peaks, stock prices at all-time highs, and “junk bond yields” near record lows, the bullish media continues to suggest there is no reason for concern.
Of course, such should not be a surprise. At market peaks – “everyone’s in the pool.”
“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham
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