Pattern Recognition: Is the S&P 500 Forming a Head and Shoulders Bottom?

I don’t always share when I observe stock market patterns unfold, but when I do, it’s usually to inform (or aggravate) my friends who don’t understand (or want to understand) technical analysis.

Long before I started developing computerized trading systems based on quantitative signals I learned and applied chart patterns and trend lines to determine if a trend was up, down, or sideways. Said another way, up until 15 years ago I identified the direction of price trends visually looking at a price trend on a chart. I later defined up, down, and sideways with mathematical equations that help to systematize the process of trend identification. I believe my starting out learning trends by hand and visual representation helped me to develop better quantitative trend systems. The two go hand in hand.

We can define the direction of a trend with an equation as simple as momentum. For example, I have 14 different definitions of momentum and equations that define it. A simple one is X period rate of change. If it’s positive, the trend is up. If it’s negative, the trend is down. The factor that determines the trend direction is the time frame. Many academic types like using simple time series momentum methods like this because it’s easy to backtest. Pattern recognition is more difficult, so fewer have developed systems to automate pattern recognition and make it testable.

Chart patterns have historically been more visual. Chartists or technical analysts look at the chart of a price trend to determine if there is a pattern. The pattern we are looking for tells the story of supply and demand. The chart of a price trend shows us what has been going on with the battle between supply and demand from buyers and sellers. We may get an idea of who may be winning the battle and position our capital in that direction. For example, when prices are rising the buyers are in control and when prices all falling selling pressure is dominant. So, pattern recognition is just another form of trend following. Instead of using X-day breakouts, moving average, or channel breakouts, it’s using a pattern that is believed to tell the story of price action. We don’t make decisions based on a pattern, but the underlying asymmetry between buyers and sellers that caused the pattern and the direction of the price trend.

Simple > Complex

To me, it’s a much more simple way to determine if buyers or sellers are in control of the price trend than trying to find a fundamental narrative. There are so many different reasons for buying demand and selling pressure we could never really know why one is dominating the other. The news attempts to explain it, but the truth is, investors could be buying or selling based on perceived fundamentals, trend lines, moving averages, stop losses, buy stops, fear of missing out, fear of losing money, or tax reasons. Rather than trying to figure out what the majority is thinking, the pattern of the price trend tells the net result of all the buying and selling. It fits the idea of simple beats complex and if we simply stay with the direction of the trend we can’t be too wrong for too long. Someone making decisions based on things other than the price trend itself has the potential to stray far away from the reality of the price.

To me, chart patterns are really just a little more elaborate versions of trend lines. A trend line is just a line marking a chart such as how I marked the higher highs and higher lows yesterday in Divergence in the Advance-Decline Line May be Bullish. 

I observed today the S&P 500 seems to be forming a head and shoulders bottom pattern. The head and shoulders pattern happens when a market trend is in the process of reversal either from a bullish or bearish trend.  There are two kinds of head and shoulders.

  • A head and shoulders top is a pattern that forms after an uptrend. After it is completed, it signals a reversal of the trend from up to down.
  • A head and shoulders bottom is an inverse of the head and shoulders top. The head and shoulders bottom forms after a downtrend and signals a change of trend from down to up.

Below is the chart of a theoretical index used to represent an idealized head and shoulders. It includes both head and shoulders tops and head and shoulders bottoms. Stockcharts offers this index for educational purposes to see what idealized head and shoulders look like. You may notice each top and bottom are a little different – they aren’t perfect.

head and shoulders pattern recognition

I put the green box around a head and shoulders bottom. You can see why when you look at the S&P 500 stock index chart below.

head and shoulders bottom patterns recognition

An inverse head and shoulders pattern is simply a downtrend caused by selling pressure, interrupted by a brief reversal (left shoulder), a selling climax (head), an interruption again (right shoulder), then it would move on to new highs. Moving on to new highs will determine if it is completed as a reversal bottom, or not. To reverse the downtrend, selling pressure must be exhausted as buying demand becomes dominant.

Many patterns like the head and shoulders rely on volume as confirmation, so chartists can make it as complicated as they want, or keep it simple by looking at the pattern. For my purpose, I’m going to keep it simple and say we’ll know if this is indeed a head and shoulders bottom reversal pattern if it follows through on the upside. If it does, we would expect the price trend of this index to at least reach its old highs. If the price doesn’t hold and it doesn’t follow through to the upside, it’s probably going to at least test the prior low again.

Either way, patterns are never completely accurate. It’s probabilistic, never a sure thing. The head and shoulders is simply a pattern formation commonly seen after a downtrend that, if completed, may signal the end of the downtrend and reversal into a new uptrend. It’s based on the visual representation of the battle between supply (selling pressure) and demand (buying interest). For example, when the head and shoulders bottom completes the low point in the (inverse) head, it marks the point when those who wanted to sell have sold. So, the right (inverse) shoulder signals selling has dried up and buyers are taking over. It is completely normal to observe profit-taking after an advance, so the last few days is normal even if this is a reversal up. You can probably see how volume gets involved to confirm the pattern. In the case recently, the volume was high at the lows signaling selling pressure. The volume is declining on the right shoulder. The good news is, the volume didn’t expand on these recent down days.

Let’s see how it all unfolds.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

 

The stock market is swinging its way to an inflection point

Trying not to sound like a broken record, I’ll share a few updates from what I said last in Observations of the stock market downtrend. 

The stock market is at an inflection point. An inflection point is a time of meaningful change in a situation; a turning point. The reality is, there are many inflection points within market cycles and price trends. So, we observe different inflection points across different time frames. For those who watch the stock market daily as a professional portfolio manager, we observe every move. But, the overall focus needs to be on the bigger trends. Every market cycle and price trend is made up of smaller cycles as prices swing up and down on their way to forming a directional trend. Market cycles don’t trend straight up or down.

The U.S stock indexes have dropped about -10% in October, giving up gains for the year. Many investors probably believe October is historically the worst month of the year for the stock market because of famous October declines. September is actually the worst month historically, but October is historically a volatile month. It just so happens, this decline occurred inside of October.

I don’t use seasonality as a signal for my decisions, but we’ve all heard of “sell in May and go away.” The period from May through October is supposed to be the weak season and November to April is the stronger season for stocks. The S&P 500 had defied the expectation that stocks would be weak last summer and gained nearly 10% from May through September, then lost the gain in October. Many leading growth stocks that previously showed the strongest momentum declined even more than the stock indexes. I pointed out a few months ago that international stock indexes including both emerging and developed countries were already in downtrends. So, the global equity markets were generally down in October.

That’s the bad news for anyone invested in these markets.

The good news is after those who wanted to sell have sold, prices eventually reach a low enough point to attract new buying interest.

I focus on what the price trends are actually doing, so I’ll share my observations of the trends and update some sentiment and breadth indicators I’ve discussed in previous observations.

First, we look at what the price trend is actually doing. Below is the S&P 500 stock index year-to-date. We see after declining about -10% from its September high, the stock index has reversed back up to the price of the prior low on October 11th.

 

In technical analysis of price trends, we say “prior support may become resistance” and that may be what happens next. We shouldn’t expect prices to trend straight up or down, they swing up and down. Prices making higher highs and higher lows form uptrends or lower lows and lower highs form downtrends. So, it wouldn’t be abnormal to see the stock index trend back down to the low again, or it could pause and continue the recent upward direction.

For a sustained move higher, those who want to sell need to have sold and prices need to have reached a low enough point to attract new buying demand.

Have those who want to sell, sold?

To get an idea for observation of investor sentiment, we can look at a few simple indicators. I explained the thinking behind the Fear & Greed Index in Observations of the stock market downtrend.

The Fear & Greed Index is based on 7 indicators of investors sentiment and can be a useful gauge to help investors keep their own sentiment in check. It currently remains at an “Extreme Fear” level, which is typical after a stock market decline and a high level of bearish sentiment that has historically preceded stock prices reversing back up- as those who want to sell have sold. However, in a prolonged bear market, this oscillating indicator could stay low for a long time or it could swing up and down along with price trends.

But, nothing illustrates buying and selling, supply and demand, better than the actual price trends. Another interesting indicator I’ve shared in recent observations is the percent of stocks in the S&P 500 that are trading above their short-term moving average.

 

It shows us how many stocks have participated in an uptrend or downtrend. When it reaches a high point and most stocks have participated in an uptrend, it may be nearer a reversal back down. Price trends don’t move straight up. When it reaches a low level is indicates most stocks have declined and at an extreme, it can suggest capitulation – those who want to sell may have sold. But, prices don’t trend straight down. Prices swing up and down along the way to drifting directionally. At this point, this indicator has reached the February and April lows and reversed up.

Shorter term, it’s an inflection point as I highlighted. If more stocks trend back up, we’ll see this trend higher.

Let’s see how it all unfolds…

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

Observations of the stock market downtrend

Observations of the stock market downtrend

In the last observation I shared about the stock market, “The stock market trends up with momentum,” we saw the stock market reverse back up with strong momentum. The S&P 500 stock index had declined about -7% from its high, then reversed back up 3%. I discussed how investor behavior and sentiment drives market prices. Many investor sentiment measures signaled investor fear seemed to be in control, driving down prices. Volatility had spiked and then started to settle back down. Many individual stocks in the S&P 500 had declined enough to signal shorter-term downtrends, but then they reversed up. I closed by saying:

In summary, today was a strong upward momentum day for the stock market and most stocks participated in the uptrend. After sharp declines like we’ve seen this month, the stock market sometimes reverses up like this into an uptrend only to reverse back down to test the low. After the test, we then find out if it breaks down or breaks out.

One day doesn’t make a trend, but for those who are in risk taker mode with stocks, so far, so good.

The part I bolded with italics has turned out to be the situation this time.

Below is a year to date price trend of the S&P 500 stock index. As of today, my observation “the stock market sometimes reverses up like this into an uptrend only to reverse back down to test the low” is what we are seeing now.

stock market trend

I’ve always believed investment management is about probability and possibilities, it’s never a sure thing. The only certainty is uncertainty, so all we can do is stack the odds in our favor. As I said before, “After the test, we then find out if it breaks down or breaks out.” 

The positive news is, investor sentiment measures are reaching levels that often precede short-term trend reversals back up.

The bad news is if the current trend becomes a bigger downtrend these indicators will just stay at extremes as long as they want. We have to actively manage our exposure to loss if we want to avoid large losses, like those -20% or more that are harder to overcome.

Down -10% is one thing, down -20% is another. Any investor should be willing to bear -10% because they will see them many times over the years. Only the most passive buy and hold investors are willing to bear the big losses, which I define as -20% or more.

Nevertheless, I see some good news and bad, so here it is. I’ll share my observations of the weight of the evidence by looking at relatively simple market indicators. I don’t necessarily make my tactical decisions based on this, but it is instead “market analysis” to get an idea of what is going on. Observations like this are intended to view the conditions of the markets.

Fear is the dominant driver. 

The Fear & Greed Index tracks seven indicators of investor sentiment. When I included it a week ago, it was at 15, which is still in the “Extreme Fear” zone. The theory is, the weighting of these seven indicators of investor sentiment signals when fear or greed is driving the market. Clearly, fear is the dominant driver right now.

fear greed index investor sentiment behavioral finance

At this point, we can see investor sentiment by this measure has now reached the low level of its historical range. In this chart, we can see how investor sentiment oscillates between fear and greed over time in cycles much like the stock market cycles up and down.

fear and greed back test over time investor sentiment indicator

I believe investor behavior is both a driver of price trends, but investors also respond to price trends.

  • After prices rise, investors get more optimistic as they extrapolate the recent gains into the future expecting the gains to continue.
  • After prices fall, investors fear losing more money as they extrapolate the recent losses into the future expecting them to get worse.

Investor sentiment and price trends can overreact to the upside and downside and the herd of investors seems to get it wrong when they reach an extreme. We observe when these kinds of indicators reach extremes, these cycles are more likely to reverse. It is never a sure thing, but the probabilities increase the possibility of a reversal. But, since there is always a chance of a trend continuing longer in time and more in magnitude, it is certainly uncertain. Since there is always a chance of a bad outcome, I  have my limits on our exposure to risk with predetermined exits or a hedge.

Speaking of a hedge. 

I started pointing out my observation several weeks ago of a potential volatility expansion. If you want to read about it, most of the past few weeks observations have included comments about the VIX volatility index. Over the past few days, we’ve observed a continuation in the volatility expansion.

vix hedge volatility expansion asymmetric hedge asymmetry

Implied volatility has expanded nearly 100% over in the past 30 days.

vix volatility expansion trading

As a tactical portfolio manager, my first focus is risk management. When I believe I have defined my risk of loss, I become willing to shift from risk manager to risk taker. I share that because I want to point out the potential for hedging with volatility. Rather than a detailed exhaustive rigorous 50-page paper, I’m going to keep it succinct.

My day job isn’t to write or talk about the markets. I’m a professional portfolio manager, so my priority is to make trading and investment decisions as a tactical investment manager. I’m a risk manager and risk taker. If I never take any risk, I wouldn’t have any to manage. The observations I share here are just educational, for those who want to follow along and get an idea of how I see things. I hope you find it helpful or at least interesting. It’s always fun when it starts new conversations.

To keep the concept of hedging short and to the point for my purpose today, I’ll just share a simple chart of the price trend of the stock index and the volatility index over the past 30 days. The stock index has declined -8.3% as the implied volatility index expanded over 95%. You can probably see the potential for a hedge. However, it isn’t so simple, because these are just indexes and we can’t buy or sell the VIX index.

vix volatility as a hedge stock market risk management

The purpose of a hedge is to shift the risk of loss from one thing to another. The surest way to reduce the possibility of loss is to simply sell to reduce exposure in the thing that is the risk. That’s what I do most of the time. For example, when I observed a potential volatility expansion, I reduced my exposure to positions that had the possibility of loss due to increased volatility. Once prices fall and volatility contracts, maybe we increase exposure again to shift back to risk-taking. If we take no risk at all, we would have no potential for a capital gain. So, tactical portfolio management is about increasing and decreasing exposure to the possibility of gain and loss. If we do it well, we create the kind of asymmetric risk/reward I aim for.

So, any hedging we may do is really just shifting from one risk to another, hoping to offset the original risk. Keep in mind, as I see it, a risk is the possibility of loss. I’ll share more on hedging soon. I have some observations about hedging and hedge systems you may find interesting.

Most stocks are participating in the downtrend. Below is an updated chart of the percent of the stocks in the S&P 500 that are above their 50-day moving average. If you want to know more about what it is, read the last observations. The simple observation here is that most stocks are declining.

stock market breadth risk indicator

Much like how we saw investor sentiment cycle and swing up and down, we also see this breadth indicator oscillate from higher risk levels to lower risk levels.

  • After most stocks are already in uptrends, I believe the risk is higher that we’ll see it reverse.
  • After most stocks have already declined into downtrends, it increases the possibility that selling pressure may be getting closer to exhaustion.

The good news is, at some point selling pressure does get exhausted as those who want to sell have sold and prices reach a low enough level to bring in new buying demand.

That’s what stock investors are waiting for now.

These are my observations. I don’t have a crystal ball, nor does anyone. I just predetermine my risk levels in advance and monitor, direct, and control risk through my exits/hedging how much I’m willing to risk, or not. We’ll just have to see how it all unfolds in the days and weeks ahead.

Only time will tell if this is the early stage of a bigger deeper downtrend or just another correction within the primary trend.

I hope you find my observations interesting and informative.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

Observations of the stock market decline and volatility expansion

Observations of the stock market decline and volatility expansion

On September 25th I shared in VIX level shows market’s expectation of future volatility when I pointed out a low level of expected volatility as implied by the VIX index.

I said:

The current level of the VIX index has settled down to a lower historical level suggesting the market expects the future range of the price of the S&P 500 to be lower. Below is the current level relative to the past year.

I went on to explain my historical observations of volatility cycles driven by investor behavior:

The VIX Index is intended to provide a real-time measure of how much the market expects the S&P 500 Index to fluctuate over the next 30 days. The VIX Index reflects the actual order flow of traders

Since investors tend to extrapolate the recent past into the future, they usually expect recent calm markets to continue and violent swings to persist.

After the stock market declines and volatility expands, investors extrapolate that recent experience into the future and expect volatility to continue. Sometimes it does continue, but this time it gradually declined as the price trend became calmer.

When markets have been calm, traders and investors expect volatility to remain low. Before February, the VIX implied volatility had correctly predicted low realized volatility for months. But, both realized and expected volatility was so low that many investors were shocked when stock prices fell sharply, and volatility expanded.

When the market expects volatility to be low in the next 30 days, I know it could be right for some time. But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.

I shared the chart below, showing implied volatility at the low end of the cycle over the past year:

Since that date, we’ve indeed witnessed a volatility expansion of more than 90% in the VIX index and a decline in the S&P 500 stock index over -6%.  Implied volatility has expanded and stocks declined. As implied volatility is now starting to contract, below we can see the recent expansion as it trended from 12 to 24. Today its back to its long-term average of 20.

Stock market indexes, both U. S. and international, have declined 6 – 7% from their highs.

At this point, this has been a normal short-term cycle swing in an ongoing uptrend that is frequently referred to as a “correction.”

To be sure, we can see by looking at the % drawdowns in the primary uptrend that started in March 2009.

Markets cycle up and down, even within overall primary uptrends. As we see over a nine-year period, the current decline is about average and half as deep as the largest declines since 2009.

You can probably see what I meant by situational awareness of the markets cycles, trends, and volatility levels.

It isn’t enough to just say it or write about it. My being aware of the situation helps me to do what I said, which is worth repeating:

But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.

As far as the stock market condition, I like to see what is going on inside. Just as volatility swings up and down in cycles, so do price trends. As I’ve pointed out before, I observe prices swinging up and down often driven by investor behavior. For example, many investors seem to oscillate between the fear of missing out and the fear of losing money.

“The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.” – Warren Buffett

One visual way to observe the current stage is the breadth of the stock market as I shared last week in The Stock Market Trend. Below is the percent of stocks in the S&P 500 index trending above their 50 day moving averages often used as a short-term trend indicator. This is a monthly chart since 2009 so we can see how it oscillates up and down since the bull market started. At this point, the number of stocks falling into short-term downtrends is about what we’ve seen before.

stock market breadth asymmetric risk

The risk is: this continues to be an aged old bull market, so anything is possible. That is why my focus every day is situational awareness. But, there is always a risk of a -10% or more decline in the stock market, regardless of its age or stage.

The good news is, we’ve now experienced some volatility expansion, stocks have now pivoted down to the lower end of their cycles, so maybe volatility will contract and stock prices resume their uptrend.

We’ll see.

All that is left to do is observe, be prepared, and respond tactically as it all unfolds.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

The Stock Market Trend

The stock market declined with heavy selling pressure on a major stock market anniversary that I haven’t heard anyone mention.

October 10, 2018, is the 10-year anniversary of the waterfall decline of 2008.

Below is the S&P 500 stock index from October 9, 2007 to October 10, 2008. I remember it very well. It was the first part of the waterfall decline up to this day 10 years ago.

stock market decline 2008

But, as a reminder, while this bear market is often called the “2008 Financial Crisis” and misquoted as being only about the year 2008, it actually continued through March 9, 2009.

average length of bear market crash 2008.jpg

With stock indexes only about -5% or so off their all-time highs, we are far from that today.  But, the stock market decline today was impressive in magnitude and broad across all sectors.

stock market sector ETF October 10 2018

The breadth of the decline was unmistakable by the 50% decline in the % of stocks in the S&P 500 trading above their 50 day moving average. The percentage of stocks trading above the moving average is a breadth indicator that measures internal strength or weakness in the stocks in the index and the index itself. We say that breadth is strong when the majority of stocks in an index are trading above their moving average. Since the 50-day moving average is used to measure the short-medium term trend, it reveals that only 24% of the 500 stocks in the S&P 500 index are above their short-term trend.

percent of stocks above 50 day moving average SPX SPY.jpg

I colored the top red and the bottom green because the extreme highs and extreme lows can signal overbought and oversold levels.

The indicator is an oscillator that cycles between 0% and 100%.

After most stocks have trended up, we say an uptrend has broad participation, which is positive. However, markets cycle and oscillate up and down, so once most stocks have already been in uptrends at some point they reverse back down.

After most stocks have trended down, we say a downtrend becomes washed out. As selling eventually gets exhausted because those who want to sell have already sold.

Next, we observe the % of stocks in the S&P 500 index that are trending above their 200 day, which a longer term trend signal. 19% of the stocks declined below their 200 day moving average today leaving about half of the stocks still in a longer-term uptrend.

SPX BREADTH PERCENT OF STOCKS ABOVE 200 DAY MOVING AVERAGE

Since we are talking about moving averages and the S&P 500, below is the index itself with the 50 and 200 day moving average. Notice the 50 day moving average has been too tight to contain the uptrend. In other words, entering and exiting it would lead to many buys and sells and whipsaws like in June. The 200 day has better contained the trend since April, but notice if it were used as an exit it would have resulted in selling at the low. This observation is just using these moving averages as a very simple way to define uptrend vs. downtrend, it is not a complete trading system. Such measures are never perfect, and they don’t have to be.

stock market SPX 200 day moving average trend following

Today’s decline was impressive because the stock indexes declined over -3% in a single day. One day doesn’t make a trend, but it was enough to erase most of the year to date gains for the stock index.

stock market year to date 2018 trend following momentum

 

The Dow Jones Industrial Average of 30 of America’s largest companies declined even more than the S&P 500. There was even more weakness in small companies, momentum stocks, and an ETF tracking the top-ranked growth and momentum stocks by Investor’s Business Daily declined nearly -6%. As a proxy for leading growth and momentum stocks, this is an indication the leaders declined the most today.

stock market momentum ETF trend following asymmetric

You can probably see why I believe it’s essential to actively manage risk by knowing in advance when to exit a loser to cut losses short as well as understanding the market risk level. For those of us who weren’t fully exposed to the decline who have the capital to eventually buy at lower prices, we get to take advantage of a falling trend.

Over the past week, I shared observations of volatility expansion as the implied volatility index has been trending up. Below is its year to date trend.

VIX VOLATILITY EXPANSION

Here it is over the past week since I mentioned it. I included the S&P 500 stock index to illustrate as the stock market declined about -5% the past week, implied volatility expanded 98%.

SPY SPX VIX ASYMMETRIC RISK REWARD

We’ll see in the days and weeks ahead if this is the beginning of a more significant downtrend that becomes a waterfall decline or if it was enough to exhaust the selling pressure of those who wanted to sell.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

 

Divergence in Global Asset Allocation

We’ve observed divergence across global markets since September, so those invested in a static global asset allocation probably notice it the most. I focus my U.S. equity portfolio exposures more granularly into individual stocks and sectors rather than these broad asset classes, but I still monitor them all. I’ll share some recent observations.

Since the first of September, I observed small cap stocks started to trend down. In the chart below, up until September, we see small cap stocks (orange) had trended up with the best momentum since the drop in February and April. Large and mid-cap stocks trends converged with each other until recently when mid-cap stocks turned down more than the large stocks index. At this point, the small company stock index year to date trend has declined to converge with the popular S&P 500 stock index of mainly large companies.

stock market divergence between large and small cap stocks

To get a better visual of the recent divergence, I draw a chart of the % off high to see each of their drawdowns. Here we see the S&P 500 has barely declined off its high. The weakness is in mid-cap stocks and even more in small-cap stocks. Investors who have the typical asset allocation portfolio hold some static mix of small, mid, and large. They probably notice unusual strength until September, then those gains faded away.

divergence small and large cap trend following momentum

But, the divergence isn’t just in U.S. stocks. In fact, U.S. stocks have been the strongest trends in the world recently. Bonds, for example, have been in a downtrend. Here are three bond index ETFs year to date. The broad U.S. Aggregate Bond index has declined nearly -5%, corporate bonds -7%, and the long-term U. S. Treasury -10% this year alone.

bond trend momentum losses in 2018

Yes, that is U. S. Treasuries, U.S. government bonds, down over -10% year to date. However, the downtrend in bonds didn’t just start this year. This trend has been going for a while, so here we see the % off high the past three years for a better view of the downside. The long-term U.S. Treasury index is down about -21% from its top three years ago. So, to the extent that static global asset allocation portfolios have a fixed allocation to bonds, you can probably see how they weigh down a portfolio. In fact, to the point of offsetting gains in stocks if their weight is enough.

bond fund ETF drawdowns risk

In May 2015 I warned of this when I shared Allocation to Stocks and Bonds is Unlikely to Give us What We Want and What You Need to Know About Long-Term Bond Trends. I suggested that bonds may not provide a crutch in the next bear market. In fact, in September 2015 I shared that Bonds Aren’t Providing a Crutch for Stock Market Losses.

You can probably see why I prefer to rotate and shift between markets based on trends and tactical decisions rather than a fixed asset allocation to them.

Market trends move in cycles over time. No market price trends up all the time. Even within long-term uptrends, markets cycle up and down along the way with smaller trends within the larger trend. For example, the small-cap divergence at this point is a smaller divergence. Before small stocks declined, they had stronger momentum.

When it comes to bonds or other investments that pay interest or dividend yield, there can be some positive about the price trend falling. As the price trends down, the yield it pays trends up. I discussed this in more detail last spring in When I apply different trend systems to ETFs. But I’ll share an example here.

Since the long-term Treasury is down the most, I’ll use it as an example. First, let’s consider as risk-conscious investors, we should naturally prefer to position our capital in the safest investments possible if we can achieve our return objective with it. In other words, if we can get the capital gains and yield we want from government bonds, we would prefer that over even more risky stocks. All markets and all investments have risks and investors who have held long-term Treasuries (or other bonds) the past few years have certainly experience that even fixed income has risks.

However, for those of who didn’t buy and hold bonds the past few years, their yields are beginning to look more interesting as the price has declined. We can illustrate that very clearly with the chart below showing the declining price trend of the long-term Treasury, but the yield is rising the lower the price falls. Clearly, if we were going to have some exposure to these bonds, we would prefer them now over prior periods because the yield it pays is higher.

TLT long term treasury

So, there is divergence within U.S. stocks and also some divergence within bonds and interest rates. Most investors who have an asset allocation have a global asset allocation, not just U.S. stocks, and bonds. The more “sophisticated” institutional style portfolio like the endowments and pension funds allocate capital to International markets, real estate, and commodities, etc.

In Emerging Markets Reached a Bear Market Level I shared an observation that the emerging markets index has declined -20%. Below is the total return of the emerging markets and developed international stocks markets.

emerging markets international stocks 2018 drawdown trend momentum EEM EFA

As always, to get the full view of the downside risk we have to observe the drawdown in terms of % off high. Here we see that international developed and emerging markets are still in downtrends. With both of them down between -11% and -21%, you can see how their declines could offset any gains from U.S. stocks in static global asset allocation.

emerging market drawdown risk management

Since our topic is divergence across global markets and we are taking a global macro view for typical global asset allocation, we’ll include real estate (REITs) and private equity. This real estate index ETF seeks to provide precise exposure to companies from real estate management and development and REITs, excluding mortgage REITs. Since private equity, like what some of the pensions and endowments invest in, is actually private companies instead of publically traded company stocks, we’ll use the Global Listed Private Equity index ETF. The Index it tracks includes securities of 40 to 75 private equity companies, including business development companies (BDCs), master limited partnerships (MLPs) and other vehicles whose principal business is to invest in, lend capital to or provide services to privately held companies (collectively, listed private equity companies). Once again, any exposures to these markets aren’t helping global asset allocation in 2018.

real state and private equity trends momentum global tactical asset allocation

I didn’t want to end on a downtrend, so I saved the commodity indexes for last. For a proxy for commodities, we observe trend price trend of index ETFs like the iShares S&P GSCI Commodity-Indexed Trust. It seeks to track the results of a fully collateralized investment in futures contracts on an index composed of a diversified group of commodities futures. Unlike other markets, the price of “stuff” has trended up lately. Only time will tell if the trend continues, but the rising price of commodities can be considered inflation.

commodity ETF trend following momentum asymmetric risk

You may be wondering, what is the big global macro driver of most of these trends?

As I shared in the observation in The Trend in Interest Rates and the Impact on the Economy and Stock Market and Rising Interest Rate Impact on Real Estate and Home Construction:

Interest rates are rising for the first time in over a decade.

rising interest rates trend .jpg

Some divergence isn’t necessarily a bad thing for those of us who are willing and able to tactically shift between global markets and actively manage risk.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. 

The volatility expansion continues like tropical storm Michael that could become a hurricane

The volatility expansion observation I shared last week has continued.

If you haven’t followed along, I suggest reading VIX level shows the market’s expectation of future volatility and Here comes the volatility expansion to see where I am coming from.

Implied volatility as measured by the CBOE Volatility Index $VIX has gained about 45% in the past three trading sessions, so volatility is expanding.

VIX $VIX VOLATILITY EXPANSION VOL TRADING ASYMMETRIC.jpg

I discussed what a rising VIX and volatility expansion means in the prior observations.

Rising implied volatility means rising expectations for future volatility as implied by options prices. Ultimately, Implied volatility is determined by the price of options contracts.

In other words, implied volatility is driven by supply and demand and order flow.

An increase in options buying increases the price of options which results in higher implied volatility.

The net selling of options decreases the price of options which results in lower implied volatility.

Volatility isn’t directional.

Volatility is a measure of movement and how wide prices spread out, which says nothing about the direction of the price trend. Prices can be trending up sharply and volatility measures could expand.

Here are some examples:

Trending up with volatility expansion: a price trend that gains 10% a day for several days is a directional uptrend, but it’s also volatile. We would say the trend is up, but it’s also a volatility expansion as the price range is expanding.

Non-trending with volatility expansion: a price trend that cycles up and down around 5% a day for a long time with no clear direction up or down is a non-trending condition, but it’s also volatile. We would say it is non-trending, but it’s also a volatility expansion.

Trending down with volatility expansion: a price trend that declines 10% a day for several days is clearly a downtrend, with volatility. We could say the trend is down with expanding volatility.

Most of the time, the risk is asymmetric since we tend to see increased volatility when we see falling prices. As prices fall, more investors and traders respond to the simple fact the prices are falling and they are losing money. This serial correlation with falling prices can lead more prices falling even more as investors sell because prices are falling.

However, occasionally we may observe prices trending down with volatility contraction. A falling price trend with contracting volatility is necessarily going to be a slower downtrend with less directional movement. Instead of 5% or 10% declines, it may be 1 or 2% declines. A downtrend without volatility expansion would be observed as a slower decline that would necessarily take longer for a large loss to develop. For example, a -30% loss would happen much faster with -10% down periods than it would at a rate of -1%. You can probably see how volatility expansions in downtrends get the attention of someone who wants to manage their drawdown.

I’ll share some more detailed ways to observe volatility to decide if volatility is expanding or contracting.

At the top of the chart is the S&P 500 stock index. The bands around the stock index are 2 times the stock index average true range over the past 20 days. The dotted line in the center of the bands is the 10-day moving average. Price trends move in cycles, so they oscillate up and down over time. When we apply bands around the price trend is gives us a visual representation of a “normal” range of prices around the trend. We observe the price trend tends to oscillate or cycle up and down within certain parameters – the range. When this range spreads out, I call it volatility expansion. When the range contracts, it’s volatility contraction. Volatility itself also tends to cycle between expansion and contraction. We can see that here.

volatility expansion stock market VIX ATR

Below the price trend chart with bands of the average true range (ATR) I included a chart of ATR, standard deviation, and the VIX. Both standard deviation and average true range are actual, historical, and realized volatility. These indicators are measuring how the price of the index has actually expanded or contracted. As I pointed out before, the VIX is a measure of options prices on the stocks in this index, so it’s driven by expectations of future volatility over the next 30 days determined by the price of options. ATR and standard deviation are the actual range of movement of the index.

I started with the year-to-date time frame to show how the price trend spread out as it started swinging up and down at the beginning of the year and has since trended up with lower volatility; smaller cycles, smaller swings.

Just as we observe market price trends tend to cycle and swing up and down over time, so does volatility. p

  • Price trends may reach an extremely high or low point, then reverse in the other direction.
  • Volatility may reach an extremely high or low point, then reverse in the other direction.

When we see volatility reach an extreme low/high point, we can expect to see it drift the other way eventually. Investors and traders who only believe trends in price and volatility only go one way are those who get surprised and caught in a loss trap.

Now, let’s zoom in for a closer look with just a three-month time frame to observe what has been going on more recently.

I highlighted in green the recent volatility expansion I pointed out last week. Notice the forward-looking VIX index at the bottom turned up sharper and has trended up higher than its last cycle high last month. However, realized historical volatility as measured by standard deviation and the average true range of index prices has also trended up, but on a lag relative to the forward-looking VIX.

Volatility expansion stock market risk management vix asymmetric risk reward

So, you can probably see why I’m calling it a volatility expansion. It is drifting up, though it could certainly trend up a lot more, or it could reverse back down. For now, the rising prices in options suggest there is demand for protection and it is probably in response to something the market believes may lead to increase risk or volatility. It could be something seasonal like earnings season or it could be as simple as the month of October is historically one of the most volatile months.

Speaking of October…

October is a typical month to see hurricanes in the Gulf and Atlantic, too. Right now, we have Michael (no relation) coming up through the Gulf of Mexico. As of this morning, Michael was just a named storm, but its expected to expand into a Category 2 or 3 hurricane by the time it reaches the Florida panhandle to our favorite places like Sandestin, Miramar Beach, Destin, and the 30A area like Rosemary Beach and Alys Beach. The intensity, speed, and how wide the storm spreads out to reach higher categories is a lot like volatility expansion in market price trends. Most people prefer to experience calm and quiet. We would prefer to see the storm contract and slow down its speed.

Although the tropical storm monitors have ways of measuring the probability of speed, expansion, etc. we are always dealing with the certainty of uncertainty. Hurricanes can shift and drift in different directions, speed up or slow down, and expand or contract. How we respond is a matter of situational awareness of measuring the cone of uncertainty as best we can. Some of us do it better than others. Some of us prepare more timely and respond better than others.

Right now we have some volatility expansion and we are positioned as such. The implied volatility index suggests the market believes we’ll see some price swings (up and down) this month.

We’ll see how it all plays out.

Semper Gumby (Always Flexible).

Let’s hope Michael doesn’t give me a bad name.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

 

 

 

 

 

 

Here comes the volatility expansion

Nine days ago in VIX level shows market’s expectation of future volatility I shared an observation that the implied volatility VIX, a measure of expected future volatility that is implied by option prices, had reached an extremely low point. I explained what that means and how I use it:

When the market expects volatility to be low in the next 30 days, I know it could be right for some time.

But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near.

Today we have some volatility expansion.

The VIX Volatility Index has gained 35%. It implies the market now expects higher volatility. Specifically, the market expects the range of prices to spread out over 15% instead of 12%.

VIX $VIX Volatility Expansion asymmetry asymmetric convexity divergence

The popular stock indexes are down over -1% for the first time in a while.

stock market asymmetry asymmetric risk

As I said nine days ago, it should be no surprise to see some volatility expansion. Volatility is mean reverting, which means it tends to oscillate in a high and low range and reverse back to an average after its reaches those cycle highs and lows.

Implied volatility had reached its historical low end, so it’s expanding back out. Stock prices are also spreading out and declining so we shouldn’t be surprised to see more movement in prices in the coming weeks.

At around the same time volatility was contracting and calm, my momentum indicators were signaling stock indexes and many individual stocks were reaching short-term extreme levels that often preceded a short-term decline. These systems prompt me tactically reduce exposure to stocks to dynamically manage our risk.

Only time will tell how it all plays out. We’ll see how it unfolds from here.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. 

Stanley Druckenmiller on his use of Technical Analysis and Instinct

Stanley Druckenmiller has a 30-year track record that is considered “unrivaled” by many. From 1988 to 2000, Druckenmiller was a portfolio manager for George Soros as the lead portfolio manager for Quantum Fund. He founded Duquesne Capital to manage a hedge fund in 1981 and closed the fund in August 2010.

Kiril Sokoloff of Real Vision interviewed him recently and shared parts of the interview on YouTube.

I watched the full 90-minute interview and noted some observations I’ll share.

Speaking of dealing with “algo trading” and “the machines,” Kiril Sokoloff asks Stan Druckenmiller:

“Let’s talk about the algos. We haven’t seen the algos sell, we’ve only seen them buy. We saw a little bit of it in February when there was some concentrated selling. We saw it in China in 2015, which was scary. Most people weren’t focused on that but I was and I think you were, too.

They (algos/machines) are programmed to sell when the market is down -2%. The machines are running and can’t be stopped and a huge amount of trading and money is managed that way. We’ve been operating in a bull market and a strong economy.

What happens when it’s a bear market and a bad economy, will things get out of hand?”

So, knowing that and knowing we’re at risk of that any moment… what are you watching for? …. how are you protecting yourself? What are you watching for? 

Stanley Druckenmiller answers:

“I’m going to trust my instincts and technical analysis to pick up this stuff up. 

But what I will say… the minute the risk reward gets a little dodgy I get more cautious than I probably would have been without this in the background.”

What was most fascinating about the rare interview of Stanley Druckenmiller is that some of us have figured out a successful tactical trading global macro strategy using the common elements of price trends, relative strength, risk management, and momentum combined with a dose of instinct all applied to global markets.

You can see for yourself at:

This wasn’t the first time Stan Druckenmiller spoke of his use of technical analysis and charts. In Part IV “Fund Managers and Timers” of The New Market Wizards in 1992, Jack Schwager included an interview with Stanley Druckenmiller titled “THE ART OF TOP-DOWN INVESTING.”

When asked what methods he used, he spoke of earnings, and then:

“Another discipline I learned that helped me determine whether a stock would go up or down is technical analysis. Drelles was very technically oriented, and I was probably more receptive to technical analysis than anyone else in the department. Even though Drelles was the boss, a lot of people thought he was a kook because of all the chart books he kept. However, I found that technical analysis could be very effective.”

Then, he was asked about his experiences during the 1987 stock market crash:

Jack Schwager: What determined the timing of your shift from bullish to bearish?

Stanley Druckenmiller: It was a combination of a number of factors. Valuations had gotten extremely overdone: The dividend yield was down to 2.6 percent and the price/book value ratio was at an all-time high. Also, the Fed had been tightening for a period of time. Finally, my technical analysis showed that the breadth wasn’t there—that is, the market’s strength was primarily concentrated in the high capitalization stocks, with the broad spectrum of issues lagging well behind. This factor made the rally look like a blow-off.

Jack Schwager: How can you use valuation for timing? Hadn’t the market been overdone in terms of valuation for some time before you reversed from short to long?

Stanley Druckenmiller: I never use valuation to time the market. I use liquidity considerations and technical analysis for timing. Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction.

Jack Schwager: The catalyst being what?

Stanley Druckenmiller: The catalyst is liquidity, and hopefully my technical analysis will pick it up.

Well, that sounds familiar.

What is most fascinating to me is that I’ve come to the same conclusions through my own experience over more than two decades without knowing Stanley Druckenmiller or others similar to him beforehand. I have to admit that I didn’t remember having so much in common with his strategy because I read The New Markets Wizards so long ago.

Some of us have discovered very similar beliefs and strategies through independent thinking and our own experiences. When I discover that others have found success I see the common characteristics and that confirms what drives an edge.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

 

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

The Trend in Interest Rates and the Impact on the Economy and Stock Market

The Federal Reserve raised interest rates and raised expectations for a fourth rate hike in December. The Fed unanimously agreed to raise the federal funds rate a quarter percentage point, to a range of 2% to 2.25%.

But, what does that mean?

The Federal Funds Rate is the interest rate at which depository institutions like banks and credit unions lend their reserve balances to other banks and credit unions overnight, on an uncollateralized basis. The U.S. Target Federal Funds Rate is at 2.00%, compared to the previous market day and 1.00% last year. This is lower than the long-term average of 2.61%.

The interest rate the borrowing bank pays to the lending bank to borrow the funds is negotiated between the two banks. The weighted average of this rate across all such transactions is the Effective Federal Funds Rate. The Effective Federal Funds Rate is at 1.91%, compared to 1.91% last month and 1.16% last year. This is lower than the long-term average of 4.83%.

Below we chart the trend of the Federal Funds Rate and the Effective Federal Funds Rate over the past 5 years. The trend in interest rates is clear.

Federal Funds Rate Interest Rates Effective Target

Why do we care about rising interest rates?

The Federal Funds Rate drives interest rates for mortgages, consumer loans, and credit cards. For example, loans based on the prime rate will be adjusted to reflect the trend in the Federal Funds Rate.

The rising trend in interest rates impacts many things beyond consumer credit cards. Ultimately, when the cost of borrowing increases it can impact real estate, homebuilders, and home construction as I pointed out in Rising Interest Rate Impact on Real Estate and Home Construction.

We haven’t seen the Federal Funds Rate this high in over 10 years.

Federal Funds Interest rate last 10 years

The Federal Funds Rate was much higher at around 4.5% at the peak of the stock market in October 2007. The Fed quickly and sharply lowered interest rates in response to the economic recession in 2008. The U.S. Fed kept a zero interest rate policy like Japan from December 2008 through December 2015.

federal funds rate since october 2007 bull market peak

Many investors wonder how the change in the directional trend of interest rates impacts the stock market. It is no surprise that mutual fund companies who want investors to keep their money invested in their funds that stay fully invested all the time will present data showing rising interest rates don’t impact stocks.

The Fed has been steadily raising rates to keep the U.S. from growing so fast that inflation gets out of hand. Increasing the cost of borrowing will likely slow down spending at some point for both consumers and capital spending of businesses.

The Federal Funds Rate seems to trend follow the stock market. Looking at a chart from the stock market peak in January 2000, we see the Fed Funds Rate was 6%. The Fed lowered the rate to around 2% during the -50% stock market decline and economic recession. I marked the recession in gray.

FED FUNDS RATE TREND FOLLOWING STOCKS ECONOMIC RECESSION

The Fed naturally increases and decreases the Fed Funds Rate in response to changing conditions.

After an economic expansion and the stock market appears highly valued, the Fed begins to raise interest rates to prevent inflation.

After the stock market declines and an economic recession, the Fed begins to lower interest rates to help stimulate recovery. In the chart above, we can see the zero interest rate policy after the crash of 2008 -2009 is abnormal.

Below is the trend Federal Funds Rate going back to the 1950’s. The interest rate has been much higher in the past, but not kept so low.

federal fed funds rate long term history trend following

Now that interest rates are trending up again it’s going to be interesting to observe how it impacts the economy and the stock market.

Many investment advisors and fund companies will probably try to use the data to show a silver lining. If your money is invested buy and hold into funds that are fully exposed to market risks all the time, those funds incentive is to keep you invested in them regardless of the level of risk.

I don’t believe market returns give us what we want over a full market cycle. After the stock indexes have gained for 10 years without a -20% or more bear market, many investors have probably become complacent with their exposures to market risks. That is especially true with one the longest bull market in history and the second highest valuation.

Along with long uptrends, we can experience devastating downtrends that result in large losses. That’s what we’ve experienced the past 25 years. The giant uptrend 1995 – 1999 was reversed from 2000 -2003. The uptrend 2003 to 2007 was reversed 2008 – 2009 and didn’t recover its 2007 high until 2013.

Rather than full exposure to market risk and reward all the time, I believe we must manage risk to increase and decrease exposure to the possibility of gain and loss.

It doesn’t matter how much the return is if the downside risk is so high you tap out before it’s achieved.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

Rising Interest Rate Impact on Real Estate and Home Construction

The Federal Reserve raised interest rates today and raised expectations for a fourth rate hike in December. They unanimously agreed to raise the federal funds rate a quarter percentage point, to a range of 2% to 2.25%. The rate helps drive interest rates for mortgages, consumer loans, and credit cards. In 2019, the Fed expects at least three more rate hikes.

The rising trend in interest rates impacts many things beyond consumer credit. Ultimately, when the cost of borrowing increases it can impact real estate, homebuilders, and home construction.

The price trend of homebuilders and home construction stocks is down. The ETF of home builders and home construction stocks is down about -20% from their highs in January.

SPDR® S&P Homebuilders ETF XHB iShares Home Construction ETF $ITB

The price trends in Homebuilders stock ETF (XHB) and Home Construction ETF (ITB) show they really haven’t recovered from the fall that started in 2007.

home builders construction ETF sector ETFs

Below we add the 10-year treasury rate. Rising interest rates may be having some impact on real estate home builders and construction.

rising interest rates impact on housing real estate home builders construction

Rising interest rates are supposed to boost the profit margins of financials like banks and insurance. However, so far we observe the bank stocks and insurance stocks ETFs are trending mostly sideways since interest rates moved higher.

Bank ETF insurance ETFs rising interest rates

Another real estate sector is represented by the Real Estate sector ETF (XLRE), which seeks to provide precise exposure to companies from real estate management and development and REITs, excluding mortgage REITs. I shared some observations about the overall real esate sector earlier this year in Interest Rate Trend and Rate Sensitive Sector Stocks. The impact of rising rates has continued.

rising interest rate impact on real estate REIT

A clearer observation is seen in the chart of homebuilders stocks along with the trend in the 15-year and 30-year mortgage rate.

rising mortgage rate homebuilders home construction

Clearly, there seems to be some correlation between rising rates and falling real estate sector and industry groups like homebuilders and home construction stocks.

This is why I shift between markets and sectors based on their price trends instead of just allocating capital to them regardless of their directional trend. It’s also why we manage our risk in absolute terms with our intention of avoiding large losses created by significant down-trending price trends. I rotate between world markets rather than allocate to them.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

What trends are driving emerging markets into a bear market?

In Emerging Markets Reached a Bear Market Level we noted the emerging markets index has declined -20%, which is considered to be in bear market territory. The emerging markets index includes 24 countries classified as emerging countries.

To see the country exposure, we examine the iShares MSCI Emerging Markets ETF holdings. China is about 31%, South Korea is about 15%, Taiwan is over 12%, so the top three countries make up 58% of the country exposure. Add India at 10% and the top four countries is a dominant 68% of the exposure. Clearly, we’d expect the drift of these top holdings to dominate the trend.

what countries are emering markets ETF ETFs

Below we see the 2018 price trends of the emerging markets ETF and the top four countries that make up 68% of the emerging markets index ETF exposure. We see that South Korea and China are the primary downtrends that are trending close to the emerging markets index ETF. Taiwan and India have stronger relative momentum.

emerging markets $EEM china $FXI india south korea 2018 trend

To get a better understanding of what is driving the downtrend, we draw the % off high charts to see the drawdowns. From this observation, we can see what is really driving the trend. Of the top four countries in the index, the negative momentum of China and South Korea are driving the trend down. China is down -24% over the past year as South Korea is down -17%.

emerging market ETF trends

Taiwan and India have stronger relative momentum since they have trended up more recently since July. Prior to July, they were trending closer to China and South Korea.

You can probably see why I include the individual countries in my global universe rather than just the broad emerging markets index ETF that includes 24 countries. I want to find potentially profitable price trends, so I increase my opportunity to find them when I give myself more options.

There are 24 countries represented in the MSCI Emerging Markets Index and we’ve looked at the top 4 because they are given 68% of the exposure. That leaves only 32% in the other 20 countries. So, in regard to understanding what is driving the MSCI Emerging Markets Index, viewing the trend of the top holdings is enough to get an idea of the countries driving returns. But, in wanting to go find potentially profitable price trends, I research all the countries trends.

What about the rest of the emerging markets countries? 

Looking at the other 20 countries classified as emerging markets, I’ll divide them into groups. First, we’ll look at the other countries that are down -10% or more year-to-date. Then, I’ll draw a chart of those that are down this year,  but not as much. We’ll end with the few that are positive in 2018.

Emerging markets countries down the most year-to-date include Turkey, South Africa, Indonesia, Brazil, Philippines, Chile, Poland, and Peru. Priced in U.S. dollars, these countries are down between -14% and -52%. Turkey is down the most.

emerging markets countries down 2018 $EEM

Looking at their % off high shows us the drawdown over the past year, which is a different perspective. If you had held one of these ETFs, this is the amount it would be down from its highest price over the past year.

Emerging markets countries down the most 2018

Clearly, these emerging countries are in downtrends and a bear market if we define a bear market as a -20% decline. Keep in mind, these ETFs are foreign stocks priced in U.S. dollars, so to U.S. investors, this is what the trends of these countries look like.

Next, we observe emerging markets countries that are down less than -10% in 2018. Russia, Columbia, Thailand, and Malasia are down between -3% and 8% so far. Their trends are generally down: lower highs and lower lows.

emering markets year to date 2018

We can see the downtrends in a different perspective when we view their drawdowns as a % off high over the past year.

emering market countries percent off high asymmetric risk reward

I saved the best for last. The strongest trending top momentum emerging markets countries so far in 2018 are Mexico, Taiwan, Saudi Arabia, and Qatar. Saudi Arabia was previously classified as a smaller frontier market, but, this summer MSCI announced it will include the MSCI Saudi Arabia Index in the MSCI Emerging Markets Index.

top momentum emerging markets countires 2018

Hearing names like Mexico, Taiwan, Saudi Arabia, and Qatar may highlight home country bias for some investors. Home country bias is the tendency for investors to favor companies from their own countries over those from other countries or regions.

I don’t have a home country bias. I am open to finding potentially profitable price trends in any country around the world. We encourage investors to be open to global trends and not limit their choices, but if our clients don’t want exposure to any specific country, we are able to exclude it in our ASYMMETRY® Managed Portfolios.

While the United States is the single largest economy in the world, according to JP Morgan it accounts for only a small fraction of global GDP and just over 35% of the world’s capital markets. Yet, studies show that U.S. investors have nearly 75% of their investments in U.S.-based assets. As we’ve shown here, there has been a good reason to avoid emerging countries for now, but as we explain in Emerging Markets Reached a Bear Market Level there are times when these countries present strong relative momentum over U.S. stocks.

This is why I tactically shift between global markets based on their directional price trends rather than a fixed buy and hold global asset allocation.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

 

 

 

 

 

 

The U.S. stock market was strong in August, but…

August was a strong month for the U.S. stock market, but the broad S&P 500 stock index and leading sectors have reached short-term overbought extremes that often indicate short-term elevated risk.

My focus is to position capital in the primary direction of trends across different time frames, but trends can reach short-term extremes within the primary trend. We can focus only on the bigger trend, or we can try to take advantage of the short-term moves.

To understand where I am coming from for this observation, let’s define trend and extreme.

Trend is a direction that a price is moving, developing, evolving, or changing. A trend is a directional drift, one way or another. When we speak of price trends, the directional drift of a price trend can be up, down, or sideways. When I say a price is trending, it’s drifting up or down. I call sideways oscillation non-trending.

Extreme is reaching a high or the highest degree; very great, furthest from the center or a given point.

Tactical traders can be either directional traders or non-directional. For example, all investors are necessarily directional: they invest in a thing and want its price to go up.

A tactical trader can be directional: buying a stock, bond, commodity, or currency, hoping it will go up with them or they can sell it short hoping it will trend directionally down. They are directional traders, so they necessarily need to define the direction of the trend. Which way is it drifting?

However, not all traders are directional. Volatility traders who trade volatility through listed options or futures are trading movement itself, so when we trade volatility we aren’t concerned at all with the direction of the trend – we just want movement. Volatility traders may have no bias at all regarding the direction, we focus on volatility expansion or volatility contraction.

Trend Following is a directional strategy that requires the portfolio manager to determine the direction of the trend and enters that trend expecting inertia and momentum to continue in that direction. There are more than 300 published academic studies alone that prove that the most recent 3 to 12-month price momentum tends to continue rather than reverse. That doesn’t include the vast research and testing conducted by actual trading firms and hedge fund managers (like mine) that are not published to the public. These methods rely on directional trends to exploit for profit.

Countertrend is another directional strategy that requires the portfolio manager to determine the directional trend. However, my counter-trend system is designed to identify trends that are more likely to reverse and change direction than to continue. It may seem this strategy is the opposite of trend following, and in some ways it is, but countertrend systems are based on different time frames when executed correctly.

For example, a trend-following strategy that has been profitable has necessarily identified existing trends that have continued and trend following profits from the magnitude of those gains.

A counter trend can also be profitable and even combined with a trend following system. A counter trend system identifies reversals when the trend has changed or likely to change. The time frame, then, is different.

For example, while research shows that directional momentum over the recent 3 – 12 months tends to continue for another 12 months or longer, we also observe that trends have lasted 4-5 years tend to reverse and change trend.

You may notice stock market uptrends (bull markets) last about 4-5 years before they reverse into a downtrend (bear market). You may also notice investors and their advisers have a tendency to buy funds with the highest 5-year returns, only to catch the end of the excellent performance. You can probably see how they are “trend following” but using the wrong time frame. We find that trends actually reverse around the time those performance tables look appealing to investors. Counter trend systems aim to get positioned for big reversals in trend to profit from their directional change. Skilled counter trend portfolio managers develop and operate countertrend systems that are proven and quantified to identify and profit from such changes in trend.

We also observe short-term countertrends within the 30-day time frame.  Sometimes short-term extremes result in at least a temporary countertrend move in the opposite direction. These are shorter trend countertrends within an overall primary trend. Of course, countertrend reversals can also become longer trend changes, too.

Back to August, it was a strong month for U.S. stocks, but the broad indexes and leading sectors have reached higher risk levels in the short term.

sector rotation august 2018 stock market returnThe Technology sector reached a short-term overbought extreme in June and again in July and declined about -4% before resuming an uptrend.

The Consumer Discretionary sector where Amazon (AMZN) has a 25.5% weighting reached an overbought extreme in June and declined about -4% before resuming an uptrend.

The Healthcare sector has also shown strong momentum in its trend. It also reached a short-term overbought level, but only declined about -3%. However, by my measure, the Healthcare sector is more overbought than others.

These shorter trend trends are partly driven by investor sentiment. So, investor sentiment measures can be useful secondary confirming indicators to understand the condition of trends. At this point, most investor sentiment readings are only modestly elevated to levels that suggest greed is driving the market trend. Price could keep trending until enthusiasm is exhausted and sellers become dominant.

This is a very short-term observation of current trends. It’s just a near-term insight that we shouldn’t be surprised to see stocks decline at least a few percents in the weeks ahead.

And… it’s September… for those who follow seasonality, September has historically been one of the weakest months for stocks. I don’t make decisions based on seasonality. If stocks decline this month, the cause will be what I highlighted, not because which month it happens to be.

The bottom line is the broad stock indexes are trending up and led by a few strong sectors, but they’ve reached levels that my countertrend momentum systems suggest the risk of at least a temporary decline is elevated.

 

Mike Shell is the Founder, and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Managed Portfolios and ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

The week in review shows some shifts

Much of the observations I shared last week are continuing to be more apparent this week.  So, in case you missed it, this may be a good time to read them.

Earnings season is tricky for momentum growth stocks

I discussed how earnings season can drive a volatility expansion in stocks, especially high growth momentum stocks. The stock market leaders can become priced for perfection, so we never know how investors will react to their earnings reports. To achieve asymmetric returns from momentum stocks, we need a higher magnitude of positive reactions than adverse reactions over time. On a quarterly basis, it can be tricky. The gains and losses as much as 20% or more in the most leading momentum stocks like Facebook ($FB), Google ($GOOGL), Twitter ($TWTR), Grub ($GRUB), and NetFlix ($NFLX) have since provided a few examples.

Front-running S&P 500 Resistance

In Front-running S&P 500 Resistance I shared an observation that many market technicians incorrectly say support and resistance appear before it actually does. We won’t know if resistance to a price breakout exists until the price actually does pause and reverse. I suggested the S&P 500 may indeed pause and reverse, but not because the index drives the 500 stocks in it, but instead because my momentum indicators suggested the $SPY was reaching a short-term overbought range “So, a pause or reversal, at least some, temporarily, would be reasonable.” As of today, the S&P 500 has paused and reversed a little. We’ll see if it turns down or reserves back up to continue an uptrend.

Asymmetry of Loss: Why Manage Risk?

asymmetry of loss losses asymmetric exponential

In Asymmetry of Loss: Why Manage Risk? I showed a simple table of how losses compound exponentially. When losses become greater than -20%, it becomes more exponential as the gains required to recover the loss are more and more asymmetric.  This simple concept is essential and a cornerstone to understanding portfolio risk management. Buy and hold type passive investors who hold a fixed allocation of stocks and bonds are always fully exposed to market risk. When the market falls and they lose -20%, -30%, -50% or more of their capital, they then face hoping (and needing) the market to go back up 25%, 43%, or 100% or more just to get back to where they were. This can take years of valuable time. Or, it could take a lifetime, or longer. Just because the markets have rebounded after being down for four or five years from their prior highs doesn’t guarantee they will next time. Past performance is no guarantee of future results.

Trend following applied to stocks

In Trend following applied to stocks, the message was short and sweet: gains are produced by being invested in stocks or markets that are trending up and losses are created by stocks trending against us. Investors prefer to be in rising stocks and out of falling stocks. But, as I showed in Earnings season is tricky for momentum growth stocks the trick is giving the big trends enough room to unfold. In fact, applying trend following and momentum methods to stocks is also tricky. It’s a skill that goes beyond just looking at a chart and it’s not just a quantitative model.

Stock market investor optimism rises above the historical average

About two weeks ago,  the measures of investor sentiment showed a lot of optimism about future stocks prices, so we shouldn’t have been surprised to see some stocks fall. When a lot of enthusiasm is already priced in, investors can respond with disappointment when their stocks don’t live up to high expectations.

Much of the momentum and trend following in stocks is driven by an overreaction to the upside that can be accompanied by an overreaction to the downside. A robust portfolio management system factors these things in.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

Earnings season is tricky for momentum growth stocks

Momentum stocks are stocks that show high upside momentum in their price trend. Momentum stocks are trending not only regarding their absolute price gains but also relative strength vs. other stocks or the stock market index.

Momentum stocks are usually high growth stocks. Since momentum stocks are the strongest trending stocks, their trends are often driven by growth in sales and earnings. Growth stocks are companies that are growing earnings at a rate significantly above average. Growth stocks have high increases in earnings per share quarter over quarter, year over year, and may not pay dividends since these companies usually reinvest their strong earnings to accelerate growth.

Now that we have defined what I mean by “momentum stocks,” we can take a look at some examples of momentum stocks and their characteristics like how their prices trend.

Grubhub Inc. ($GRUB) is an online and mobile food-ordering company that connects diners with local restaurants. GrubHub is a great example today of a high momentum growth stock.  GrubHub stock has gained 24% today after smashing Wall Street’s expectations. Earnings grew 92% to 50 cents a share, marking the fifth quarter in a row of accelerating EPS growth. Revenue soared 51% to $239.7 million, a quarterly best.

Grubhub $GRUB GRUB

Before today, GrubHub stock was in a positive trend that developed a flat base since April (highlighted on the chart). GRUB had already gained 60% year to date, but after such as explosive uptrend in momentum, it trended sideways for a while.

It is earnings season, which can be tricky for the highest momentum stocks. Once a stock has already made a big move, it could already have a lot of good news expectations priced in. That concerns some momentum stock traders. In fact, I know some momentum stock traders who exit their stocks before their quarterly earnings announcements. If they had exited GrubHub, they would have missed today’s continuation of its momentum. However, they would avoid the downside of those that trend in the other direction.

I’ve been trading momentum stocks for over two decades. Over the years I’ve observed different regimes of how they act regarding trend strength and volatility. There are periods of volatility expansion and contraction and other periods when momentum is much stronger.

Volatility is how quickly and how far the price spreads out. When price trends are volatile, it’s harder to stick with them because they can move against us. We like upside volatility, but smart investors are loss averse enough to dislike downside volatility that leads to drawdowns. To understand why the smart money is loss averse, read: “Asymmetry of Loss: Why Manage Risk?“.

Strong upward trending stocks are sometimes accompanied by volatility. That’s to be expected because momentum is a kind of volatility expansion. Upward momentum, the kind we like, is an upward expansion in the range of the price – volatility.

That’s good vol.

But, strong trending momentum stocks necessarily may include some bad volatility, too. Bad volatility is the kind investors don’t like – it’s when the price drops, especially if it’s a sharp decline.

I mentioned GrubHub had gained 60% YTD. I like to point out, observe, and understand asymmetries. The asymmetry is the good and the bad, the positive and the negative, I prefer to skew them positively. What I call the Asymmetry® Ratio is a chart of the upside total return vs. the chart of the downside % off high. To achieve the gain for GrubHub, investors would have had to endure its price declines to get it. For GrubHub, the stock has declined -10% to -15% many times over the past year. It has spent much of the time off its high. To have realized all of the gains, investors had to be willing to experience the drawdowns.

grubhub stock GRUB

I point this out because yesterday I wrote “Asymmetry of Loss: Why Manage Risk?” where I discussed the mathematical basis behind the need for me to actively manage the downside risk. To achieve the significant gain, we often have to endure at least some of the drawdowns along the way. The trick is how much, and for me, that depends on many system factors.

Earnings season, when companies are reporting their quarterly earnings, is especially tricky for high momentum stocks because stocks that may be “priced for perfection” may be even more volatile than normal. Accelerating profit growth is attractive to investment managers and institutional investors because increasing profit growth means a company is doing something right and delivering exceptional value to customers. I’m more focused on the direction of the price trend – I like positive momentum. But, earnings are a driver of the price trend for stocks.

Earnings can trend in the other direction, too, or things can happen to cause concern. This information is released in quarterly reports.

Another example of a momentum stock is NetFlix. By my measures, GrubHub is a leading stock in its sector and NetFlix (NFLX) is the leader in its industry group, too, based on its positive momentum and earnings growth. As we see in the chart below, NFLX has gained 88% year to date. That’s astonishing momentum considering the broad stock market measured by the S&P 500 has gained around 5%, and its Consumer Services Sector ETF has gained 11%.

NetFlix NFLX $NFLX

However, NetFlix stock regularly declines as much as -15% as a regular part of its trend. It has fallen over -10% five times in the past year on its way to making huge gains. The latest reason for the decline was information that was released during its quarterly earnings announcement. The stock dropped sharply afterward.

netflix stock risk downside loss

But, as we see in the chart, it’s still within its normal decline that has happened five times the past year.

While some of my other momentum stock trader friends may exit their stocks during the earnings season, I instead focus more on the price trend itself. I predefine my risk in every position, so I determine how much I’ll allow a stock to trend to the downside before I exit. When a stock trends down too far, it’s no longer in a positive trend with the side of momentum we want. To cut losses short, I exit before the damage gets too large.

How much is too much? 

A hint is in the above charts.

If we want to experience a positive trend of a momentum stock, we necessarily have to give it enough room to let it do what it does. When it trends beyond that, it’s time to exit and move on. We can always re-enter it again it if trends back to the right side.

Sure, earnings season can be tricky, but for me, it’s designed into my system. I’m looking for positive Asymmetry® – an asymmetric risk/reward. What we’ve seen above are stocks that may decline as much as -15% as a normal part of their trend when they fall, but have gained over 50% over the same period.

You can probably see how I may be able to create a potentially positive asymmetric risk/reward payoff from such a trend.

 

Mike Shell is the Founder, and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Managed Portfolios and ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

 

 

 

 

 

Asymmetry of Loss: Why Manage Risk?

“The essence of portfolio management is the management of risks, not the management of returns.” —Benjamin Graham

Why actively manage investment risk?

Why not just buy and hold markets and ride through their large drawdowns?

Losses are asymmetric and loss compounds exponentially.

The larger the loss, the more gain is required to recover the loss to get back to breakeven.

The negative asymmetry of loss starts quickly, losses more than -20% decline start to compound against you exponentially and with a greater magnitude the larger the loss is allowed to grow.

If your investment portfolio experiences a -20% loss, it needs a 25% gain to get back the breakeven value it was before the loss.

asymmetry of loss losses asymmetric exponential

At the -30% loss level, you need a 43% gain to get it back.

Diversification is often used as an attempt to manage risk by allocating capital across different markets and assets.

Diversification and asset allocation alone doesn’t achieve the kind of risk management needed to avoid these large declines in value. Global markets can fall together, providing no protection from loss.

For example, global markets all fell during the last two bear markets 2000-2003 and 2007-2009.

global asset allocation diversification failed 2008

It didn’t matter if you had a global allocation portfolio diversified between U.S. stocks, international stocks, commodities, and real estate REITs.

Diversification can fail when you need it most, so there is a regulatory disclosure required: Diversification does not assure a profit or protect against loss.

This is why active risk management to limit downside loss is essential for investment management.

I actively manage loss by knowing the absolute point I’ll exit each individual position and managing my risk level at the portfolio level.

Active risk management, as I use it, applies tactics and systems to actively and dynamically decrease or increase exposure to the potential for loss.

My risk management systems are asymmetric risk management systems. Asymmetric risk management intends to manage risk with the objective of a positive asymmetric risk/reward.

My asymmetric risk management systems are designed to cut losses short, but also protects and manages positions with a profit.

After markets trend up for a while without any significant interruption, investors may become complacent and forget the large damage losses can cause to their capital and their confidence. When investors lose confidence in the markets, they tap-out when their losses are allowed to grow to large.

I prefer to stop the loss before it gets too large. How much is too large depends on the client, but also the math. As seen here, I have a mathematical basis for believing I should actively manage investment risk.

It’s why I’ve been doing it for two decades. Because I understood the math, I knew I had to do it over twenty years ago and developed the systems and tactics that proved to be robust in the devastating bear markets I’ve executed through since then.

 

Mike Shell is the Founder, and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Managed Portfolios and ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

Stock market investor optimism rises above historical average

“Optimism among individual investors about the short-term direction of the stock market rebounded, rising above its historical average.”

AAII Investor Sentiment Survey

The AAII Investor Sentiment Survey is a widely followed measure of the mood of individual investors. The weekly survey results are published in financial publications including Barron’s and Bloomberg and are widely followed by market strategists, investment newsletter writers, and other financial professionals.

It is my observation that investor sentiment is trend following.

Investor sentiment reaches an extreme after a price trend has made a big move.  After the stock market reaches a new high, the media is talking about and writing about the new high, which helps to drive up optimism for higher highs.

When they get high, they believe they are going higher.

At the highest high they are at their high point — euphoria.

No, I’m not talking about cannabis stocks, I’m just talking about the stock market. Cannabis stocks are a whole different kind of high and sentiment.

A few years ago, I would have never dreamed of making a joke of cannabis stocks or writing the word marijuana on a public website. Who had ever thought there would be such a thing? But here I am, laughing out loud (without any help from cannabis).

Back to investor sentiment…

Excessive investor sentiment is trend following – it just follows the price trend.

Investor sentiment can also be a useful contrarian indicator to signal a trend is near its end. As such, it can be helpful to investors who tend to experience emotions after big price moves up or down.

  • Investor sentiment can be a reminder to check yourself before you wreck yourself.
  • Investor sentiment can be a reminder to a portfolio manager like myself to be sure our risk levels are where we want them to be.

Although… rising investor optimism in its early stages can be a driver of future price gains.

Falling optimism and rising pessimism can drive prices down.

So, I believe investor sentiment is both a driver of price trends, but their measures like investor sentiment polls are trend following.

For example, below I charted the S&P 500 stock index along with bullish investor sentiment. We can see the recent spike up to 43% optimistic investors naturally followed the recent rise in the stock price trend. investor sentiment July 2018

However, in January we observed something interesting. Investor sentiment increased sharply above its historical average in December and peaked as the stock market continued to trend up.

Afterward, the stock market dropped sharply and quickly, down around -12% very fast.

Maybe the investor sentiment survey indicated those who wanted to buy stocks had already bought, so there wasn’t a lot of capital left for new buying demand to keep the price momentum going.

The S&P 500 is still about -2.4% from it’s January high, so this has been a non-trending range-bound stock market trend for index investors in 2018. The Dow Jones Industrial Average was last years more gaining index and it is still -6% from its high.

stock market 2018 level and drawdown

The stock index will need some buying enthusiasm to reach its prior high.  We’ll see if the recent increase in optimism above its historical average is enough to drive stocks to new highs, or if it’s a signal of exhaustion.

Only time will tell…

I determine my asymmetric risk/reward by focusing on the individual risk/reward in each of my positions and exposure across the portolio. For me, it’s always been about the individual positions and what they are doing.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

 

Is it a stock pickers market?

Is it a stock pickers market?

Sometimes the stock market is trending so strongly that the rising tide lifts all boats. No matter what stocks or stock fund you invest in, it goes up. That was the case much of 2017.

Then, there are periods when we see more divergence.

When we observe more divergence, it means stocks, sectors, size, or style has become uncorrelated and are trending apart from each other.

I pointed out in Sector Trends are Driving Equity Returns; there is a notable divergence in sector performance, and that is driving divergence in size and style. Growth stocks have been outperformance value, and it’s driven by strong momentum in Technology and Consumer Discretionary sectors.

When specific sectors are showing stronger relative momentum, we can either focus more on those sectors rather than broad stock index exposure. Or, we can look inside the industry to find the leading individual stocks.

For example, Consumer Discretionary includes industries like automobiles and components, consumer durables, apparel, hotels, restaurants, leisure, media, and retailing are primarily represented in this group. The Index includes Amazon, Home Depot, Walt Disney, and Comcast. Consumer Discretionary is the momentum leader having trended up 9.7% so far this year as the S&P 500 has only gained just under 1%.

momentum sectors

If we take a look inside the sector, we see the leaders are diverging farther away from the sector ETF and far beyond the stock market index.

momentum stocks consumer discretionary sector NFLX AMZN AAPL

In fact, all the sectors 80 stock holdings are positive in 2018.

The Consumer Discretionary sector is about 13% of the S&P 500. As you can see, if these top four or five sectors in the S&P 500 aren’t trending up it is a drag on the broad stock index.

ETF Sector Allocation exposure S&P 500

So, Is it a stock pickers market? 

When we see more divergence, it seems to be a better market for “stock pickers” to separate the winners from the losers.

Another way to measure participation in the market is through quantitative breadth indicators. Breadth indicators are a measure of trend direction “participation” of the stocks. For example, the percent of the S&P 500 stocks above or below a moving average is an indication of the momentum of participation.

Below is the percent of stocks above their 50 day moving average tells us how many stocks are trending above their moving average (an uptrend). Right now, the participation is symmetrical; 52% of the stocks in the S&P 500 are in a positive trend as defined by the 50 day moving average. We can also see where that level stands relative to the stock market lows in February and April and the all-time high in January when over 85% of stocks were in an uptrend. By this measure, only half are trending up on a shorter term basis.

SPX SPY PERCENT OF STOCKS ABOVE 50 DAY MOVING AVERAGE 1 YEAR

The 200-day moving average looks back nearly a year to define the direction of a trend, so it takes a greater move in momentum to get the price above or below it. At this point, the participation is symmetrical; 55% of stocks are above their 200-day moving average and by this time frame, it hasn’t recovered as well from the lows. The percent of stocks above their 200-day moving average is materially below the 85% of stocks that were participating in the uptrend last year. That is, 30% fewer stocks are in longer trend uptrends.

SPY SPX PERCENT OF STOCKS ABOVE 200 DAY MOVING AVERGAGE 1 YEAR

In the above charts, I only showed a one-year look back of the trend. Next, we’ll take a step back to view the current level relative to the past three years.

The percent of stocks above their 50 day moving average is still at the upper range of the past three years. The significant stock market declines in August-September 2015 and December-January hammered the stocks down to a very washed out point. During those market declines, the participation was very asymmetric: 90% of the stocks were in downtrends and only about 10% remained in shorter-term uptrends.

SPX SPY PERCENT OF STOCKS ABOVE 50 DAY MOVING AVERAGE 3 YEARS

The percent of stocks above their 200 day moving average also shows a much more asymmetrical situation during the declines in 2015 and 2016 when the stock index dropped around -15% or more. Only 20% of stocks remained in a positive trend.

SPX PERCENT OF STOCKS ABOVE 200 DAY MOVING AVERAGE 3 YEARS

Is it a stock pickers market?

Only about half of the stocks in the index are in uptrends, so the other half isn’t. So, if we avoid the half that are in downtrends and only maintains exposure to stocks in uptrends and the trends continue, we can create alpha.

But, keep in mind, that doesn’t necessarily mean we should have any exposure at all in the S&P 500 stock index because happens to have the highest sector exposure in the leading sectors.

But, for those who want to engage in “stock picking”, the timing has a higher probability now to diverge from the stock index than last year because so fewer stocks are in uptrends and more are in downtrends.

For individual stocks traders willing to look inside the box, this is a good thing.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

When I apply different trend systems to ETFs

In my portfolio management, I primarily want to identify trends and get positioned with that trend. As long as there is uncertainty, we’ll see trends. Investor sentiment and expectations underreact to information causing the price to adjust gradually and that’s what produces a trend. The trend following systems I wrote about in My Introduction to Trend Following are designed to buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue.

We also see the overreaction of investor sentiment and their expectations. After price keeps rising, investors may become overly enthusiastic, which causes prices to overreact and move up to an extreme that matches their sentiment. We saw that the last part of 2017 and it continued in January. We say these markets have become “overbought” and mathematical indicators can signal a countertrend.

We also sometimes see investor sentiment and their expectations plunge as they panic when prices are falling. We say these markets have become “oversold” and mathematical indicators can signal a countertrend. Looking back over the past two months, we may have seen an overreaction on the upside, then an overreaction on the downside. I say that because the stock market very quickly dropped -10%, then recovered most of it a few weeks later.

Someone asked recently “Do you invest and trade in all ETFs and stocks using the same trend system?” The answer is “not necessarily.” As I described above, trend following and countertrend systems are very different. Trend following systems can be multiple time frames, but usually longer trends of at least several months to years. Countertrend moves are normally shorter term as a market may get overbought or oversold, but it doesn’t usually stay that way a long time. For example, the S&P 500 was overbought the last few months of 2017 and that was an anomaly. It was one of the most overbought periods we’ve seen in the stock indexes. So, it was no surprise to see a fast -10% decline.

My point is, different trend systems can be applied to markets. Both trend following and countertrend are trend systems, they just intend to capitalize on a different trend in behavior – overreaction or underreaction.

When I apply my countertrend systems to markets, a great illustration is the high dividend yield market. A great example is the Global X SuperDividend® ETF $SDIV which invests in 100 of the highest dividend yielding equity securities in the world.

Below is a price chart in blue and it’s dividend yield in orange over the past five years. As you can see, the price trend and dividend yield have an inverse correlation. As the price goes up, the dividend yield from that starting point goes down. That is, if we invest in it at higher prices, the dividend yield would have been lower. But, as the price goes down, the dividend yield from that starting point goes up. If we invest in it at lower prices, our future income from dividend yield is higher.

 

For example, I highlighted in green the price was at its low when the yield was also at its highest at 8%. Investors who bought at the lower price earn the higher yield going forward (assuming the stocks in the index continue paying their dividend yields). If we invested in it in 2014 the yield was 6%. High yielding stocks are not without risks. High yielding stocks are often speculative, high-risk investments. These companies can be paying out more than they can support and may reduce their dividends or stop paying dividends at any time, which could have a material adverse effect on the stock price of these companies and the ETFs performance. You can probably see how an ETF that includes 100 of these stocks may be more attractive to gain exposure rather than risking a few individually.

This is an example of when we may use a countertrend system. As I am more inclined to invest in positive trends, this is an example of a situation I may be more willing to buy low. But, I always focus on Total Return. All of my systems include Total Return data that includes the dividend yield, not just the price trend. So as I explain this, keep in mind we still apply my risk management and trend systems but we consider and account for the high yield that makes up its total return.

Below is a chart of the Global X SuperDividend® ETF $SDIV from the low point in 2016 (I highlighted in green above). I charted both the price trend by itself as well as the Total Return which includes dividends. Had someone invested in it at the low, we saw above their yield would be 8% and the impact is evident in the difference. With the dividend yield included, the return was 36% and 18% without it. In other words, the dividend was half the return over this period. The higher the dividend yield at the point of entry, the more it can have an impact on Total Return.

As a special note for our investment management clients who are invested in ASYMMETRY® Global Tactical. We do not reinvest dividends. Instead, we want the cash dividends to go into the cash portion of our portfolio. Since we usually have some positions that generate a monthly yield, it provides the cash balance we need to cover any slippage between trades, investment management costs, as well as provide cash for other investments. I mention this, because any position we hold like this with a high yield may not appear to have as large of a percentage gain since it only represents the price return, not the total return. That is simply because we are using the cash instead of reinvesting the dividends.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

 

 

February Global Market Trends

After a very positive January for U.S. and international stocks, in February it only took 10 days for the S&P 500 to decline -12% intraday and a -10% drawdown based on closing price.

stock market decline drawdown februrary 2018

Yet, February ended with the S&P 500 only down -3.5% after that -12% intra-month drawdown.  For the month, International (MSCI EAFE) and Emerging Markets declined the most viewing the below board based indexes. The U.S. Dollar gained 1.8%.

global market returns february 2018 loss drawdown

Next, we view February global market returns relative to the S&P 500 stock index by holding it constant. This visual shows us how much markets gained/lost net of the S&P 500, Though in the absolute trend table above I showed bonds declined in absolute return, they gained relative to the S&P 500,

global market trend returns relative to spx spy S&P 500

Of course, one month isn’t a trend. In fact, I’m going to explain how this is an intentional logical inconsistency. Speaking of one time period in isolation, be it a month, year, or series of years is just an arbitrary time frame. What’s worse is viewing just the result over a time frame, like the month of February above, in just a table format.

A return stream is precisely that; a stream. A return stream is a continuous price trend in a continuous specified direction. Continuous is forming an unbroken whole; without interruption. So, I like to view return streams as price trends on a chart so I can see how the trend really unfolded over the period. Observed as a visual price trend, we see both the good and the bad of the price action along the way. You can probably see how it does that better than a simple performance table, monthly return % of the period or the bar chart above.

stock market decline februrary 2018

In the chart above, we see how much the price trends of those markets declined along the way before closing the month yesterday. I wrote about the short-term risk reversal in Stock Market Analysis of the S&P 500 suggesting it may reverse back up at least temporarily and retrace some loss and it did.

Now, what is essential about looking at performance data and trends is what the investor experiences. Investors experience what they choose to experience. For example, suppose and the investor is fully invested in the stock market, they could experience the month one of three ways.

  • If the investor only looks at his or her month-end statement, they would experience either the month end “-3.5%”.
  • If the investor watches their account or market indexes closely every day, they experienced every daily move and the full -12% decline and then some recovery.
  • Some may not pay any attention at all either because they are disinterested or they have an investment manager they trust to manage their risk-taking and risk management for them.

Investors and traders get to choose what time frame they watch things. I’ve always observed that “watching it too closely” can lead to emotional mistakes for many. For me, I’m paying attention and may zoom in and pay more attention when trends get more volatile or seem to reach an extreme. But, I’m a tactical portfolio manager, it’s what I do. I can view short term or long term trends alike with self-discipline. I have an edge that has been quantified by a long track record of 14 years in the current portfolio I manage.

I said this recently on Twitter:

If the investor doesn’t like to see such losses like those experienced in many markets in February, they may choose to instead not be fully invested in stocks all the time. That’s what I do. I’m not invested in any specific market all the time. My exposure to risk and return increases and decreases over time based on trends and my risk systems. I intentionally increase and decrease my exposure to the possibility of loss and gain. I’m also unconstrained so I can do it across any global market like bonds, currency, stocks, commodities, or alternatives like REITs, inverse (shorting), or volatility.

According to the American Association of Individual Investors, the decline was so quick most individual investors didn’t seem to respond:

Majority of Investors Avoided Taking Action in Recent Market Correction

“This week’s Sentiment Survey special question asked AAII members what portfolio action, if any, they took in response to the recent market correction. The majority of respondents (62%) said they didn’t make any change or only made a small change. Many of these respondents described themselves as being focused on the long term, viewing this month’s correction as being only temporary in nature or not severe enough to warrant any action. A few of these respondents described the correction as lasting too short of a time for them to take advantage of it. Nearly 33% respondents said they took advantage of the decline to buy stocks or funds. Some said they took advantage of the reduced prices to either add to current positions or buy new holdings. Just 7% of respondents said they sold stocks during the correction. A small number of respondents said they sold some positions and then bought new positions.”

I say investors should find and do what helps them, not make it worse. Know yourself, know your risk, and know your risk tolerance. That’s what we do.

So, that is what happened during the month of February, and a little asymmetric observation to go with it.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

Asset Class Returns are Driven by Sector Exposure

The popular U. S. stock indexes closed in the red for the year Monday, erasing their big starting gains in January. As I mentioned many times; quick gains can be lost even faster. The financial news has mostly been quoting the Dow Jones Industrial Average because it had gained the most year-to-date. It had gained over 7% in January, but lost that gain, and then some, in two days. After just a few days, the Dow Jones dropped -14% in the futures market and -8% on a closing basis. That was enough to wipe out recent gains and mark the index down nearly -2% for the year.

I discussed the market risk in our portfolio commentary for our investment management clients, and we were positioned for it. I also explained it in In remembrance of euphoria: Whatever happened to Stuart and Mr. P? and In the final stages of a bull market. So, it should have been no surprise.

But, when I looked at the asset class performance table, I saw some interesting divergence. Large Cap Growth is still outperforming Small Value. As most of the U.S. equity asset classes were in the red, Large Growth remained positive on the year. I thought I would share a look as to why.

I am a tactical portfolio manager, so my focus is on finding trends and shifting to the trends I want and avoiding those I don’t. That’s a lot different than “asset allocation.” Financial advisors who create asset allocation models for their investment clients normally allocate into funds in the asset class style box. This is also typical with 401(k) plans. They offer funds that provide broad exposure to an asset class style box, rather than the individual stock market sectors I prefer to focus on. So, we often hear style box asset classes quoted like “Large Growth is beating Small Value” or “Large Caps ard leading Small Caps.”

According to Morningstar:

The Morningstar Style Box is a nine-square grid that provides a graphical representation of the “investment style” of stocks and mutual funds. For stocks and stock funds, it classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis).

Below is a recent performance for the equity markets. As you see, U.S. Large Growth was leading with a 2.89% gain year-to-date, Small Value was down -4.83%.  When we observe such a divergence, it makes us curious what is causing it.

 

To understand what is driving the return, we take a look inside to see “what is different.” Below is the sector exposure breakdown of Large-Cap Growth.  We can understand the sector exposure of the iShares Morningstar Large-Cap Growth ETF. Clearly, the big standout is heavy exposure to Information Technology. The other two larger exposures are Consumer Discretionary and Health Care.

Large Growth Stocks Outperform Small

Next, we observe the sector exposure of the Small Value asset class. We can see the sector exposure in the holdings of iShares Morningstar Small-Cap Value ETF.

The Small Value index has 22% exposure to Financials since many financial sector stocks are smaller companies. The other top sector exposures are Industrials, Consumer Discretionary, Real Estate, and Energy.

Small Value Stocks Underperforming Why are

What is different?

Clearly, the single largest difference is that Large Growth is very heavily exposed to the trend in Technology sector. Technology is 50% of Large Growth while it’s only 8% of Small Value. On the other hand, Financials is only 5% of Large Growth but its the largest exposure in Small Value at 22% of the index.

Stock market asset class returns are driven by their sector exposure. Recently, the Tech sector has been one of the mightiest trends, so it’s helped Large Growth also appear more dominant over equity styles that hold less of it. I would preferably look inside and find out what return driver is causing the difference, then get exposure to that trend in momentum.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.

Black Monday: Huge Losses a Reminder of Risk

30 years ago today, global stock markets collapsed. The U.S. stock market represented by the S&P 500 had gained over 35% year-to-date. Investors were likely optimistic. It only took a single day to erase the gain.

The loss on Black Monday was -31.5%. Notice that a -31.5% decline more than erased a 35%+ gain. In fact, after the index had gained over 35% for the year, it was down nearly -9% after a -31% decline.

 

As I explain in Asymmetric Nature of Losses and Loss Aversion, losses are asymmetric. Losses compound exponentially, which is what makes risk management and the pursue of drawdown control worthwhile.

Below we see it in action. It only took a decline of -31% to erase over 60% of a 100% gain since 1984. The S&P 500 stock index had gained over 100% since 1984. The -31% decline brought the gain all the way down to 37%. Losses are very asymmetric.

Black Monday is talked about as a single one-day event, but really it wasn’t. Several weeks of weakness led up to a big down day. But, it would have taken a rather tight risk management system to have exited.

Looking even closer, the % off high chart shows the stock index was about -7% off its price high for several weeks before the crash. So, a drawdown control and risk management system trading this index would have had to exit because of this trend.

It doesn’t have to happen in a single day to erase a lot of gains.

Let’s remember this one.

And more recently, this one.

Today is a reminder that markets are risky and they necessarily require risk management.

 

 

Even Hurricane Irma Hasn’t Shaken Recent Investor Greed

It has been over a week since Hurricane Irma came smashing through South Florida. Hurricane Irma was an extremely powerful and catastrophic Cape Verde type hurricane, the strongest observed in the Atlantic since Dean in 2007. I saved the radar image below on my phone. The yellow star is my home in Tampa Bay. Of course, we evacuated northwest to the spend a few days in Rosemary Beach in the panhandle. As Irma shifted more into the gulf, we drove on to Knoxville days in advance of her. Better safe than sorry.  We returned several days after she passed and fortunately, our neighbors were safe and our homes weren’t damaged in our area. However, many still were without power for a week. Our area is a new development, so our power lines are underground. We weren’t just lucky – we were better prepared. I’m not a fan of relying on luck to survive.

Hurricane Irma Maria

Hurricane Irma was a Category 5 Hurricane as she approached Florida. Irma was only two weeks after Hurricane Harvey caused severe damage to the Houston, Texas area.

This has been a very volatile hurricane season.

But, we can’t say the same about stock market volatility.

Amazingly, the U.S. stock market has remained resilient. In fact, the range of how much the prices have spread out has gotten tighter lately and the declines are smaller. We can see this in the chart below that shows % off highs of the S&P 500 stock index.

low volatility

This is also reflected in the investor sentiment, which has once again become extended to the point of “Extreme Greed” on the Fear & Greed Index. This index uses several indicators to estimate investor fear and greed.

Fear and Greed Index Investor Sentiment

Calm and quiet periods are nice, but eventually, an inertia comes along and changes that trend. You would think two destructive hurricanes in two weeks would be that inertia, but investors in stocks aren’t shaken just yet.

In fact, below I drew a chart of world market returns since Irma struck the United States. Generally, most of the markets are flat. Initially, most markets declined, but overall “safe assets” like U.S. Treasuries, Gold, and Real Estate Investment Trusts actually declined around -2% since Irma.

market returns since irma

Cash has been as good as anything since that period – and with no risk.

We shouldn’t be surprised to see a meaningful decline at some point and prices trending in a wider range.

We’ll see.

VIX Trends Up 9th Biggest 1-day Move

About a week after a hedge fund manager who is popular with the media but has a poor track record of managing risk said “please stop talking about the low VIX”, it gains 44.4% in a single day – its 9th biggest 1-day move. He was suggesting the low VIX wasn’t an indication of high risk. If you have followed my observations, you know that I disagree. I’m one who has been talking about the low VIX and suggesting it is one of many indications of complacency among investors. That is, investors hear “all time new highs” and get overly optimistic instead of reducing their risk or being prepared to manage downside loss.

VIX biggest moves

I point out the hedge fund manager’s comment because I believe a low VIX is an indication of complacency because it measures expected implied volatility for options on the S&P 500 stocks. When implied volatility gets to historical low points, it means options traders aren’t paying high premiums for hedging “protection”. Others can believe what they want to believe. I don’t just point out observations at extremes. I actually do something.

As I pointed out recently in “No Inflection Point Yet, But… ” the VIX was at an extreme low. About a week later this other fund manager implies it may not be meaningful. That’s exactly what we expect to hear when the expected volatility gets to such an extreme low. We expect to see it shift the other direction at some point. I like to follow trends until they reach an extreme – and reverse.

Here is what it looked like.

VIX 9th biggest one day move

More importantly, here is what the stock indexes looked like on Google Finance after the close:

Stock market down Korea

Another observation I shared in “No Inflection Point Yet, But…” is that leading stocks can sometimes be more volatile and yesterday was no exception. While the stock indexes were down around -1.5% some of the most popular stocks were down about twice as much:

FANG stocks downSource: Google Finance

Of course, this is all just one day. We’ll see if it continues into a longer trend.

It’s always a good time to manage risk, but sometimes it’s more obvious than others.

Is this the Inflection Point for Stocks?

As if the election result wasn’t enough, the U.S. stock market has surprised most people by trending up since last November.

But, it has been stalling since March. The S&P 500 drifted down about -3% into March and April.

The stock market seems to be at an inflection point now.

Understanding the market state is an examination of the weight of the evidence.

The weight of the evidence seems to suggest defense.

My first indicator is always the actual price trend itself. If we want to know what is going on, there is no better observation than the actual price trend. The price action tells us what force is in control: supply or demand. And, we can see the potential for the inflection point – when the direction is changing. In the chart below, I highlight a recent point of “resistance”. I call it resistance because the stock index hasn’t broken above the March high and is instead drifting sideways.

average age of bull market top

Investors sometime assume a prior price high will automatically become “resistance” just because it’s the price range they expect to see the price trend stall. Resistance is the price level where selling is expected to be strong enough to prevent the price from rising further. We can see that recently in the chart. As the price advances towards the prior peak, supply may overcome demand and prevent the price from rising above resistance. For example, it may be driven by investors who wished they had sold near the prior peak and had to wait as the price recovered again. They anchor to that prior high. Once it gets back to the prior peak, they exit. Prior highs don’t always become “resistance” as expected. Sometimes demand is strong enough to break through and keep trending up. At this point, we see there has been some resistance at the prior high. I highlighted it in yellow in the chart above. So, we shouldn’t be surprised to see the price decline if this resistance holds for a while. Or, it could be an inflection point.

The S&P 500 stock index is mainly large companies. Smaller companies tend to lead larger companies. Their price trends move in a wider range and they sometimes move faster, so they get to a point sooner. That’s why we say small company stocks “lead” large company stocks. In that case, I highlight below that the small company stock index, the S&P 600 Small Cap ETF, reached its prior, but found resistance and reversed down. The soldiers may lead the way for the Generals.

Small Cap

It seems that the stock index is stalling at a time when investors are complacent. When investors are complacent or overly optimistic an inflection point is more likely. The CBOE Volatility Index® (VIX® Index)  is very low. The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX® historically trends between a long-term range. When the VIX® gets to an extreme, it becomes more likely to eventually reverse. In the chart below I show the price level of the VIX® since its inception in 1993. We can see its long-term average is around 20. I highlighted in red its low range is around 12 and it has historically spiked as high as 25 or 60. This means the traders of options are expecting lower volatility in the weeks ahead at a time when other things seem to suggest otherwise.

As I continue sharing some observations, I’m going to get farther away from my main decision maker which is the directional price trend, but you’ll see how these indicators help to quantify the state of the trend and the potential for an inflection point. As we keep going, keep in mind that indicators are a derivative of the price at best or a derivate of something unrelated to the directional price trend. In the case of the VIX® Index index above, it’s a measure of options (a derivative) on the stocks in the S&P 500. When we start looking at things like economic growth and valuations we are necessarily looking at things that are a derivative of price, but not as absolute as the price trend itself. The direction of the price trend is the arbiter.

Another signal of an inflection point is breadth. That is, what percent of stocks are rising or falling. Since I have mentioned the S&P 500 stock index, I’ll show the S&P 500 Bullish Percent Index below. The Bullish Percent is a breadth indicator based on the number of stocks on Point & Figure buy signals. Developed by Abe Cohen in the mid-1950s, the Bullish Percent Index was originally applied to NYSE stocks. Cohen was the first editor of ChartCraft, which later became Investors Intelligence. BP signals were further refined by Earl Blumenthal in the mid 70’s and Mike Burke in the early 80’s. The S&P 500 Bullish Percent shows a composite of the 500 stocks in the S&P 500 index that are in a positive trend. The S&P 500 Bullish Percent recently reversed to a column of O’s from a high point of 80, which means about 80% of the S&P 500 stocks were in a positive trend and about 8% of them are now in a negative trend. In addition to the direction, the level is important because we consider the level above 70% or 80% to be a higher risk (red zone) and the levels below 30% to be lower risk (green zone). So, more and more stocks within the index are starting to decline. This weak “breadth” or participation could be a signal of a change in trend.

Bullish Percent

I’m not necessarily a big user of economic indicators. I believe the stock indexes are the leading indicator for the economy, so that’s my guide. However, I have a strong sense of situational awareness so I like to understand what in the world is going on. The total return of stocks is a function of three things: earnings growth + dividend yield + P/E ratio expansion or contraction. Since earnings growth has made up nearly 5% of the historical total return of the S&P 500 since 1926, it does matter in the big picture in regard to expected return. Today, we observe the headline in the Wall Street Journal:

GDP Slows to Weakest Growth in Three Years

The U.S. economy’s output grew at the slowest pace in three years during the first quarter, underscoring the challenges facing the Trump administration as it seeks to rev up growth.

The New York Times says:

G.D.P. Report Shows U.S. Economy Off to Slow Start in 2017

■ The economy barely grew, expanding at an annual rate of only 0.7 percent.

■ The growth was a sharp decline from the 2.1 percent annual rate recorded in the final quarter of last year. It was the weakest quarterly showing in three years.

■ Consumption, the component reflecting individual spending, rose by only 0.3 percent, well below the 3.5 percent rate in the previous quarter.

The Takeaway

The first-quarter performance upset expectations for a Trump bump at the start of 2017.

If you want an economic catalyst for why prices could stall or reverse down, there you go. You see, earnings growth of stocks is part of GDP. GDP is the sales of all U.S. companies, private and public. The earnings growth of the S&P 500 is the earnings of those 500 companies. In other words, GDP of the economy is highly connected to EPS of an index of 500 stocks.

This recent stall in the price trend and economic growth along with a dash of complacency comes at a time when stocks are “significantly overvalued”, according to my friend Ed Easterling at Crestmont Research:

“In the first quarter the stock market surged 5.5%, well more than underlying economic growth. As a result, normalized P/E increased to 29.4—significantly above the level justified by low inflation and low interest rates. The current status remains “significantly overvalued.” The level of volatility plunged over the past quarter and is now in the lowest 4% of all periods since 1950. The trend in reported earnings for the S&P 500 Index reflects a repeating pattern of overly-optimistic analysts’ forecasts. Earnings and volatility should be watched closely and investors should heighten their sensitivity to the risks confronting an increasingly vulnerable market.”

Oh, and one more thing: Monday will be May. I’m not a huge fan of using seasonality as an indicator to enter or exit the stock market, but there is some tendency for certain periods to gain or lose value historically. For example, a common seasonality is “Sell in May and go away”. Depending on the historical time frame you look and which index, some periods show a “summer slump”. One theory is many investors and traders go on vacation in the summer, so volume is light. They return after the summer and take more action.

So, maybe this will be a good time to sell in May and go away. Not because it’s May, but instead because the weight of the evidence suggests this could be an inflection point.

We’ll see.

March 9th is the Bull Market’s 8-Year Anniversary

I observed many headlines pointing out that March 9th is the 8th anniversary of the current bull market in U.S. stocks.

The rising trend in stocks is becoming one of the longest on record. It is the second longest, ever.

Looking at it another way, March 9, 2009 was the point that stock indexes had fallen over -50% from their prior highs.

Since most of the discussion focuses on the upside over the past 8 years, I’ll instead share the other side so we remember why March 9, 2009 matters.

 ‘Those who cannot remember the past are condemned to repeat it.’

– George Santayana

When investors speak of the last bear market they mostly call it “2008” or “o8”.

However, the end of the last bear market was actually March 9, 2009 and the beginning was October 2007.

Below is a chart of the S&P 500 stock index from October 9, 2007 to March 9, 2009. The price decline was -56%.

No one knew that March 9, 2009 was the lowest it would go. It could have gotten much worse.

Talking only about the gains since the low leaves out the full story.

When we research price trends, we must necessarily consider the full market cycle of both rising and falling trends. For example, below is the price trend since the peak nearly 10 years ago on October 9, 2007.  Even after such a large gain, the Risk-to-Reward Ratio isn’t so good if you had to hold through the big loss to achieve it. That is, investors had to experience -56% on the downside for how much gain?

It isn’t the upside that causes so much trouble, it’s the downside.

That’s why we must manage risk to increase and decrease exposure to the possibility of gain and loss.

Asymmetric Volatility

Volatility is how quickly and how far data points spread out.

Asymmetric is not identical on both sides, imbalanced, unequal, lacking symmetry.

This time of year we are reminded of asymmetric volatility in the weather. The wide range in the temperature is highlighted in the morning news.

This morning, it’s 72 degrees and sunny down south and below freezing and snowing up north.

asymmetric-volatility

Source: MyRadar

Some of the news media presents the variation in a way that invites relative thinking. Just like the financial news programs that show what has gained and lost the most today, the weather shows the extreme highs and lows.

Those who watch the financial news may feel like they missed out on the stock or market that gained the most, then be glad they weren’t in one that lost the most. Some feelings may be more asymmetric: they feel one more than the other.

Prospect Theory says most of us feel a loss much greater that we do a gain. It’s another asymmetry: losses hurt more than gains feel good (loss aversion).

If you are up north trying to stay warm, you may wish you were down south sitting on the beach.

If you are down south trying to stay cool, you may wish you were up north playing in the snow!

It really doesn’t matter how extreme the difference is (the volatility). The volatility is what it is. Volatility is just a range.

What matters is what we want to experience.

If we want to experience snow we can fly up north.

If we want to experience sunny warmth we can fly down south.

If we want less volatility, we could live down south in the winter and up north in the summer.

We get to decide what we experience.

So Goes January, So Goes the Year?

 

Focusing on an arbitrary time frame is called “reference dependence.” It regards the comparative nature of human perception. It also concerns the tendency of people to compare things to some reference point. Perception of an outcome depends on the reference point that a person chooses. The reference point or time frame is arbitrary and is based on random choice or personal whim.

The idea of reference dependence reminds me of when I watched Arkansas play Virginia Tech in the Belk Bowl last week.

After the first quarter, Arkansas was beating Virgina Tech 17-0. If we judged the game at that reference point, the score was so one-sided that it seemed like Arkansas was going to decimate Virginia Tech.

arkansas-virginia-tech-first-halfSource: http://secsports.go.com/scores/football/arkansas-razorbacks

By halftime, the score was 24-0. Arkansas was ahead by three touchdowns and a field goal. The momentum was evident. The game appeared to be a terrible mismatch. If we placed bets, it would have been for Arkansas to win the game. At that point, this outcome was most probable.

When a game is close, fans “watch it closely.” However, when the score broadened to 24- 0, many fans probably stopped paying attention and expected Arkansas to be the winner.

Yet football has four quarters, not just two.

Three touchdowns and a field goal are a tough lead to overcome. It would require Virginia Tech first to play very well with their defense so as to prevent Arkansas from scoring more points against them. Then, they would need their offense to score many touchdowns and field goals just to catch up.

In the third quarter, that’s exactly what they did.

arkansas-virginia-tech-final-score

By the end of the third quarter, Virginia Tech had scored 21 points to make the score 21–24. In the final and fourth quarter, they scored another 14 points to take the lead 35–24. They scored 35 points, and their defense held Arkansas to zero in the second half. It was a high-volatility game – swinging from one extreme in one period to another extreme in the next.

Now, look at it from the perspective of a Virginia Tech fan. By halftime, they were losing 0–24. All hope was gone. They may have stopped watching. If they were at the game, they might have left at halftime.

The end of the game was the only time frame that mattered.

Global markets operate in the same way. Our perception is just the result of our reference point – the time frame we choose. Below is the S&P 500 stock index over 18 months from January 2015 to June 2016. Overall, it was non-trending and volatile.

non-trending-stock-market-period

It wasn’t just U.S. stocks. Developed countries and Emerging Markets countries declined even more as they trended in wider swings.

global-market-trends-returns-asymmetric

 

You can probably see why very few people invest all their money all the time in the stock market. It doesn’t matter how much the return is if the risk is so high that you reach your uncle point before it’s achieved. At some point, investors decide to look, and when they do, their perceptions depend on the reference point they choose. For this reason, global markets require risk management, and investors need behavioral management. If the swings of 10% to 25% observed over the past two years aren’t enough to shake out every investor, the declines of -50% or more that we’ve seen the past fifteen years probably are.

Much like the Belk Bowl, the stock index was down and out for most of the period but ended the year positively in the final quarter.

last-quarter-spy

 

As investors, our most important reference point is, ultimately, our full investment time horizon. For most people, that means their entire lifespan. For those who establish trusts, foundations, or endowments with their money, their reference point goes beyond their own lives. Investment management is different from football in that the score compounds for as long as you have money invested. It is not just one season, or one quarter, or a single game.

The end is the only time frame that matters. Everything in between is just you deciding to compare one reference to another.

I titled this observation, “So Goes January, So Goes the Year.”

You can probably see how arbitrary it is to say that.

By the way, you can see on the chart that the stock market dropped sharply last January, but it ended positively for the year.

“So Goes January, So Goes the Year”?

Not always.

The end is the only time frame that really matters.

Investor Optimism is Reaching Extreme

As it often does, the U.S. stock market trended the complete opposite of what market pundits expected after the election.

Clearly, a Presidential election can be the blame for volatility we saw this year before the election. However, instead of crashing down U.S. stocks regained their previous losses quickly. Along with that, investor sentiment shifted from fearful a month ago to much more optimistic as prices trended up. At this point, investors have probably forgotten how volatile markets were the first part of 2016. Once the losses are regained, they eventually forget the stock indexes were down -12% or more in January and February.

Investors tend to get optimistic (or even greedy) after prices have gone up and then fearful after prices go down.

I am not necessarily a contrarian investor. I mainly want to be positioned in the direction of global markets and stay there until they change. But markets sometimes get to an extreme – increasing the probability of a reversal. At this point, a tactical trader can hedge, reduce exposure, realize profits, or wait until an actual reversal to respond.

My purpose of pointing out these extremes in investor sentiment (fear and greed) is to illustrate how investors’ feelings oscillate between the fear of missing out (if global markets have gone up and they aren’t in them) and the fear of losing money (if they are in global markets and they are falling). Fear and greed is a significant driver of price trends. When stock market investor sentiment reaches an extreme, it often reverses trend afterward.

Indicators suggest that investors are pursuing higher risk strategies and that investor optimism has reached a short-term extreme. I like to use the Fear & Greed Index that is a simple snapshot for anyone to see. Below is the reading as of yesterday as it reached “Extreme Greed.”

cnn-fear-greed-index

We shouldn’t be surprised to see the recent upward price trend reverse down, at least temporarily.

Along with that, we could see investor sentiment reverse from “Extreme Greed” to “Fear” as prices fall.

It’s OK to feel and experience your feelings… if you feel the right feeling at the right time.

Indicators like this can help investors observe how they tend to feel the wrong feeling at the wrong time.

 

To learn more, below are some of my previous observations about sentiment reaching an extreme greed level of optimism.

Investor Optimism Seems Excessive Again

It’s official: extreme greed is driving the stock market

What emotion is driving the market now? Extreme Greed

Essence of Portfolio Management

Essence of Portfolio Management

“The essence of investment management is the management of risks, not the management of returns. Well-managed portfolios start with this precept.”

– Benjamin Graham

The problem is many portfolio managers believe they manage risk through their investment selection. That is, they believe their rotation from one seemingly risky position to another they believe is less risk is a reduction in risk. But, the risk is the exposure to the chance of a loss. The exposure is still there. Only the perception has changed: they just believe their risk is less. For example, for the last thirty years, the primary price trend for bonds has been up because interest rates have been falling. If a portfolio manager shifts from stocks to bonds when stocks are falling, bonds would often be rising. It appears that trend may be changing at some point. Portfolio managers who have relied on bonds as their safe haven may rotate out of stocks into bonds and then their bonds lose money too. That’s not risk management.

They don’t know in advance if the position they rotate to will result in a lower possibility of loss. Before 2008, American International Group (AIG) carried the highest rating for an insurance company. What if they rotated to AIG? Or to any of the other banks? Many investors believed those banks were great values as their prices were falling. They instead fell even more. It has taken them a long time to recover some of their losses. Just like tech and telecom stocks in 2000.

All risks cannot be hedged away if you pursue a profit. If you leave no chance at all for a potential profit, you earn nothing for that certainty. The risk is exposure to an unknown outcome that could result in a loss. If there is no exposure or uncertainty, there is no risk. The only way to manage risk is to increase and decrease the exposure to the possibility of loss. That means buying and selling (or hedging).  When you hear someone speaking otherwise, they are not talking of active risk management. For example, asset allocation and Modern Portfolio Theory is not active risk management. The exposure to loss remains. They just shift their risk to more things. Those markets can all fall together, as they do in real bear markets.

It’s required to accomplish what the family office Chief Investment Officer said in “What a family office looks for in a hedge fund portfolio manager” when he said:

“I like analogies. And one of the analogies in 2008 brings to me it’s like a sailor setting his course on a sea. He’s got a great sonar system, he’s got great maps and charts and he’s perhaps got a great GPS so he knows exactly where he is. He knows what’s ahead of him in the ocean but his heads down and he’s not seeing these awesomely black storm clouds building up on the horizon are about to come over top of him. Some of those managers we did not stay with. Managers who saw that, who changed course, trimmed their exposure, or sailed to safer territory. One, they survived; they truly preserved capital in difficult times and my benchmark for preserving capital is you had less than a double-digit loss in 08, you get to claim you preserved capital. I’ve heard people who’ve lost as much as 25% of investor capital argue that they preserved capital… but I don’t believe you can claim that.Understanding how a manager managed and was nimble during a period of time it gives me great comfort, a higher level of comfort, on what a manager may do in the next difficult period. So again it’s a it’s a very qualitative sort of trying to come to an understanding of what happened… and then make our best guess what we anticipate may happen next time.”

I made bold the parts I think are essential.

If you are like-minded and believe what we believe, contact us.

Situational Awareness

Chuck Yeager was a famous test pilot and the first man to fly faster than the speed of sound. He understood the risk, so he was prepared.

Chuck Yeager

“I was always afraid of dying. Always. It was my fear that made me learn everything I could about my airplane and my emergency equipment, and kept me flying respectful of my machine and always alert in the cockpit.”

– Brigadier General Chuck Yeager
Yeager, An Autobiography

Image source: http://www.chuckyeager.com/

 

What in the World is Going on?

The trend has changed for U.S. stocks since I shared my last observation. On January 27th I pointed out in The U.S. Stock Market Trend that the directional trend for the popular S&P 500®  U.S. large cap stock index was still up, though it declined more than -10% twice over the past year. At that point, it had made a slightly lower high but held a higher low. Since then,  theS&P 500® declined to a lower low.

First, let’s clearly define a trend in simple terms. A trend is following a general course of direction. Trend is a direction that something is moving, developing, evolving, or changing. A trend is a directional drift, one way or another. I like to call them directional trends. There is an infinite number of trends depending on the time frame. If you watch market movements daily you would probably respond to each day’s gain or loss thinking the trend was up or down based on what it just did that day. The professional traders who execute my trades for me probably consider every second a trend because they want to execute the buy or sell at the best price. As a tactical position trader, I look at multiple time frames from months to years rather than seconds or a single day.  So, trends can be up over one time frame and down over another.

As we observe the direction of  “the trend”, let’s consider the most basic definitions over some specific time frame.

  • Higher highs and higher lows is an uptrend.
  • Lower lows and lower highs is a downtrend.
  • If there is no meaningful price break above or below those prior levels, it’s non-trending.

Below is the past year of the S&P 500® stock index, widely regarded as a representation of large cap stocks. Notice the key pivot points. The top of the price trend is lower highs. The bottom of the range is lower lows. That is a “downtrend” over the past year. It could break above the lower highs and hold above that level and shift to an uptrend, but for now, it is a downtrend. It could also keep swinging up and down within this range as it has the past year, or it could break down below the prior low. At this moment, it’s a downtrend. And, it’s a downtrend occurring after a 7-year uptrend that began March 2009, so we are observing this in the 7th year of a very aged bull market. As I said in The REAL Length of the Average Bull Market, the average bull market lasts around 4 years. This one was helped by unprecedented government intervention and  is nearly double that length.

stock market downtrend

Another interesting observation is the trend of small and mid-size company stocks. In the next chart, we add small and mid-size company stock indexes. As you see, they are both leading on the downside. Small and mid-size company stocks have made even more pronounced lower highs and lower lows. Market trends don’t always play out like a textbook, but this time, it is. For those who want a story behind it, small and mid-size company stocks are expected to fall first and fall more in a declining market because smaller companies are considered riskier. On the other hand, they are expected to trend up faster and stronger since a smaller company should reflect new growth sooner than a larger company. It doesn’t always play out that way, but over the past year, the smaller companies have declined more. Large companies could catch up with them if the declining trend continues.

small and mid cap underperformance relative strength momentum

What about International stocks? Below I included International indexes of developed countries (EFA) with exposure to a broad range of companies in Europe, Australia, Asia, and the Far East. I also added the emerging markets index (EEM) that is exposure to countries considered to be “emerging” like China, Brazil, and India. Just as small U.S. stocks have declined more than mid-sized and mid-sized have declined more than large companies, emerging markets and developed International countries have declined even more than all of them.

global market trends

What in the world is going on?

Well, within U.S. and International stocks, the general trends have been down. This could change at any time, but for now, it is what it is.

You can probably see why I think actively managing risk is so important. 

 

This is not investment advice. If you need individualized advice please contact us or your advisor. Please see Terms and Conditions for additional disclosures. 

Risk comes from not knowing what you are doing so wide diversification is only required when investors are ignorant.”  – Warren Buffett

 

quote-risk-comes-from-not-knowing-what-you-are-doing-so-wide-diversification-is-only-required-warren-buffett-125-94-63

Sourcce: http://www.azquotes.com/quote/1259463

 

 

The U.S. Stock Market Trend

When we define the direction of a trend, we consider the most basic definitions.

  • Higher highs and higher lows is an uptrend.
  • Lower lows and lower highs is a downtrend.
  • If there is no meaningful price break above or below those prior levels, it’s non-trending.

Below is the past year of the S&P 500® stock index, widely regarded as a representation of large cap stocks. Notice a few key points. The top of the price range is just that: a range, with no meaningful breakout. The bottom is the same. The price trend has dropped to around the same level three times and so far, has trended back up. What’s going to happen next? At this point, this stock market index is swinging up and down. It would take a meaningful break below the prior low that holds to make a new “downtrend”. It could just as well trend up. We could put an exit point below those prior lows and let it all unfold.

Stock market trend

Of course, as I’ve mentioned a lot the past several months, other global markets and small company U.S. stocks and mid-cap stocks have been much weaker than large U.S. stocks and certain sectors within the U.S. You can read the details of this in The Stock Market Trend: What’s in Your Boat? As I pointed out then, in the chart below we can see the mid-size and small cap stocks have actually declined much more. But, the capitalization-weighted indexes are driven by their sector exposure.

small cap mid cap stocks

Some U.S. sectors are still holding up and still in uptrends. Below is the Technology sector index, for example. I consider this an uptrend, though volatile. Less volatile trends are easier to hold, more volatile trends are more difficult unless we focus on the directional trend.

Tech Sector Trend

Below is the U.S. Healthcare sector. It’s down, but not out. It’s still so far holding a higher low.

healthcare sector

The really weak markets that have been in more clear downtrends are the commodity related sectors like Energy and Basic Materials.  This could signal the beginning of a larger move down in other sectors if they follow, or not. But if we focus on “what’s in our boat” we are focused only on our own positions.

Energy Sector basic materials

The key to tactical decision-making is sometimes holding exposure to potentially positive trends and giving them room to see how they unfold: up or down. The other key is avoiding the clearest downtrends. Then, there comes a point when those trends change and reverse. Even the downtrends eventually become uptrends. We can be assured after that happens everyone will wish they had some exposure to it!

Never knowing for sure what will happen next it always involves uncertainty and the potential for a loss we must be willing to bear. I think the edge is predefining risk by knowing at what point to exit if the trend has really changed, accepting that, then letting it all unfold.

 

Extreme Fear is Now Driving Markets

On October 27th I wrote in Fear and Greed is Shifting and Models Don’t Avoid the Feelings that:

The CNN Fear & Greed Index shows investor fear and greed shifted to Extreme Fear a month ago as the popular U.S. stock indexes dropped about -12% or more. Many sectors and other markets were worse. Since then, as prices have been trending back up, Greed is now the driver again. I believe fear and greed both drives market prices but also follows price trends. As prices move lower and lower, investors who are losing money get more and more afraid of losing more. As prices move higher and higher, investors get more and more greedy. If they have reduced exposure to avoid loss, they may fear missing out.

Since global markets declined around August and some markets recovered much of their losses by November, global markets have declined again. Below are charts of U.S. stocks, International stocks, U.S. bonds, and commodities. Even the iShares iBoxx $ Investment Grade Corporate Bond ETF that seeks to track the investment results of an index composed of U.S. investment grade corporate bonds is near -8% from its peak. Small and mid companies U.S. stocks are down more than -20% from their peak. Commodities and emerging countries are down the most.

global markets 2016-01-15_13-59-45.jpg

This all started with investors being optimistic in late October as I mentioned in Fear and Greed is Shifting and Models Don’t Avoid the Feelings. So, it is no surprise that today is just the opposite. As markets have declined investors become more and more fearful. As of now, Extreme Fear is the driver of the market.  Below is the current reading of the CNN Fear & Greed Index.

Fear and Greed Index

Source: CNN Fear & Greed Index 

As you see in the chart below, it’s now getting close to the Extreme Fear levels that often signal at least a short-term low.

Fear and Greed Over Time

Another publicly available measure of investor sentiment is the AAII Investor Sentiment Survey. The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. The most recent weekly survey shows investors are very bearish and again, such pessimism occurs after price declines and at such extremes sometimes precedes a reversal back up.

Survey Results for Week Ending 1/13/2016

AAII Investor Sentiment January 2016

Source: AAII Investor Sentiment Survey

I say again what I said in October: This is the challenge in bear markets. In a bear market, market prices swing up and down along the way. It’s these swings that lead to mistakes. Above was a chart of how the Fear and Greed Index oscillates to high and low points over time. Investors who experience these extremes in emotion have the most trouble and need to modify their behavior so they feel the right feeling at the right time. Or, hire a manager with a real track record who can do it for them and go do something more enjoyable.

The Starting Point Matters

For long term investors who buy and hold, the risk/reward expectations are sometimes very, very, simple.

If you bought the long term U.S. Treasury index via the iShares 20+ Year Treasury Bond ETF (Symbol: TLT) about 12 years ago your yield is around 5% and the total return has been 100%.

Keep in mind, the total return is price appreciation + interest (or yield).

At this starting point, if you are buying it today, your yield is 2.6%… so the expected future total return from the yield is half.

Bond Return Rising Rates

Clearly, the expected total return for bonds is much lower today than just over 10 years ago.

Since the yield is lower, the risk/reward payoff isn’t as positive. The lower yield limits the upside for price appreciation.

There may be times this long term U.S. Treasury is the place to be and times it isn’t.

But over a longer expectation, it’s much less attractive than it was.

No market or security performs well in all conditions, so traditional allocation often holds positions with a negative risk/return profile.

You can probably see why I think it’s critical to be unconstrained and flexible rather than a fixed allocation that ignores the current condition.

Fear and Greed is Shifting and Models Don’t Avoid the Feelings

Investors are driven by fear and greed. That same fear and greed drives market prices. It’s Economics 101 “Supply and Demand”. Greed drives demand, fear drives selling pressure. In fact, investors are driven by the fear of losing more money when their account is falling and fear missing out if they have cash when markets go up. Most investors tend to experience a stronger feeling from losing money than they do missing out. Some of the most emotional investors oscillate between the fear of missing out and the fear of losing money. These investors have to modify their behavior to avoid making mistakes. Quantitive rules-based systematic models don’t remove the emotion.

Amateur portfolio managers who lack experience sometimes claim things like: “our quantitive rules-based systematic models removes the emotion”. That couldn’t be further from the truth. Those who believe that will eventually find themselves experiencing feelings from their signals they’ve never felt before. I believe it’s a sign of high expectations and those expectations often lead to even stronger reactions. It seems it’s the portfolio managers with very little actual performance beyond a backtest that make these statements. They must believe a backtested model will act to medicate their feelings, but it doesn’t actually work that way. I believe these are the very people who over optimize a backtest to make it perfectly fit historical data. We call it “curve-fitting” or “over-fitting”, but it’s always “data mining”. When we backtest systems to see how they would have acted in the past, it’s always mining the data retroactively with perfect hindsight. I’ve never had anyone show me a bad backtest. If someone backtests entry and exit signals intended to be sold as a managed portfolio you can probably see how they may be motivated to show the one that is most optimized to past data. But, what if the future is very different? When it doesn’t work out so perfectly, I think they’ll experience the very feelings they wish to avoid. I thought I would point this out, since many global markets have been swinging up and down. I’m guessing some may be feeling their feelings.

The CNN Fear & Greed Index shows investor fear and greed shifted to Extreme Fear a month ago as the popular U.S. stock indexes dropped about -12% or more. Many sectors and other markets were worse. Since then, as prices have been trending back up, Greed is now the driver again. I believe fear and greed both drives market prices but also follows price trends. As prices move lower and lower, investors who are losing money get more and more afraid of losing more. As prices move higher and higher, investors get more and more greedy. If they have reduced exposure to avoid loss, they may fear missing out.

CNN Fear and Greed IndexSource: http://money.cnn.com/data/fear-and-greed/

This is the challenge in bear markets. In a bear market, market prices swing up and down along the way. It’s these swings that lead to mistakes. Below is a chart of how the Fear and Greed Index oscillates to high and low points over time. Investors who experience these extremes in emotion have the most trouble and need to modify their behavior so they feel the right feeling at the right time. Or, hire a manager with a real track record who can do it for them and go do something more enjoyable.

Fear and Greed Over time investor sentiment

Source: http://money.cnn.com/data/fear-and-greed/

The markets always go back up?

Someone recently said: “the markets always go back up!”.

I replied: “Tell that to the Japanese”.

The chart below speaks for itself. Japan was the leading country up until 1990. The NIKKEI 225, the Japanese stock market index, has been in a “Secular Bear Market” for about 25 years now. I believe all markets require active risk management. I suggest avoiding any strategy that requires a market “always go back up” because it is possible that it may not. Or, it may not in your lifetime

Long Term Japan Stock Market Index NIKKEI

Source: http://www.tradingeconomics.com/japan/stock-market

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Investing involves risk a client must be willing to bear.

Actively Managing Investment Risk

The global market declines in early August offered a fine example of the kind of conditions that cause me to exit my long positions and end up in cash. For me, this is a normal part of my process. I predefine my risk in each position, so I know my risk across the portfolio. For example, I know at what point I’ll sell each position if it falls below a certain point in which I would consider it a negative trend. Since I know my exit in advance for each position, I knew in advance how much I would lose in the portfolio if all of those exits were reached due to market price movements trending against me. That allowed me to control how much my portfolio would lose from its prior peak by limiting it to my predefined amount. I have to take ‘some’ risk in order to have a chance for profits. If I took no risk at all, there could be no profit. The key for me is to take my risk when the reward to risk is asymmetric. That is, when the probability for a gain is much higher than the probability for a loss.

The concept seems simple, but actually doing it isn’t. All of it is probabilistic, never a sure thing.  For example, prices sometimes move beyond the exit point, so a risk control system has to account for that possibility.  More importantly, the portfolio manager has to be able to actually do it. I am a trigger puller. To see the results of over 10 years of my actually doing this, you can visit ASYMMETRY® Managed Accounts.

 

 

Gold Isn’t Always A Hedge or Safe Haven: Gold Stock Trends Have Been Even Worse

For several years we often heard investors suggesting to “buy gold”. We could throw in Silver here, too. They provide many theories about how gold bullion or gold stocks are a “safe haven”. I’ve written about the same assumption in Why Dividend Stocks are Not Always a Safe Haven.

In fact, the Market Vectors Gold Miners ETF website specifically says about the gold stock sector:

“A sector that has historically provided a hedge against extreme volatility in the general financial markets”.

Source: http://www.vaneck.com/gdx/

When investors have expectations about an outcome, or expect some cause and effect relationship, they expose themselves in the possibility of a loss trap. I will suggest the only true “safe haven” is cash. 

Below is a 4 year chart of two gold stock ETFs relative to the Gold ETF. First, let’s examine the index ETFs we are looking at. Of course, the nice thing about ETFs in general is they are liquid (traded like a stock) and transparent (we know what they hold).

GLD: SPDR Gold “Shares offer investors an innovative, relatively cost efficient and secure way to access the gold market. SPDR Gold Shares are intended to offer investors a means of participating in the gold bullion market without the necessity of taking physical delivery of gold, and to buy and sell that interest through the trading of a security on a regulated stock exchange.”

GDX: Market Vectors Gold Miners ETF: “The investment seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the NYSE Arca Gold Miners Index. The fund normally invests at least 80% of its total assets in securities that comprise the Gold Miners Index. The Gold Miners Index is a modified market-capitalization weighted index primarily comprised of publicly traded companies involved in the mining for gold and silver.”

GDXJ: Market Vectors Junior Gold Miners ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Market Vectors Global Junior Gold Miners Index. The Index is intended to track the overall performance of the gold mining industry, which may include micro- and small capitalization companies.

Gold stocks vs Gold

Source: Shell Capital Management, LLC created with http://www.stockcharts.com

Clearly, gold has not been a “safe haven” or “provided a hedge against extreme volatility in the general financial markets”. It has instead demonstrated its own extreme volatility within an extreme downward price trend.

Further, gold mining stocks have significantly lagged the gold bullion index itself.

These ETFs have allowed for the trading of gold and gold stocks, SPDR Gold explains it well:

“SPDR Gold Shares represent fractional, undivided beneficial ownership interests in the Trust, the sole assets of which are gold bullion, and, from time to time, cash. SPDR Gold Shares are intended to lower a large number of the barriers preventing investors from using gold as an asset allocation and trading tool. These barriers have included the logistics of buying, storing and insuring gold.”

However, this is a reminder that markets do not always play out as expected. The expectation of a “safe haven” or “hedge against extreme volatility” is not a sure thing. Markets may end up much worst that you imagined they could.  As many global and U.S. markets have been declining, you can probably see why I think it’s important to manage, direct, limit, and control exposure to loss. Though, not everyone does it well. It isn’t a sure thing…

______

For informational and educational purposes only, not a recommendation to buy or sell and security, fund, or strategy. Past performance and does not guarantee future results. Please click the links provide for specific risk information about the ETFs mentioned. Please visit this link for important disclosures, terms, and conditions.

The Trend of the U.S. Stock Market and Sectors Year-to-Date

As of today, the below table illustrates the year-to-date gains and losses for the S&P 500® Index (SPY) and the 9 Sector SPDRs in the S&P 500®. We observe the current and historical performance to see how the U.S. Sectors match up against the S&P 500 Index.

So far, the S&P 500 Index is down -5.68% year-to-date. Only the Consumer Discretionary (XLY) and Health Care (XLV) are barely positive for the year. Energy (XLE) has entered into its own bear market. Materials (XLB) and Utilities (XLU) are in double-digit declines.

year to date S&P 500 and sector returns 2015-09-10_11-31-05

Source: http://www.sectorspdr.com/sectorspdr/tools/sector-tracker

The trouble with a table like the one above is it fails to show us the path the return streams took along the way. To see that. below we observe the actual price trends of each sector. Not necessarily to point out any individual trend, but we can clearly see Energy (XLE) has been a bear market. I also drew a red line marking the 0% year-to-date so point out that much of this year the sectors have oscillated above and below it and most are well below it now.

year to date stock market sector trends 2015-09-10_11-32-40

Source: http://www.sectorspdr.com/sectorspdr/tools/sector-tracker

Speaking of directional price trends is always in the past, never the future. There are no future trends, today. We can only observe past trends. In fact, a trend is today or some time in the past vs. some other time in the past. In this case, we are looking at today vs. the beginning of 2015. It’s an arbitrary time frame, but still interesting to stop and look to see what is going on.

As many global and U.S. markets have been declining, you can probably see why I think it’s important to manage, direct, limit, and control exposure to loss. Though, not everyone does it well as it isn’t a sure thing…

Bonds Aren’t Providing a Crutch for Stock Market Losses

In Allocation to Stocks and Bonds is Unlikely to Give us What We Want and What You Need to Know About Long Term Bond Trends I suggested that bonds may not provide a crutch in the next bear market.

It seems we are already observing that. So far this year, bond indexes have declined along with other markets like stocks and commodities.

Below is a chart of 4 different bond index ETFs year-to-date. I use actual ETFs since they are tradable and present real-world price trends (though none of this is a suggestion to buy or sell). I drew the chart as “% off high” to show the drawdown – how much they have declined off their previous highest price.

Bond ETF market returns 2015

The long-term U.S. Treasury bonds are down the most, but even the others have declined over -3%. That’s certainly not a large loss over a 9 month period, but bond investors typically expect safety and stability. Asset allocation investors expect bonds to help offset their losses in other market allocations like stocks, commodities, or REITs.

Keep in mind: the Fed hasn’t even started to increase interest rates yet. If you are an asset allocation investor, you have to consider:

What may happen if interest rates do start to increase sharply and that drives down bond prices?

What if both stocks and bonds fall in the next bear market?

Bonds haven’t provided much of a crutch this year for fixed asset allocators…

I believe world markets require active risk management and defining directional trends. For me, that means predefining my risk in advance in each position and across the portfolio.

The person who says it cannot be done should not interrupt the person doing it.

– Chinese Proverb

The person who says it cannot be done Should not interupt the person doing it

Source: https://www.pinterest.com/explore/chinese-proverbs/

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