Stock prices may not be finished falling, but some opportunities for asymmetric risk-reward may be present for those willing to take risks

Based on my velocity measuring algorithms, the stock indexes are now starting to get oversold. That is, the stock indexes are reaching a point we could see at least a short term countertrend back up, on a short term basis. These measures are based on short term market overreactions, such as when price decline sharply beyond a point we expect mathematically over a period. It certainly doesn’t mean the price trend can’t fall farther as they often do but instead signals a potential countertrend that could drive prices to retrace some of their loss. However, if the downtrend price trend becomes a prolonged and deeper downtrend, these countertrend measures fail to perfectly time the low. Investment management is probabilistic, never a sure thing, so I never expect anything more.

What matters most is if I wanted to take some risk right now on a short term oversold market, I would predefine my exit to cut my loss short if it doesn’t work out and let it rip. We never know for sure in advance when prices will reverse, I can only determine when it is more likely.

The challenge right now, in addition to some other observations I’ve shared recently about valuation, etc. is stock market breadth is far from oversold. So, my breadth measures do not yet suggest any significant selling pressure has been exhausted. I believe when investors sell stocks with great enthusiasm, it shows up in the percent of stocks above and below the trend lines. After prices have plummeted and most of the stocks have fallen into downtrends I start to wonder if the desire to sell is losing steam. At this point, these indicators don’t yet signal a significant panic level selling, so that’s the risk from this point.

I’ll share some of the price trends and indicators I look at when stock prices are falling.

First up is the percent of S&P 500 stocks above their 50-day moving averages. As the chart shows, last month about 82% of the stocks were above their shorter-term trend line. I consider levels above 80% to be a higher risk zone. As we see below, the percent of S&P 500 stocks above their 50-day moving averages made a lower high since January and now is falling at 38%.

breadth percent of stocks below 50 day

While we don’t use it as a market timing indicator, it instead provides some situational awareness of the risk of decline. After most stock prices have already risen, where does more demand come from? At higher levels, I consider the enthusiasm to buy may be becoming exhausted. It once again seems to be what has happened here as investors were enthusiastic about stocks until recently.

Another warning shot across the bow was when this breadth measure failed to confirm an all-time new high in the stock market. Below is the same indicator as above, but I overlayed it with the price trend of the S&P 500. As the SPX trended up to an all-time new high, the percent of S&P 500 stocks above their 50-day moving averages showed a material divergence, indicating fewer stocks were participating in the uptrend. I’ve been monitoring these indicators for two decades now and from my experience, a divergence like this that indicates less participation and “breadth” of the trend is a warning sign. In a healthy uptrend, most stocks are trending higher, so the percent of S&P 500 stocks above their 50-day moving averages is increasing, not decreasing.

breadth failed to confirm new stock market high february 2020

For a longer-term context, below is the percent of S&P 500 stocks above their 200 day moving averages. I consider below 20 or 30% to be an overreaction to the downside, but currently, 66% of stocks are above this longer-term trend line. On the one hand, higher participation is positive, but it’s declining from a relatively high level, which makes it more negative. It also provides us with the awareness that stocks could certainly fall a lot more. The times when less than 20% of these stocks were above their 200-day moving average was periods of notable stock market drawdowns.

percent of stocks above 200 day moving average long term breadth

So, these are some examples of why I started reducing our exposure to zero a month ago and only recently have been increasing exposure by rotating back out of US Treasuries into high dividend yield positions. The nice thing about high dividend yield positions is as the price falls, the dividend yield increases. It’s one time when I buy after prices fall, so we earn the dividend yield from that point forward. My timing is rarely perfect and it doesn’t have to be.

By way of example only, below is a chart of the Alerian MLP Index price and dividend yield. MLP’s are Master Limited Partnerships and in this case, they are publically traded. The Alerian MLP Index is the leading gauge of energy infrastructure Master Limited Partnerships (MLPs). The capped, float-adjusted, capitalization-weighted index, whose constituents earn the majority of their cash flow from midstream activities involving energy commodities, is disseminated in real-time. I’m using this index for illustration to show how (1) the price trend of the MLP index has fallen with energy prices and (2) since its holdings pay high dividend yield, as the price falls, the yield trends up as seen in the chart.

MLP high dividend yield strategy

The purple line shows the dividend yield is 9.41% based on the current price and the price is making a new low. This is one of the most extreme examples right now to make the point. It not only makes the point that buying lower prices in high yield securities can potentially capture asymmetric risk-reward, but also these high yielding securities are not without risks that need to be managed. The risk is made obvious by the price trend chart, which is down -27% over the past year.

As with most things in life, timing is everything. If we had entered a position with the risk/reward profile that existed a year ago, it was more risk than reward, as the high yield income from dividends wouldn’t have been enough to offset the loss from the price decline. But, in the case of exposures that provide higher potential income streams from dividend yield at lower prices, you can probably see how to offset the potential from asymmetric returns from an asymmetric risk-reward payoff. But again, it isn’t so simple and requires risk management, because there is no guarantee stocks, bonds, or MLPs will always keep paying their yields.

In summary, my short term velocity algorithms suggest the popular stock indexes are nearing a short term level we could see a countertrend, but the bigger picture isn’t so positive as there remains plenty enthusiasm to be exhausted. In other words, in late December 2018, my indicators suggested an extreme level of panic selling has happened and it was likely becoming exhausting. It turned out to be exactly what happened. The current measures are nowhere near that level of oversold, but if sellers aren’t panicking to sell it will not get there, either.

At this point, the stock index is only -6% off its high, which is just short of the decline last summer and well within a normal decline. We typically see 2-3 price declines of -5% annually.

february 2020 stock market decline drawdown amount

To put it into context, the current stock market decline is less than 1/3rd of the waterfall decline over a year ago.

stock market historical drawdowns

Only time will tell if the desire to sell is being exhausted. Fortunately, we had already de-risked our portfolio before this started and are now looking to take on new asymmetric risk-reward positions as they present themselves. My risk management and drawdown control systems handle the rest.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. 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 views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

Now, THIS is what a stock market top looks like!

Stock Market Risk is Elevated

I walked out the front door this morning with a cup of coffee to take the pup out and pick up my weekly Barron’s in the driveway.

When I got inside, I opened it up and BEHOLD! 

Barrons cover signal indicator

Gracing the cover of Barron’s is:

“Dow 30,000 THE MARKET’S BIG RUN: Why stocks could vault past the milestone”

I haven’t read the article, as the cover is signal enough for me.

The Magazine cover indicator says that the cover story on the major business magazines is often a contrary indicator.

I’m sure they made a great case for higher stock prices.

The trend is your friend until it ends.

Markets can remain irrational longer than you expect, but there are times when markets overreact and the probability of a trend reversal becomes more and more likely.

This looks like one of those times.

I searched for other headlines:

Dow 30,000 Barron's

I found a few.

barron's dow 30,000 melt up won't stop

And as a friend on Twitter pointed out, it’s way ahead of schedule. In 2017 Barron’s said :

“Next Stop Dow 30,000” and followed with “the Dow could surpass 30,000 by the year 2025.”

dow 30,000 2017 barron's call

So far, Barron’s was right on that prediction. Below is the Dow price trend since the cover in 2017. But, consider the Dow is near 30,000 five years earlier than expected. 

dow performance barron's 2017 30,000 call to 2020

Notwithstanding the Dow is only about 2% from 30,000, the articles are calling for more uptrend. Sure, it’s possible this calm uptrend will continue to drift up without a volatility expansion, but it’s become much less likely as I see it.

I love me some good quiet uptrends, but all good things eventually come to an end.

In the case of equity market trends, these calm uptrends usually end when the majority least expect it.

That seems to be the case now.

Right now, the Dow Jones Industrial Average is signaling the higher likelihood of a volatility expansion. I say this because the Dow price trend has drifted above its average true range volatility channel and the Bollinger Band® lines plotted two standard deviations away from a 20-day simple moving average. These volatility measures visually illustrate volatility expansions and contractions and signal when a price trend moves outside it’s “normal” range. I call it “the normal noise of the market.” Periods of low volatility are often followed by volatility expansions.

dow 30,000 trend

My observations this week seem especially important because risk levels have become more elevated, yet individual investor sentiment is extremely optimistic.

As I’ve had very high exposure to stocks, I have now taken profits in our managed portfolios.

It’s a good time to evaluate portfolio risk levels for exposure to the possibility of loss and determine if you are comfortable with it. 

For more information on my observations that risk is becoming elevated, read:

You probably want to invest in stocks

Investor sentiment is dialed up with stock trends

Is gold a good buy right now?

What’s the stock market going to do next?

Questions, comments, need help? email me here.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. 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 views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

What’s the stock market going to do next?

Last week, I ended “You probably want to invest in stocks” with: Is it a good time to buy stocks? That’s my next observation as I’ll share the big picture.

As promised, here is my observation and insight on the big picture as well as the short term possibilities.

THE BIG PICTURE 

First, I start with the big picture.

The S&P 500 is trading at 31.8 x earnings per share according to the Shiller PE Ratio which is the second-highest valuation level it has been in 150 years. Only in 1999 did the stock index trade at a higher multiple times earnings.

Shiller PE ratio for the S&P 500

This price-earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10.

What is the P/E 10 and how is it calculated?

  1. Look at the yearly earning of the S&P 500 for each of the past ten years.
  2. Adjust these earnings for inflation, using the CPI (ie: quote each earnings figure in 2020 dollars)
  3. Average these values (ie: add them up and divide by ten), giving us e10.
  4. Then take the current Price of the S&P 500 and divide by e10.

The bottom line is, the stock market valuation has been expensive for a while now. The only time I factor in the price-earnings ratio is in the big picture. Although it isn’t a good timing indicator, it is considered a measure of the margin of safety for many investors and at this elevated level, there is no margin of safety by this measure.

As such, risk seems high in the big picture, which suggests investors should access their exposure to the possibility of loss in stocks and stock funds to be prepared for a trend reversal.

WHY MANAGE THE POSSIBILITY OF LOSS? WHY NOW?

That’s about as far as I go with “fundamental valuation” as quantitatively, I know to focus more on the direction of trends, momentum, and volatility.

So, let’s take a look.

STOCK MARKET MOMENTUM SEEMS STRETCHED.

I love me some up trends and momentum, but… sometimes all the gains come in a short period… and that’s what we’ve seen the past three months.

SPX SPY TREND AVERAGE LEVEL PAST YEAR

Just for fun, I included the average level of the S&P 500 (SPX) in the chart to show what level would be “mean reversion” if it happened. I don’t expect it to drop the low, but it’s interesting to see, nevertheless.

Next, I include the relative strength of SPX which measures the velocity of the price trend recently.

S&P relative strength momentum asymmetic returns

I highlighted the upper area red because when relative strength is really high, it often results in a price decline. Think of it as a “too far, too fast” indicator, but like all signals, it’s imperfect.

I highlighted the lower level as green because when prices fall so far, so fast that its relative strength is this low, the trend eventually reverses back up. It’s a measure of selling exhaustion.

Looking at the same data, but from a different angle, here you can see the correlation between the higher and lower relative strength levels and what happened next with the price trend.

SPX SPY RSI RELATIVE STRENGTH

In observing relative strength daily for over two decades now, in my observations, this level of relative strength suggests this is in the high-risk zone.

But, quantitative analysis of price trends is best observed through different confirming indicators.

THE WEIGHT OF THE EVIDENCE 

For the sake of brevity, I’ll skip too much of a detailed definition, but the percent of S&P 500 stocks trading above their 200 day moving average is a measure of market breadth. Market breadth shows us what percent of stocks are participating in the trend. Right now, 87% of the S&P 500 stocks are trading in longer-term uptrends as defined by the 200-day moving average.

percent of stocks above 200 day moving average SPX SPY

The high participation in the trend is a good thing until it reaches higher levels and extremes, then I start wondering where the next buying enthusiasm is going to come from. I start looking for the buying pressure to dry up. The red line I drew marks the three peak levels over the past year for reference.

In case you are wondering, here is how high the current level is relative to the past fifteen years.

investment trading offense and defense risk management

It’s up there.

I analyze markets as to the direction of the trends, momentum, volaltity and investor sentiment.

VOLATILITY LEVEL AND DIRECTION 

When it comes to volatility, I look at both the direction and rate of change in volatility, but also the level. I also split volatility into two completely different parts: implied (expected) volatility and realized (historical) volatility.

Starting with implied volatility, the VIX is extremely low again at 12.19. As we see in this long term chart, volatility cycles up and down over time, but it doesn’t really “revert to the mean.” To illustrate it, I included the long term average of 19.

VIX $VIX LONG TERM AVERAGE OF THE VIX

The bottom line is, implied volatility, which is the expected volatility as implied by options prices shows a very low expected range of prices over the next 30 days. That’s positive until it isn’t.

At such low levels in implied volatility, we should expect to see another volatility expansion.

Next is the historical volatility on the S&P 500 index, which is the 30 Day Rolling Volatility. Here we calculate 30 Day Rolling Volatility as Standard Deviation of the last 30 percentage changes in Total Return Price * Square-root of 252 then multiplying the standard deviation by the square root of 252 to return an annualized measure. 252 is the number of trading days in a year.

I’m sure you needed to hear that. I won’t do it again.

S&P 500 spx spy historical realized volatility expansion

I drew a red line over its history to highlight the current level. Historically, it’s on the low end. Volatility is commonly used as a measure of a security’s riskiness. Typically investors view a high volatility as high risk.

However, the opposite is true.

Volatility decreases over time as price trends up and by the time the price peaks, investors so confident the trend will continue they become very complacent. When volatility is extremely low as it is now, it’s when the risk of a price decline increases.

The opposite is also true. When volatile expands to a high level, it does so because prices have fallen and investors are indecisive, causing the range of stock prices to spread out. Prices spreading out is volatility and we see it spike at stock market lows.

What’s going to happen next?

The trend is up, it’s a quiet uptrend as volatility is contracting, and most stocks are trending up.

Everything is good until it isn’t.

KNOW YOUR RISK LEVEL AND RISK TOLERANCE. 

Everything is impermanent, nothing lasts forever, so this too shall pass and by my measures, it’s getting closer.

So, I implemented my drawdown control and took profits on stocks today.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. 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 views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

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