In the final stages of a bull market

In the final stages of a bull market, we normally see a parabolic move to the upside, a final blowoff that gets in the last investors. Buying demand is the response of investor euphoria like I pointed out last week.

An indication of a parabolic move is seen in price channels and confirmed with momentum oscillators. Only time will tell if this is it, but in the chart, I highlight the S&P 500 stock index broke out above an upper moving average channel.

spy spx trend

Price trends usually peak with volatile swings up and down before a larger leg down. Some swing tighter than others, but there is normally a period of “indecision” that precedes an intermediate trend change or drawdown. A drawdown is a decline in the value of an investment or market below its all-time high. Below is the period leading up to the -15% drawdown in the stock index late 2015 – 2016. In the green box, I show the price trend entered a period of swings up and down before breaking an upward trend, drifting more sideways, then a-15% decline.

 

spy eem stock market

Next is the swings in the S&P 500 entered into what became a -18% decline in 2011. My point here is that larger legs down don’t necessarily happen all at once, there are indecisive swings that eventually fall apart.

spy 2011 decline

The top in 2007 presented much larger swings and of course ended up declining -56% over nearly two years afterward. I believe these swings up and down before a larger trend unfolds is indecision among traders and investors. Again, my point here is that larger legs down don’t necessarily happen all at once, we instead observe indecisive swings that eventually fall apart.

spy spx 2007 stock market top

Lastly, here is the 1999 – 2000 peak that also presented wings like the previous peaks. The stock market trend broke above a simple channel a few times before entering a -50% bear market.

stock market top 1999

The current trend just recently stretched above the channel and at the same time, was very overbought for months as measured by the momentum oscillators. This happened at the same time bullish investor sentiment measures was reaching record highs and volatility at historical lows. However, as seen in observations above, the U.S. stock market could just now be entering into a phase of swings up and down that could last for months or years, or it could fall apart sooner. Either way, I make this point for situational awareness.

As a portfolio manager, I don’t need to know for sure what’s going to happen next.  I just know what I’ll do next as trends unfold.

Only time will tell if this is the early stages of an end of an aged bull market or just an interruption of a euphoric “melt up”. We don’t need to know when a major top is in. It doesn’t require an ON/OFF switch. When a big bear market does come, it will be made up of many swings up and down along the way over many months. People will crave to be in, out, in out, in, out, as it all unfolds.  Adaptability is essential: the consistent willingness and ability to alter attitudes, thoughts, and behaviors to appropriately respond to actual or anticipated change in the environment.

Clearly, it’s the swings we have to be prepared for… if we want to avoid a loss trap.  In a loss trap, investors get caught in a loss and have a hard time getting out. When they lose more than they can afford or more than their risk tolerance, they are prone to tap out after large declines. To avoid the loss trap, know your risk tolerance and actively manage risk within that tolerance.

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

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

 

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.

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